**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

**ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**Forthe fiscal year ended December 31, 2005**

**CommissionFile Number:  0-18832**

**FIRST FINANCIAL SERVICE CORPORATION**

(Exact name of registrantas specified in its charter)

| **Kentucky**                                |   | **61-1168311**       |
|---------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of            |   | (I.R.S. Employer     |
| incorporation or  organization)             |   | Identification  No.) |
| **2323 Ring Road, Elizabethtown, Kentucky** |   | **42701**            |
| (Address of  principal executive offices)   |   | Zip Code             |

 

Registrant’s telephone number, including areacode:   **(270)765-2131**

Securities registered pursuant to Section 12(g) ofthe Act:

**Common Stock, par value$1.00 per share**

(Title of Class)

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o No x

Indicate by check mark ifthe registrant if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes o No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past ninety days. Yes xNo o

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).  Yes xNo o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K.

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theAct). Yes o No x

The aggregate market valueof the outstanding voting stock held by non-affiliates of the registrant basedon a December 30, 2005 closing price of $28.96 as quoted on the NASDAQNational Market was $91,008,132.Solely for purposes of this calculation, the shares held by directors andexecutive officers of the registrant and by any stockholder beneficially owningmore than 5% of the registrant’s outstanding common stock are deemed to beshares held by affiliates.

As of February 28,2006****there were issued and outstanding****3,983,530****shares of the registrant’s common stock.

**DOCUMENTSINCORPORATED BY REFERENCE**

1.                 Portionsof the Registrant’s Definitive Proxy Statement for the 2006 Annual Meeting ofShareholders to be held May 10, 2006 are incorporated by reference into Part IIIof this Form 10-K.

 

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**FIRST FINANCIAL SERVICE CORPORATION2005 ANNUAL REPORT AND FORM 10-K**

**TABLE OF CONTENTS**

|            | ** ** |                                                                                             | ** ** | **Page** | ** ** |
|------------|------------|---------------------------------------------------------------------------------------------|------------|----------|------------|
|       |       | **Part I.**                                                                            |       |     |       |   |   |
| Item 1.    |       | Business                                                                                    |       |     | 2          |   |   |
| Item  1A.  |       | Risk  Factors                                                                               |       |     | 14         |   |   |
| Item 1B.   |       | Unresolved Staff Comments                                                                   |       |     | 16         |   |   |
| Item 2.    |       | Properties                                                                                  |       |     | 17         |   |   |
| Item  3.   |       | Legal  Proceedings                                                                          |       |     | 17         |   |   |
| Item 4.    |       | Submission of Matters to a Vote of Security Holders                                         |       |     | 17         |   |   |
| ** ** |       | **Part II.**                                                                           |       |     |       |   |   |
| Item 5.    |       | Market for Registrant’s Common Stock and Related  Stockholder Matters                  |       |     | 18         |   |   |
| Item 6.    |       | Selected Financial Data                                                                     |       |     | 19         |   |   |
| Item 7.    |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |       |     | 20         |   |   |
| Item 7A.   |       | Quantitative and  Qualitative Disclosures about Market Risk                                 |       |     | 41         |   |   |
| Item 8.    |       | Financial  Statements and Supplementary Data                                                |       |     | 43         |   |   |
| Item 9.    |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosures      |       |     | 76         |   |   |
| Item 9A.   |       | Controls and Procedures                                                                     |       |     | 76         |   |   |
| Item  9B.  |       | Other  Information                                                                          |       |     | 76         |   |   |
| ** ** |       | **Part III.**                                                                          |       |     |       |   |   |
| Item 10.   |       | Directors and Executive Officers of the Registrant                                          |       |     | 77         |   |   |
| Item 11.   |       | Executive Compensation                                                                      |       |     | 77         |   |   |
| Item 12.   |       | Security Ownership of Certain Beneficial Owners and  Management                             |       |     | 77         |   |   |
| Item 13.   |       | Certain Relationships and Related Transactions                                              |       |     | 77         |   |   |
| Item 14.   |       | Principal Accountant Fees and Services                                                      |       |     | 77         |   |   |
|       |       | **Part IV.**                                                                           |       |     |       |   |   |
| Item 15.   |       | Exhibits and Financial Statement Schedules                                                  |       |     | 78         |   |   |
|       |       | Signatures                                                                                  |       |     | 79         |   |   |

 

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**CautionaryStatement Regarding Forward-Looking Statements**

Certain statements contained in this Annual Report on Form 10-Kthat are not statements of historical fact constitute forward-lookingstatements within the meaning of the Private Securities Litigation Reform Act.In addition, statements in our future filings with the Securities and ExchangeCommission, in press releases or in oral and written statements made by or withour approval that are not statements of historical fact, also constituteforward-looking statements. Examples of forward-looking statements include, butare not limited to: (i) projections of revenue, income or loss, earningsor loss per share, the payment or nonpayment of dividends, capital structureand other financial items, (ii) statements of plans and objectives of oursor our management or board of directors, including those relating to productsor services, (iii) statements of future economic performance and (iv) statements“anticipates”, “expects”, “intends”, “plans”, “targets”, and similarexpressions are intended to identify forward-looking statements but are not theexclusive means of identifying such statements.

Forward-looking statements involve risks anduncertainties, which may cause actual results to differ materially from ourestimates in such statements. In addition to the matters described under “Item1A Risk Factors,” factors that could cause actual results to differ from thosediscussed in the forward-looking statements include, but are not limited to: (i) thestrength of the U.S. economy in general and the strength of the local economiesin the markets in which we operate; (ii) the effects of and changes intrade, monetary and fiscal policies and laws, including interest rate policiesof the Federal Reserve Board; (iii) inflation, prevailing interest rates,market and monetary fluctuations; (iv) the timely development of andacceptance of new products and services and perceived overall value of theseproducts and services by users; (v) changes in consumer spending, borrowing,and savings habits; (vi) technological changes; (vii) acquisitions; (viii) ourability to increase our market share and control expenses; (ix) the effectof changes in laws and regulations (including laws and regulations concerningtaxes, banking, and securities) with which we must comply; (x) the effectof changes in accounting policies and practices, as may be adopted by theregulatory agencies as well as the Financial Accounting Standards Board,(xi) changes in our organization, compensation, and benefits plans;(xii) the costs and effects of litigation and of unexpected or adverseoutcomes in such litigation; and (xiii) our success at managing these andother risks.

Our forward-lookingstatements speak only as of the date on which they are made, and we undertakeno obligation to update any forward-looking statement to reflect events orcircumstances after the date of the statement to reflect the occurrence ofunanticipated events.

**PART I**

**Item 1.**                        Business

First Financial Service Corporation was incorporatedin August 1989 under the laws of the Commonwealth of Kentucky and becamethe holding company for First Federal Savings Bank of Elizabethtown, effectiveon June 1, 1990. Since that date, we have engaged in no significantactivity other than holding the stock of the Bank and directing, planning andcoordinating the business activities of the Bank. Unless the text clearlysuggests otherwise, references to “us,” “we,” or “our” include First FinancialService Corporation and its wholly owned subsidiary. Accordingly, theinformation set forth in this report, including financial statements andrelated data, relates primarily to the Bank and its subsidiaries.   In 2004 we amended our articles ofincorporation to change our name from First Federal Financial Corporation ofKentucky to First Financial Service Corporation.

We are headquartered in Elizabethtown, Kentucky. Wewere originally founded in 1923 as a state-chartered institution and becamefederally chartered in 1940. In 1987, we converted to a federally charteredsavings bank and converted from mutual to stock form. We are a member of theFHLB of Cincinnati and, since converting to a state charter in 2003, have beensubject to regulation, examination and supervision by the Federal DepositInsurance Corporation (“FDIC”) and Kentucky Office of Financial 

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Institutions (“KOFI”). Ourdeposits are insured by the Savings Association Insurance Fund (“SAIF”) andadministered by the FDIC.

On January 8, 2003,we converted to a Kentucky chartered commercial bank from a federally charteredsavings bank. In connection with the conversion, we changed to a fiscal yearending on December 31. This report covers the year ended December 31,2005.

**General Business Overview**

We serve the needs and cater to the economic strengthsof the local communities in which we operate and strive to provide a high levelof personal and professional customer service. We offer a variety of financialservices to our retail and commercial banking customers. These services includepersonal and corporate banking services and personal investment financialcounseling services.

Our full complementof lending services includes:

·       abroad array of residential mortgage products, both fixed and adjustable rate;

·       consumerloans, including home equity lines of credit, auto loans, recreational vehicle,and other secured and unsecured loans;

·       specializedfinancing programs to support community development;

·       mortgagesfor multi-family real estate;

·       commercialreal estate loans;

·       commercialloans to businesses, including revolving lines of credit and term loans;

·       realestate development;

·       constructionlending; and

·       agriculturallending.

We also provide abroad selection of deposit instruments. These include:

·       multiplechecking and NOW accounts for both personal and business accounts;

·       varioussavings accounts, including those for minors;

·       moneymarket accounts;

·       taxqualified deposit accounts such as Individual Retirement Accounts; and

·       abroad array of certificate of deposit products.

We also support ourcustomers by providing services such as:

·       functioningas a federal tax depository;

·       providingaccess to merchant bankcard services;

·       supplyingvarious forms of electronic funds transfer;

·       providingdebit cards and credit cards; and

·       providingtelephone and Internet banking.

Through****ourpersonal investment financial counseling services, we offer a wide variety ofmutual funds, equity investments, and fixed and variable annuities.

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We invest in the wholesale capital markets through themanagement of our security portfolio and use various forms of wholesalefunding. The security portfolio contains a variety of instruments, includingcallable debentures, taxable and non-taxable debentures, fixed and adjustablerate mortgage backed securities, and collateralized mortgage obligations.

Our results of operationsdepend primarily on net interest income, which is the difference betweeninterest income from interest-earning assets and interest expense oninterest-bearing liabilities. Our operations are also affected by non-interestincome, such as service charges, insurance agency revenue, loan fees, gains andlosses from the sale of mortgage loans and gains from the sale of real estateheld for development. Our principal operating expenses, aside from interest expense,consist of compensation and employee benefits, occupancy costs, data processingexpense and provisions for loan losses.

**Market Area Served**

We conduct operations in 14 full-service bankingcenters in six contiguous counties in Central Kentucky along the Interstate 65corridor. Our markets range from the major metropolitan area of Louisville inJefferson County, Kentucky approximately 40 miles north of our headquarters inElizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles southof Elizabethtown. Our markets are supported by a diversified industry base andhave a regional population of over 1 million. Louisville is the 16th largest city in the United States. Our coremarkets have experienced a compound annual growth rate of 5% in deposits forthe past four years. Management anticipates a similar growth rate of ourmarkets for the next few years and believes it is well positioned to benefitfrom this continued growth.

The counties we operate in include Hardin, Nelson,Hart, Bullitt, Meade and Jefferson. Excluding Jefferson County, we control inthe aggregate over 22% of the deposit market share with the next largestcompetitor controlling just 8% of the market. Over the past four years, thesecounties have demonstrated an average growth rate in deposits of 5%. Accordingto the most recent census data, our core markets have experienced a populationincrease of 4%,****a 26% increase in the median homeprice, and a growth in****median familyincome of 22% over the past fourcensus reporting years.

We expanded our presenceinto the Louisville market, primarily through our commercial lending operations.At December 31, 2005, over 21% of our total loan portfolio resides in thismarket. In an effort to better serve these customers and to enhance our retailbranch network in this market, we opened two new full-service state of the artretail facilities in the second quarter of 2004. These facilities represent ourstate of the art prototype branch with a retail-focused design. This designfeatures an internet café with access to online banking and bill paymentservices. Large plasma screens in the lobby provide customers with current newsand information about bank products and services as well as upcoming communityevents. The facilities are staffed to offer a full range of financial servicesto the growing retail and commercial customer base. We have a combined $30million in deposits in these two new facilities, representing a 71% increase indeposits in this market during 2005. Our current deposit market share inLouisville remains under 1% of the current $13.7 billion deposit base. Based onour service-focused operating strategy, we believe we can increase our presencein Louisville, where six large out-of-state holding companies hold the largestdeposit market shares.

**General and Operating Strategies**

Our operating strategy is to serve the needs and caterto the economic strengths of the local communities in which we operate andstrive to provide a high level of personal and professional customer service. Weoffer a variety of financial services to our retail and commercial bankingcustomers.

Our growth strategy is focused on a combination ofacquisitions and expansion in our existing markets through internal growth aswell as establishing new branches.

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*BranchExpansion.**  *Managementcontinues to consider markets for branch expansion. Because of the economicgrowth in our markets over the past several years, we may consider furtherbranch expansion in our current or surrounding market areas. However, we do notrule out branch expansion in other areas experiencing economic growth.

While no new banking centers were opened in Louisvilleduring 2005, we continued to identify future branch sites. Negotiationscontinue on several locations, contingent upon successful rezoning efforts. Ourexpectation is to complete rezoning and begin construction on at least onefacility in the first quarter of 2006 with an anticipated opening date in early2007.

During 2005, we completed a major renovation of ourMt. Washington location in Bullitt County. We have also started construction ona new full service-banking center in Elizabethtown with plans of opening inearly 2006. We are also considering other possible locations within our coremarket area. Our goal is to protect and grow our 22% market share as our coremarket is becoming increasingly competitive.  .

*Acquisitions.**  *Management believes that theconsolidation in the banking industries, along with the easing of restrictionson bank branching, as well as increased regulatory burdens, concerns abouttechnology and marketing, are likely to lead owners of community banks andagencies within the Bank’s market areas to explore the possibility of sale orcombination with a broader-based financial service companies such as ourselves.

In addition, branching opportunities have arisen fromtime to time as a result of divestiture of branches by large national andregional bank holding companies of certain overlapping branches resulting fromconsolidations. As a result, branch locations become available for purchasefrom time to time.

Management’s strategy in assimilating acquisitions isto emphasize revenue growth as well as to continuously review the operations ofthe acquired entities and streamline operations where feasible. Management doesnot believe that implementing wholesale administrative cost reductions inacquired institutions, particularly reducing customer focused personnel, isbeneficial to our long-term growth, because significant administrative changesin community banks can have an adverse impact on customer satisfaction in theacquired institution’s community. However, management has determined thatcertain human resource, and accounting functions can be consolidatedimmediately upon acquisition to achieve higher productivity levels withoutcompromising customer service. Increases in revenue growth are emphasized by offeringcustomers a broader product line consistent with full service banking.

Management is very selective when evaluating apotential acquisition based upon factors such as the operating strategy,market, financial condition, and the culture of the acquisition candidate. Thelast acquisition we made was in July 1998 with the acquisition of threebank branches.

**InternalGrowth.****  **Managementbelieves that its largest source of internal growth is through our ongoingsolicitation program conducted by branch managers and lending officers,followed by referrals from customers. The primary reason for referrals ispositive customer feedback regarding our customer service and response time.

Our goal in continuing our expansion is to maintain aprofitable, customer-focused financial institution. We believe that ourexisting structure, management, data and operational systems are sufficient toachieve further internal growth in asset size, revenues and capital withoutproportionate increases in operating costs. This growth should also allow us toincrease the lending limits, thereby enabling us to increase our ability toserve the needs of existing and new customers. Our operating strategy hasalways been to provide high quality community banking services to our customersand increase market share through active solicitation of new business, repeatbusiness and referrals from customers, and continuation of selected promotionalstrategies.

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We believe that ourbanking customers seek a banking relationship with a service-oriented communitybanking organization. Our operational systems have been designed to facilitatepersonalized service. Management believes our banking locations have anatmosphere that encourages personalized services and decision-making, while weare of sufficient financial size to offer broad product lines to meet customers’needs. We also believe that economic expansion in our market areas willcontinue to contribute to internal growth. Through our primary emphasis oncustomer service and our management’s banking experience, we intend to continueinternal growth by attracting customers and primarily focusing on thefollowing:

·       *Products Offered*—We offer personal andcorporate banking services, mortgage origination, mortgage servicing, personalinvestment, and financial counseling services as well as internet and telephonebanking. We offer a full range of commercial banking services, checkingaccounts, ATM’s, checking accounts with interest, savings accounts, moneymarket accounts, certificates of deposit, NOW accounts, Individual RetirementAccounts, brokerage and residential mortgage services, branch banking, anddebit and credit cards. We also offer installment loans, including auto,recreational vehicle, and other secured and unsecured loans sourced directly byour branches. See “Lending Activities” below for a discussion of products weprovide to commercial accounts.

·       *Operational Efficiencies*—We seek tomaximize operational and support efficiencies consistent with maintaining highquality customer service. Where feasible, we share a common information systemdesigned to enhance customer service and improve efficiencies by providingsystem-wide voice and data communication connections. We have consolidated loanprocessing, bank balancing, financial reporting, investment management,information systems, payroll and benefit management, loan review, and audits.

·       *Marketing Activities*—We focus on a proactive solicitationprogram for new business, as well as identifying and developing products andservices that satisfy customer needs. We actively sponsor community eventswithin our branch areas. We believe that active community involvementcontributes to our long-term success.

**Lending Activities**

**CommercialReal Estate & Construction Lending.**   Thelargest portion of our lending activity is the origination of commercial loansthat are primarily secured by real estate, including construction loans. Theseloans are generated primarily in our market area. In recent years, we have putgreater emphasis on small business lending, originating loans for small andmedium-sized businesses from our various locations.   We make commercial loans to a variety ofindustries. Substantially all of the commercial real estate loans we originatehave adjustable interest rates with maturities of 25 years or less or are loanswith fixed interest rates and maturities of five years or less. At December 31,2005, we had $353.6 million outstanding in commercial real estate loans. Thesecurity for commercial real estate loans includes retail businesses,warehouses, churches, apartment buildings and motels. In addition, the paymentexperience of loans secured by income producing properties typically depends onthe success of the related real estate project and thus may be more vulnerableto adverse conditions in the real estate market or in the economy generally.

Loans secured by multi-family residential property,consisting of properties with more than four separate dwelling units, amountedto $18.5 million of the loan portfolio at December 31, 2005. These loansare included in the $353.6 million outstanding in commercial real estate loansdiscussed above. We generally do not lend above 75% of the appraised values ofmulti-family residences on first mortgage loans. The mortgage loans wecurrently offer on multi-family dwellings are generally one or five year ARMswith maturities of 25 years or less.

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Construction loans involve additional risks becauseloan funds are advanced upon the security of the project under construction,which is of uncertain value before the completion of construction. Theuncertainties inherent in estimating construction costs, delays arising fromlabor problems, material shortages, and other unpredictable contingencies, makeit relatively difficult to evaluate accurately the total loan funds required tocomplete a project, and related loan-to-value ratios. The analysis ofprospective construction loan projects requires significantly differentexpertise from that required for permanent residential mortgage lending. At December 31,2005 we had $13.6 million outstanding in construction loans.

Our underwriting criteria are designed to evaluate andminimize the risks of each construction loan. Among other things, we considerevidence of the availability of permanent financing or a takeout commitment tothe borrower; the reputation of the borrower and his or her financialcondition; the amount of the borrower’s equity in the project; independentappraisals and cost estimates; pre-construction sale and leasing information;and cash flow projections of the borrower.

**CommercialBusiness Lending.**   The commercial business loanportfolio has grown in recent years as a result of our focus on small businesslending. We make secured and unsecured loans for commercial, corporate,business, and agricultural purposes, including issuing letters of credit andengaging in inventory financing and commercial leasing activities.  Commercial loans generally are made tosmall-to-medium size businesses located within our defined market area. Commercialloans generally carry a higher yield and are made for a shorter term than realestate loans. Commercial loans, however, involve a higher degree of risk thanresidential real estate loans due to potentially greater volatility in thevalue of the assigned collateral, the need for more technical analysis of theborrower’s financial position, the potentially greater impact that changingeconomic conditions may have on the borrower’s ability to retire debt, and theadditional expertise required for commercial lending personnel.   Commercial business loans outstanding at December 31,2005 totaled $36.0 million.

**ResidentialReal Estate.****  **Residentialmortgage loans are secured primarily by single-family homes. The majority ofour mortgage loan portfolio is secured by real estate in Hardin, Nelson, Hart,Meade, and Bullitt counties. Fixed rate residential real estate loans weoriginate have terms ranging from ten to thirty years. Interest rates arecompetitively priced within the primary geographic lending market, and varyaccording to the term for which they are fixed. At December 31, 2005 wehad $142.7 million in residential mortgage loans outstanding.

We generally emphasize the origination ofadjustable-rate mortgage loans (“ARMs”) when possible. We offer six ARMproducts with an annual adjustment, which is tied to a national index with amaximum adjustment of 2% annually, and a lifetime maximum adjustment cap of 6%.As of December 31, 2005, approximately 43.7% of our residential realestate loans were adjustable rate loans with adjustment periods ranging fromone to five years and balloon loans of seven years or less. The origination ofthese ARMs can be more difficult in a low interest rate environment where thereis a significant demand for fixed rate mortgages. We limit the maximumloan-to-value ratio on one-to-four-family residential first mortgages to 90% ofthe appraised value and generally limit the loan-to-value ratio on secondmortgages on one-to-four-family dwellings to 90%.

**ConsumerLending.****  **Consumerloans include loans on automobiles, boats, recreational vehicles and otherconsumer goods, as well as loans secured by savings accounts, home improvementloans, and unsecured lines of credit. As of December 31, 2005, consumerloans outstanding were $97.8 million. These loans involve a higher risk ofdefault than loans secured by one-to-four-family residential loans. We believe,however, that the shorter term and the normally higher interest rates availableon various types of consumer loans help maintain a profitable spread betweenthe average loan yield and cost of funds. Home equity lines of credit as of December 31,2005, totaled $41.1 million.

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Our underwriting standards reflect the greater risk inconsumer lending than in residential real estate lending. Among other things,the capacity of individual borrowers to repay can change rapidly, particularlyduring an economic downturn, collection costs can be relatively higher forsmaller loans, and the value of collateral may be more likely to depreciate. TheConsumer Lending Policy establishes the appropriate consumer lending authorityfor all loan officers based on experience, training, and past performance forapproving high quality loans. Loans beyond individual authorities must beapproved by additional officers, the Executive Loan Committee or the Board ofDirectors, based on the size of the loan. We require detailed financial informationand credit bureau reports for each consumer loan applicant to establish theapplicant’s credit history, the adequacy of income for debt retirement, and jobstability based on the applicant’s employment records. Co-signers are requiredfor applicants who are determined marginal or who fail to qualify individuallyunder these standards. Adequate collateral is required on the majority ofconsumer loans. The Executive Loan Committee monitors and evaluates unsecuredlending activity by each loan officer.

The indirect consumer loanportfolio is comprised of new and used automobile, motorcycle and all terrainvehicle loans originated on our behalf by a select group of auto dealers withinthe service area. Indirect consumer loans are considered to have greater riskof loan losses than direct consumer loans due to, among other things:  borrowers may have no existing relationshipwith us; borrowers may not be residents of the lending area; less detailedfinancial statement information may be collected at application; collateralvalues can be more difficult to determine; and the condition of vehiclessecuring the loan can deteriorate rapidly. To address the additional risksassociated with indirect consumer lending, the Executive Loan Committeecontinually evaluates data regarding the dealers enrolled in the program,including monitoring turn down and delinquency rates. All applications areapproved by specific lending officers, selected based on experience in thisfield, who obtain credit bureau reports on each application to assist in thedecision. Aggressive collection procedures encourage more timely recovery oflate payments. At December 31, 2005, total loans under the indirectconsumer loan program totaled $31.6 million.

**Subsidiary Activities**

First Service Corporation of Elizabethtown (“FirstService”) acts as a broker for the purpose of selling investment services toour customers in the area of tax-deferred annuities, government securities,mutual funds, and stocks and bonds. First Service employs four full-timeemployees to perform these services. This investment function operates underlicenses held by First Service. The net income of First Service was $11,000 forthe year ended December 31, 2005.

First Heartland Mortgage Company of Elizabethtown (“FirstHeartland”), through which our secondary market lending department originatesqualified VA, KHC, RHC and conventional secondary market loans on the behalf ofthe investors provides necessary liquidity to us and needed loan products toour customers. We do not service these loans after the sale. During 2005, FirstHeartland originated $45.4 million in loans on the behalf of investors. The netincome of First Heartland Mortgage was $119,000 for the year ended December 31,2005.

First Federal Office Park, LLC, holds commercial lotsadjacent to our home office on Ring Road in Elizabethtown, that are availablefor sale. During the year ended December 31, 2005 lot sales resulted in a$143,000 gain. We are holding three lots for sale in this subsidiary, of theinitial nine lots held for sale.

We provide title insurancecoverage for mortgage borrowers through two subsidiaries:  First Heartland Title, LLC, and First FederalTitle Services, LLC. First Heartland Title is a joint venture with a localtitle insurance company and First Federal Title Services is a joint venturewith a title insurance company in Louisville. We hold a 48% interest in FirstHeartland Title and a 49% interest in First Federal Title Services. Thesubsidiaries generated $157,000 in net income for the year ended December 31,2005, of which our portion was $75,360.

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**Competition**

We face substantial competition both in attracting andretaining deposits and in lending. Direct competition for deposits comes fromcommercial banks, savings institutions, and credit unions located innorth-central Kentucky, and less directly from money market mutual funds andfrom sellers of corporate and government debt securities.

The primary competitive factors in lending areinterest rates, loan origination fees and the range of services offered by thevarious financial institutions. Competition for origination of real estateloans normally comes from commercial banks, savings institutions, mortgagebankers, mortgage brokers, and insurance companies. Retail establishments effectivelycompete for loans by offering credit cards and retail installment contracts forthe purchase of goods and merchandise. We believe that we have been able tocompete effectively in our primary market area.

We have offices in nine cities in six central Kentuckycounties. In addition to the financial institutions with offices in thesecounties, we compete with several commercial banks and savings institutions insurrounding counties, many of which have assets substantially greater than wehave. These competitors attempt to gain market share through their financialproduct mix, pricing strategies, internet banking and banking center locations.In addition, Kentucky’s interstate banking statute, which permits banks in allstates to enter the Kentucky market if they have reciprocal interstate bankingstatutes, has further increased competition for us. We believe that competitionfrom both bank and non-bank entities will continue to remain strong in the nearfuture.

Thefollowing table sets forth our market share and rank in terms of deposits ineach Kentucky county where we have offices. We have two offices in JeffersonCounty, which is Louisville, Kentucky. The Louisville metropolitan area has apopulation of more than one million.

| **County** | ** ** | ** ** | ** ** | **Number of Offices** | ** ** | **FFKY Market Share %** | ** ** | **FFKY Rank** | ** ** |
|------------|------------|------------|------------|---------------------------------|------------|----------------------------------------|------------|--------------------|------------|
| Hardin     |       |       | 4          |                            |       |                                   | 21.0       |               |       |   | 1 |   |   |
| Nelson     |       |       | 2          |                            |       |                                   | 8.0        |               |       |   | 5 |   |   |
| Hart       |       |       | 1          |                            |       |                                   | 17.0       |               |       |   | 3 |   |   |
| Bullitt    |       |       | 2          |                            |       |                                   | 27.0       |               |       |   | 1 |   |   |
| Meade      |       |       | 3          |                            |       |                                   | 56.0       |               |       |   | 1 |   |   |
| Jefferson  |       |       | 2          |                            |       |                                   | <1.0    |               |       |   | N/M |   |   |

 

**Employees**

As of December 31,2005, we had 262 employees, of which 247 were full-time and 15 part-time. Noneof our employees are subject to a collective bargaining agreement, and webelieve that we enjoy good relations with our personnel.

**Regulation**

**GeneralRegulatory Matters.****  **OnJanuary 8, 2003, we converted from a federally chartered savings bank to aKentucky chartered commercial bank. Before the conversion, we were subject tothe regulation of the Office of Thrift Supervision. As a Kentucky charteredcommercial bank, we are now subject to supervision and regulation, whichinvolves regular bank examinations, by both the FDIC and the KOFI. Our depositsare insured by the FDIC. Kentucky’s banking statutes contain a “super-parity”provision that permits a well-rated Kentucky banking corporation to engage inany banking activity in which a national bank operating in any state, a statebank, thrift or savings bank operating in any other state, or a federalchartered thrift or federal savings association meeting the qualified thriftlender test and operating in any state could engage, provided it first obtainsa legal opinion specifying the statutory or regulatory provisions that permitthe activity.

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In connection with the conversion, we registered tobecome a bank holding company under the Bank Holding Company Act of 1956, andare subject to supervision and regulation by the Board of Governors of theFederal Reserve System (the “Federal Reserve Board”). As a bank holdingcompany, we are required to file with the Federal Reserve Board annual andquarterly reports and other information regarding its business operations andthe business operations of its subsidiaries. We are also subject to examinationby the Federal Reserve Board and to operational guidelines established by theFederal Reserve Board. We are subject to the Bank Holding Company Act and otherfederal laws on the types of activities in which we may engage, and to othersupervisory requirements, including regulatory enforcement actions forviolations of laws and regulations.

**Acquisitionsand Change in Control.****  **As a bank holding company, we must obtain FederalReserve Board approval before acquiring, directly or indirectly, ownership orcontrol of more than 5% of the voting stock of a bank, and before engaging, oracquiring a company that is not a bank but is engaged in certain non-bankingactivities. In approving these acquisitions, the Federal Reserve Boardconsiders a number of factors, and weighs the expected benefits to the publicsuch as greater convenience, increased competition and gains in efficiency, againstthe risks of possible adverse effects such as undue concentration of resources,decreased or unfair competition, conflicts of interest or unsound bankingpractices. The Federal Reserve Board also considers the financial andmanagerial resources of the bank holding company, its subsidiaries and anycompany to be acquired, and the effect of the proposed transaction on theseresources. It also evaluates compliance by the holding company’s financialinstitution subsidiaries and the target institution with the CommunityReinvestment Act. The Community Reinvestment Act generally requires eachfinancial institution to take affirmative action to ascertain and meet thecredit needs of its entire community, including low and moderate incomeneighborhoods.

Federal law also prohibits a person or group ofpersons from acquiring “control” of a bank holding company without notifyingthe Federal Reserve Board in advance, and then only if the Federal ReserveBoard does not object to the proposed transaction. The Federal Reserve Boardhas established a rebuttable presumptive standard that the acquisition of 10%or more of the voting stock of a bank holding company with a class ofsecurities registered under the Securities Exchange Act of 1934 wouldconstitute an acquisition of control of the bank holding company. In addition,any company is required to obtain the approval of the Federal Reserve Boardbefore acquiring 25% (5% in the case of an acquirer that is a bank holdingcompany) or more of any class of a bank holding company’s voting securities, orotherwise obtaining control or a “controlling influence” over a bank holdingcompany.

**TheGramm-Leach-Bliley Act.****  **The Gramm-Leach-Bliley Act of 1999 (the “GLB Act”),signed into law on November 12, 1999, amended a number of Federal bankinglaws that affect the Corporation and First Federal. The provisions of the GLBAct believed to be of most significance to us are discussed below. Inparticular, the GLB Act permits a bank holding company to elect to become afinancial holding company, which permits the holding company to conductactivities that are “financial in nature.” To become and maintain its status as a financial holding company, thebank holding company and all of its affiliated depository institutions must bewell-capitalized, well managed, and have at least a satisfactory CommunityReinvestment Act rating. We have not filed an election to become a financial holdingcompany.

**OtherHolding Company Regulations.****  **Federal law substantially restricts transactionsbetween financial institutions and their affiliates. As a result, a bank islimited in extending credit to its holding company (or any non-bank subsidiary),in investing in the stock or other securities of the bank holding company orits non-bank subsidiaries, and/or in taking such stock or securities ascollateral for loans to any borrower. Moreover, transactions between a bank anda bank holding company (or any non-bank subsidiary) must generally be on termsand under circumstances at least as favorable to the bank as those prevailingin comparable transactions with independent third parties or, in the absence ofcomparable 

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transactions, on terms andunder circumstances that in good faith would be available to nonaffiliatedcompanies.

Under Federal Reserve policy, a bank holding companyis expected to act as a source of financial strength to, and to commitresources to support, its bank subsidiaries. This support may be required attimes when, absent such a policy, the bank holding company may not be inclinedto provide it. In addition, any capital loans by the bank holding company toits bank subsidiaries are subordinate in right of payment to deposits and tocertain other indebtedness of the bank subsidiary. In the event of a bankholding company’s bankruptcy, any commitment by the bank holding company to afederal bank regulatory agency to maintain the capital of subsidiary banks willbe assumed by the bankruptcy trustee and entitled to a priority of payment.

**CapitalRequirements.****  **TheFederal Reserve Board and the FDIC have issued substantially similar risk-basedand leverage capital guidelines applicable to the banking organizations theysupervise. Under the risk-based capital requirements, we are generally requiredto maintain a minimum ratio of total capital to risk-weighted assets (includingcertain off-balance sheet activities, such as standby letters of credit) of 8%.At least half of the total capital must be composed of common equity, retainedearnings and qualifying perpetual preferred stock and certain hybrid capitalinstruments, less certain intangibles (“Tier 1 capital”). The remainder mayconsist of certain subordinated debt, certain hybrid capital instruments,qualifying preferred stock and a limited amount of the loan loss allowance (“Tier2 capital” which, together with Tier 1 capital, composes “total capital”). Tobe considered well-capitalized under the risk-based capital guidelines, aninstitution must maintain a total risk-weighted capital ratio of at least 10%and a Tier 1 risk-weighted ratio of 6% or greater. For further information, seeItem 7—Management Discussion and Analysis of Financial Condition and Results ofOperations—Capital.

The Federal Deposit Insurance Corporation Act of 1991(“FDICIA”), among other things, identifies five capital categories for insureddepository institutions: well-capitalized, adequately capitalized,undercapitalized, significantly undercapitalized and criticallyundercapitalized. The Corporation and First Federal are classified as “well-capitalized.”  FDICIA also requires the bank regulatoryagencies to implement systems for “prompt corrective action” for institutionsthat fail to meet minimum capital requirements within these five categories,with progressively more severe restrictions on operations, management andcapital distributions according to the category in which an institution isplaced. Failure to meet capital requirements can also cause an institution tobe directed to raise additional capital. FDICIA also mandates that the agenciesadopt safety and soundness standards relating generally to operations andmanagement, asset quality and executive compensation, and authorizesadministrative action against an institution that fails to meet such standards.

In addition, the Federal Reserve Board and the FDIChave each adopted risk-based capital standards that explicitly identifyconcentrations of credit risk and the risk arising from non-traditionalactivities, as well as an institution’s ability to manage these risks, asimportant factors to be taken into account by each agency in assessing aninstitution’s overall capital adequacy. The capital guidelines also providethat an institution’s exposure to a decline in the economic value of itscapital due to changes in interest rates be considered by the agency as afactor in evaluating a banking organization’s capital adequacy. The agenciesalso jointly adopted a regulation, effective January 1, 2002, amendingtheir regulatory capital standards to change the treatment of certain recourseobligations, direct credit subsidies, residual interest and other positions insecuritized transactions that expose banking organizations to credit risk. Theregulation amends the agencies’ regulatory capital standards to align moreclosely the risk-based capital treatment of recourse obligations and directcredit subsidies, to vary the capital requirements for positions in securitizedtransactions (and certain other credit exposures) according to their relativerisk, and to require capital commensurate with the risks associated withresidual interests.

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In addition to the “prompt corrective action”directives, failure to meet capital guidelines can subject a bankingorganization to a variety of other enforcement remedies, including additionalsubstantial restrictions on its operations and activities, termination ofdeposit insurance by the FDIC, and under some conditions the appointment of aconservator or receiver.

**DepositInsurance.****  **Ourdeposits are insured by the FDIC up to the statutory maximum limit of $100,000per depositor through the Savings Association Insurance Fund.  For this protection, we must pay semiannualassessments to the FDIC. The assessment rate for an insured depositoryinstitution depends on the assessment risk classification assigned to theinstitution by the FDIC, which will be determined by the institution’s capitallevel and supervisory evaluations.

**Dividends.****  **The Corporation is a legal entityseparate and distinct from the Bank. The majority of our revenue is fromdividends paid to it by the Bank. The Bank is subject to laws and regulationsthat limit the amount of dividends they can pay. If, in the opinion of afederal regulatory agency, an institution under its jurisdiction is engaged inor is about to engage in an unsafe or unsound practice, the agency may require,after notice and hearing, that the institution cease and desist from suchpractice. The federal banking agencies have indicated that paying dividendsthat deplete an institution’s capital base to an inadequate level would be anunsafe and unsound banking practice. Under FDICIA, an insured institution maynot pay any dividend if payment would cause it to become undercapitalized or ifit already is undercapitalized. Moreover, the Federal Reserve and the FDIC haveissued policy statements providing that bank holding companies and banks shouldgenerally pay dividends only out of current operating earnings.

Under Kentucky law, dividends by Kentucky banks may bepaid only from current or retained net profits. Before any dividend may bedeclared for any period (other than with respect to preferred stock), a bankmust increase its capital surplus by at least 10% of the net profits of thebank for the period until the bank’s capital surplus equals the amount of itsstated capital attributable to its common stock. Moreover, the KOFICommissioner must approve the declaration of dividends if the total dividends tobe declared by a bank for any calendar year would exceed the bank’s total netprofits for such year combined with its retained net profits for the precedingtwo years, less any required transfers to surplus or a fund for the retirementof preferred stock or debt. We are also subject to the Kentucky BusinessCorporation Act, which generally prohibits dividends to the extent they resultin the insolvency of the corporation from a balance sheet perspective or ifbecoming unable to pay debts as they come due.

**ConsumerProtection Laws.**   We are subject to a number offederal and state laws designed to protect borrowers and promote lending tovarious sectors of the economy and population. These laws include the EqualCredit Opportunity Act, the Fair Credit Reporting Act, the Truth in LendingAct, the Home Mortgage Disclosure Act, and the Real Estate SettlementProcedures Act, and state law counterparts.

Federal law currently contains extensive customerprivacy protections provisions. Under these provisions, a financial institutionmust provide to its customers, at the inception of the customer relationshipand annually thereafter, the institution’s policies and procedures regardingthe handling of customers’ nonpublic personal financial information. Theseprovisions also provide that, except for certain limited exceptions, aninstitution may not provide such personal information to unaffiliated thirdparties unless the institution discloses to the customer that such informationmay be so provided and the customer is given the opportunity to opt out of suchdisclosure. Federal law makes it a criminal offense, except in limitedcircumstances, to obtain or attempt to obtain customer information of afinancial nature by fraudulent or deceptive means.

The Community Reinvestment Act (“CRA”) requires theFDIC to assess our record in meeting the credit needs of the communities weserve, including low- and moderate-income neighborhoods and persons. The FDIC’sassessment of our record is made available to the public. The assessment alsois part 

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of the Federal ReserveBoard’s consideration of applications to acquire, merge or consolidate withanother banking institution or its holding company, to establish a new branchoffice or to relocate an office. The Federal Reserve Board will also assess theCRA record of the subsidiary banks of a bank holding company in connection withan application to acquire a bank or other bank holding company, and suchrecords may be the basis for denying the application.

**BankSecrecy Act.****  **The BankSecrecy Act of 1970 (“BSA”) was enacted to deter money laundering, establishregulatory reporting standards for currency transactions and improve detectionand investigation of criminal, tax and other regulatory violations. BSA andsubsequent laws and regulations require us to take steps to prevent the use ofthe Bank in the flow of illegal or illicit money, including, withoutlimitation, ensuring effective management oversight, establishing soundpolicies and procedures, developing effective monitoring and reportingcapabilities, ensuring adequate training and establishing a comprehensiveinternal audit of BSA compliance activities.

In recent years, federal regulators have increased theattention paid to compliance with the provisions of BSA and related laws, withparticular attention paid to “Know Your Customer” practices. Banks have beenencouraged by regulators to enhance their identification procedures prior toaccepting new customers in order to deter criminal elements from using thebanking system to move and hide illegal and illicit activities.

**USA Patriot Act.**   TheUSA PATRIOT Act of 2001 (the “Patriot Act”) contains anti-money launderingmeasures affecting insured depository institutions, broker-dealers and certainother financial institutions. The Patriot Act requires financial institutionsto implement policies and procedures to combat money laundering and thefinancing of terrorism, including standardsfor verifying customer identification at account opening, and rules topromote cooperation among financial institutions, regulators and lawenforcement entities in identifying parties that may be involved in terrorismor money laundering, and grants the Secretary of the Treasury broad authorityto establish regulations and to impose requirements and restrictions onfinancial institutions’ operations. In addition, the Patriot Act requires thefederal bank regulatory agencies to consider the effectiveness of a financialinstitution’s anti-money laundering activities when reviewing bank mergers andbank holding company acquisitions.

**Available Information**

We file 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. Thesereports are available at the SEC’s website at *http://www.sec.gov*.The reports are also available on our website at *http://www.ffsbky.com*.You may obtain electronic or paper copies of our reports free of charge bycontacting Rebecca Bowling, Corporate Secretary-Treasurer, First Federal Savings Bank, 2323 Ring Road,Elizabethtown, Kentucky 42701 (telephone) 270-765-2131.

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**Item 1A.**                RiskFactors

We, like other financial companies, are subject to anumber of risks, many of which are outside of management’s control, though westrive to manage those risks while optimizing returns. These risks include: (a) creditrisk, which is the risk that loan and lease customers or other counterpartieswill be unable to perform their contractual obligations, (b) market risk,which is the risk that changes in market rates and prices will adversely affectour financial condition or results of operation, (c) liquidity risk, whichis the risk that we will have insufficient cash or access to cash to meet ouroperating needs, and (d) operational risk, which is the risk of lossresulting from inadequate or failed internal processes, people, and systems, orfrom external events.

In addition to the other information included readersshould consider that the following important factors, among others, couldmaterially impact our business, future results of operations, and future cashflows.

**(a) Credit Risk**

We extend credit to a variety of customers based oninternally set standards and the judgment of management. We manage the creditrisk it takes through a program of underwriting standards that we follow, thereview of certain credit decisions, and an on-going process of assessment ofthe quality of the credit we have already extended. If our credit standards andour on-going process of credit assessment do not function as intended, we couldincur significant credit losses.

Our loans and deposits arefocused in central Kentucky. Adverse economic conditions in that region, inparticular, could harm our results from operations, cash flows, and financialcondition. Adverse economic conditions and other factors, such as political orbusiness development or natural hazards that may affect Kentucky, may reducedemand for credit or fee-based products and could negatively affect real estateand other collateral values, interest rate levels, and the availability ofcredit to refinance loans at or before maturity.

**(b) Market Risk**

Changes in interest rates could harm our financialcondition or results of operations.

Our results of operations depend substantially on netinterest income, the difference between interest earned on interest-earningassets (such as investments and loans) and interest paid on interest-bearingliabilities (such as deposits and borrowings). Interest rates are highlysensitive to many factors, including governmental monetary policies and domesticand international economic and political conditions. Factors beyond ourcontrol, such as inflation, recession, unemployment, and money supply may alsoaffect interest rates. If our interest-earning assets mature or reprice morequickly than our interest-bearing liabilities in a given period, as a result ofdecreasing interest rates, our net interest income may decrease. Likewise, ournet interest income may decrease if interest-bearing liabilities mature orreprice more quickly than interest-earning assets in a given period as a resultof increasing interest rates.

Fixed-rate loans increaseour exposure to interest rate risk in a rising rate environment becauseinterest-bearing liabilities would be subject to repricing before assets becomesubject to repricing. Adjustable-rate loans decrease the risk associated withchanges in interest rates but involve other risks, such as the inability ofborrowers to make higher payments in an increasing interest rate environment. Atthe same time, for secured loans, the marketability of the underlyingcollateral may be adversely affected by higher interests rates. In a declininginterest rate environment, there may be an increase in prepayments on loans asthe borrowers refinance their loans at lower interest rates, which could reducenet interest income and harm our results of operations.

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**(c) Liquidity Risk**

If we cannot borrow funds through access to thecapital markets, we may not be able to meet the cash flow requirements of ourdepositors and borrowers, or meet the operating cash needs of the Corporationto fund corporate expansion or other activities.

Liquidity policies and limits are established by theboard of directors, with operating limits set by the Asset Liability Committee(“ALCO”), based upon analyses of the ratio of loans to deposits, the percentageof assets funded with non-core or wholesale funding. ALCO regularly monitorsthe overall liquidity position of the Bank and holding company to ensure thatvarious alternative strategies exist to cover unanticipated events that couldaffect liquidity. Liquidity is the ability to meet cash flow needs on a timelybasis at a reasonable cost. If our liquidity policies and strategies don’t workas well as intended, then we may be unable to make loans and to repay depositliabilities as they become due or are demanded by customers. The ALCOestablishes board approved policies and monitors guidelines to diversify ourwholesale funding sources to avoid concentrations in any one-market source. Wholesalefunding sources include Federal funds purchased, securities sold underrepurchase agreements, non-core brokered deposits, and medium and long-termdebt, which includes Federal Home Loan Bank (FHLB) advances that arecollateralized with mortgage-related assets.

We maintain a portfolio ofsecurities that can be used as a secondary source of liquidity. There are otheravailable sources of liquidity, including the sale or securitization of loans,the ability to acquire additional non-core brokered deposits, additional collateralizedborrowings such as FHLB advances, the issuance of debt securities, and theissuance of preferred or common securities in public or private transactions. Ifwe were unable to access any of these funding sources when needed, we might beunable to meet the needs of our customers, which could adversely impact ourfinancial condition, our results of operations, cash flows, and our level ofregulatory-qualifying capital. For further discussion, see the “Liquidity”section of Management’s Discussion and Analysis of Financial Condition andResults of Operations.

**(d) Operational Risk**

We have significant competition in both attracting andretaining deposits and in originating loans. Competition is intense in most ofthe markets we serve. We compete on price and service with other banks andfinancial companies such as savings and loans, credit unions, financecompanies, mortgage banking companies, and brokerage firms. Competition couldintensify in the future as a result of industry consolidation, the increasingavailability of products and services from non-banks, greater technologicaldevelopments in the industry, and banking reform. If our competition pricesdeposits or loans at rates significantly more favorable than ours, then we mayhave difficulty in both attracting and retaining deposits and loans.

Management maintains internal operational controls andwe have invested in technology to help us process large volumes of transactions.However, there can be no assurance that we will be able to continue processingat the same or higher levels of transactions. If our systems of internalcontrols should fail to work as expected, if our systems were to be used in anunauthorized manner, or if employees were to subvert the system of internalcontrols, significant losses could occur.

We process large volumes of transactions on a dailybasis and are exposed to numerous types of operation risk, which could cause usto incur substantial losses. Operational risk resulting from inadequate orfailed internal processes, people, and systems includes the risk of fraud byemployees or persons outside of our company, the execution of unauthorizedtransactions by employees, errors relating to transaction processing andsystems, and breaches of the internal control system and compliancerequirements. This risk of loss also includes potential legal actions thatcould arise as a result of the operational deficiency or as a result ofnoncompliance with applicable regulatory standards.

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We establish and maintain systems of internaloperational controls that provide management with timely and accurateinformation about our level of operational risk. While not foolproof, thesesystems have been designed to manage operational risk at appropriate, costeffective levels. We have also established procedures that are designed toensure that policies relating to conduct, ethics, and business practices arefollowed. From time to time, we experience loss from operational risk,including the effects of operational errors, and these losses may besubstantial.

While management continually monitors and improves oursystem of internal controls, data processing systems, and corporate wideprocesses and procedures, there can be no assurance that we will not suffersuch losses in the future. New, or changes in existing tax, accounting, areregulatory laws, regulations, rules, standards, policies, and interpretationscould significantly impact strategic initiatives, results of operations, cashflows, and financial condition.

The financial servicesindustry is extensively regulated. Federal and state banking regulations aredesigned primarily to protect deposit insurance funds and consumers, not tobenefit a financial company’s shareholders. These regulations may sometimesimpose significant limitations on operations. The significant federal and statebanking regulations that affect us are described in this report under theheading “Regulation”. These regulations, along with currently existing tax,accounting, and monetary laws, regulations, rules, standards, policies andinterpretations control the methods by which financial institutions conductbusiness, implement strategic initiatives and tax compliance, and governfinancial reporting and disclosures. These laws, regulations, rules, standards,policies, and interpretations are constantly evolving and may changesignificantly over time. Events that may not have a direct impact on us, suchas the bankruptcy of U.S. companies, can cause legislators, regulators, andauthoritative bodies, such as the Financial Accounting Standards Board, theSecurities and Exchange Commission, the Public Company Accounting OversightBoard, and other various taxing authorities to respond by adopting and orproposing substantive revisions to laws, regulations, rules, standards,policies, and interpretations. The nature, extent, and timing of the adoptionof significant new laws and regulations, or changes in or repeal of existinglaws and regulations may have a material impact on our business and results ofoperations. Changes in regulation may cause us to devote substantial additionalfinancial resources and management time to compliance, which may negativelyaffect our operating results.

**Item 1B.**               UnresolvedStaff Comments

Not applicable

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**Item 2.**                        Properties

Ourexecutive offices, principal support and operational functions are located at2323 Ring Road in Elizabethtown, Kentucky. All of our banking centers arelocated in Kentucky. The location of the 14 banking centers, whether owned orleased, and their respective approximate square footage is described in thefollowing table.

| ** **                      | ** ** | ** **        | ** ** | **Approximate** | ** ** |
|---------------------------------|------------|-------------------|------------|-----------------|------------|
| ** **                      | ** ** | **Owned or** | ** ** | **Square**      | ** ** |
| **Banking Centers**        | ** ** | ** **        | ** ** | **Leased**      | ** ** | **Footage** | ** ** |
| **ELIZABETHTOWN**               |       |              |       |            |       |   |   |   |   |
| 2323 Ring Road                  |       |              | Owned      |            |       |   | 55,000 |   |   |
| 325 West Dixie Avenue           |       |              | Owned      |            |       |   | 5,880 |   |   |
| 101 Wal-Mart Drive              |       |              | Leased     |            |       |   | 984 |   |   |
| **RADCLIFF**                    |       |              |       |            |       |   |   |   |   |
| 475 West Lincoln Trail          |       |              | Owned      |            |       |   | 2,728 |   |   |
| **BARDSTOWN**                   |       |              |       |            |       |   |   |   |   |
| 401 East John Rowan Blvd.       |       |              | Leased     |            |       |   | 4,500 |   |   |
| 315 North Third Street          |       |              | Owned      |            |       |   | 1,271 |   |   |
| **MUNFORDVILLE**                |       |              |       |            |       |   |   |   |   |
| 925 Main Street                 |       |              | Owned      |            |       |   | 2,928 |   |   |
| **SHEPHERDSVILLE**              |       |              |       |            |       |   |   |   |   |
| 395 N. Buckman Street           |       |              | Owned      |            |       |   | 7,600 |   |   |
| **MT.  WASHINGTON**             |       |              |       |            |       |   |   |   |   |
| 279 Bardstown Road              |       |              | Owned      |            |       |   | 6,310 |   |   |
| **BRANDENBURG**                 |       |              |       |            |       |   |   |   |   |
| 416 East Broadway               |       |              | Leased     |            |       |   | 4,395 |   |   |
| 50 Old Mill Road                |       |              | Leased     |            |       |   | 575 |   |   |
| **FLAHERTY**                    |       |              |       |            |       |   |   |   |   |
| 4055 Flaherty Road              |       |              | Leased     |            |       |   | 1,216 |   |   |
| **LOUISVILLE**                  |       |              |       |            |       |   |   |   |   |
| 11810 Interchange Drive         |       |              | Owned      |            |       |   | 4,675 |   |   |
| 3650 South  Hurstbourne Parkway |       |              | Owned      |            |       |   | 4,428 |   |   |
|                                 |            |                   |            |                 |            |  |  |  |  |  |  |

 

**Item 3.**                        LegalProceedings

Although, from time totime, we are involved in various legal proceedings in the normal course ofbusiness, there are no material pending legal proceedings to which we are aparty, or to which any of our property is subject.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders

No matters were submitted for shareholder approvalduring the fourth quarter of 2005.

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**PART II**

**Item 5.**                        Marketfor the Registrant’s Common Equity and Related Stockholder Matters

**(a)**   MarketInformation

OurCommon Stock is traded on the NASDAQ National Market System (NASDAQ) under thesymbol “FFKY”. The following table shows the high and low closing prices of ourCommon Stock and the dividends paid.

| ** **     | ** ** | **Quarter Ended** | ** ** |
|----------------|------------|------------------------|------------|
| **2005:(1)**   | ** ** | **3/31**               | ** ** | **6/30** | ** ** | **9/30** | ** ** | **12/31** | ** ** |
| High           |       | $                      | 22.35      |   | $ | 22.75 |   | $ | 24.49 |   | $ | 28.99 |   |
| Low            |       | 21.36                  |       | 20.95 |   | 22.72 |   | 25.90 |   |
| Cash dividends |       | 0.173                  |       | 0.173 |   | 0.173 |   | 0.190 |   |
| **2004:(1)**   | ** ** | **3/31**               | ** ** | **6/30** | ** ** | **9/30** | ** ** | **12/31** | ** ** |
| High           |       | $                      | 24.77      |   | $ | 24.09 |   | $ | 24.00 |   | $ | 23.55 |   |
| Low            |       | 22.59                  |       | 20.22 |   | 21.85 |   | 22.28 |   |
| Cash dividends |       | 0.163                  |       | 0.163 |   | 0.173 |   | 0.173 |   |

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(1)          Adjustedto reflect the impact of the stock dividend declared September 22, 2005.

**(b)**   Holders

At February 28, 2006the number of shareholders was approximately 1,130.

**(c)**   Dividends

It iscurrently the policy of our Board of Directors to continue to pay quarterlydividends, but any future dividends are subject to the Board’s discretion basedon its consideration of the our operating results, financial condition,capital, income tax considerations, regulatory restrictions and other factors.

**(d)**   SecuritiesAuthorized for Issuance Under Equity Compensation Plans

| ** **                                                  | ** ** | ** **                         | ** ** | ** **                        | ** ** | **Number of securities**      | ** ** |
|-------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                                                  | ** ** | **Number of securities** | ** ** | ** **                        | ** ** | **remaining available for**   | ** ** |
| ** **                                                  | ** ** | **to be issued**         | ** ** | **Weighted-average**              | ** ** | **future issuance under**     | ** ** |
| ** **                                                  | ** ** | **upon exercise of**     | ** ** | **exercise price of**   | ** ** | **equity compensation plans** | ** ** |
| ** **                                                  | ** ** | **outstanding options,**      | ** ** | **outstanding options,**     | ** ** | **(excluding securities**          | ** ** |
| **Plan category**                                      | ** ** | ** **                         | ** ** | **warrants and rights** | ** ** | **warrants and rights**       | ** ** | **reflected in column (1))** | ** ** |
| Equity  compensation plans approved by security holders     |       |                               | 130,977    |                              |       |                                    | $          | 20.26 |   |   |   | 35,640 |   |   |
| Equity  compensation plans not approved by security holders |       |                               | —     |                              |       |                                    | —     |   |   |   | — |   |   |
| Total                                                       |       |                               | 130,977    |                              |       |                                    | $          | 20.26 |   |   |   | 35,640 |   |   |
|                                                             |            |                                    |            |                                   |            |                                         |            |  |  |  |  |  |  |  |  |  |

 

See Note 11 of the Notesto Consolidated Financial Statements for additional information required bythis item.

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**Item6.**                        SelectedConsolidated Financial and Other Data

| ** **                          | ** ** | **At December 31,** | ** ** | **At June 30,** | ** ** |
|-------------------------------------|------------|-------------------------------|------------|---------------------------|------------|
| ** **                          | ** ** | **2005**                      | ** ** | **2004**                  | ** ** | **2003** | ** ** | **2002** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Financial Condition Data: |       |                          |       |                      |       |   |   |   |   |   |   |   |   |
| Total assets                        |       | $                             | 766,513    |                      | $          | 737,646 |   | $ | 676,335 |   | $ | 670,728 |   | $ | 679,395 |   | $ | 606,726 |   |
| Net loans  outstanding(1)           |       | 635,740                       |       | 599,428                   |       | 550,153 |   | 528,535 |   | 520,261 |   | 517,145 |   |
| Interest bearing  deposits          |       | —                        |       | —                    |       | — |   | — |   | 64,000 |   | — |   |
| Investments                         |       | 61,555                        |       | 56,843                    |       | 34,938 |   | 18,575 |   | 23,693 |   | 22,934 |   |
| Deposits                            |       | 591,106                       |       | 586,386                   |       | 529,162 |   | 521,121 |   | 529,882 |   | 468,825 |   |
| Borrowings                          |       | 107,875                       |       | 88,904                    |       | 88,283 |   | 87,683 |   | 87,778 |   | 77,298 |   |
| Stockholders’  equity          |       | 64,741                        |       | 59,801                    |       | 56,321 |   | 59,647 |   | 58,615 |   | 54,592 |   |
| Number of:                          |       |                          |       |                      |       |   |   |   |   |   |   |   |   |
| Real estate loans  outstanding      |       | 10,130                        |       | 9,358                     |       | 8,028 |   | 7,156 |   | 7,577 |   | 7,618 |   |
| Deposit accounts                    |       | 50,790                        |       | 48,637                    |       | 48,443 |   | 49,210 |   | 49,726 |   | 49,615 |   |
| Offices                             |       | 14                            |       | 14                        |       | 13 |   | 13 |   | 13 |   | 13 |   |
| Full time equivalent  employees     |       | 254                           |       | 246                       |       | 237 |   | 219 |   | 209 |   | 192 |   |
|                                     |            |                               |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                              | ** ** | **Year Ended**   | ** ** | **Six Months Ended** | ** ** | **Year Ended** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|--------------------------------|------------|---------------------|------------|
| ** **                              | ** ** | **December 31,** | ** ** | **December 31,**          | ** ** | **June 30,**   | ** ** |
| ** **                              | ** ** | **2005**              | ** ** | **2004**                       | ** ** | **2003**            | ** ** | **2002** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Operations Data:**                    |       |                  |       |                           |       |                |       |   |   |   |   |   |   |   |   |   |
| Interest income                         |       | $                     | 45,368     |                           | $          | 39,143              |       | $ | 39,339 |   |   | $ | 21,556 |   |   | $ | 44,100 |   | $ | 45,392 |   |   |
| Interest expense                        |       | 17,862                |       | 14,792                         |       | 16,365              |       |   | 9,394 |   |   | 21,426 |   | 27,429 |   |   |
| Net interest  income                    |       | 27,506                |       | 24,351                         |       | 22,974              |       |   | 12,162 |   |   | 22,674 |   | 17,963 |   |   |
| Provision for  loan losses              |       | 1,258                 |       | 1,656                          |       | 1,656               |       |   | 1,161 |   |   | 1,604 |   | 1,086 |   |   |
| Non-interest  income                    |       | 8,067                 |       | 8,104                          |       | 7,981               |       |   | 3,177 |   |   | 5,398 |   | 5,145 |   |   |
| Non-interest  expense                   |       | 20,759                |       | 19,274                         |       | 17,292              |       |   | 7,597 |   |   | 15,281 |   | 13,570 |   |   |
| Income tax  expense                     |       | 4,412                 |       | 3,735                          |       | 4,004               |       |   | 2,199 |   |   | 3,729 |   | 2,803 |   |   |
| Net income                              |       | 9,144                 |       | 7,790                          |       | 8,003               |       |   | 4,382 |   |   | 7,458 |   | 5,649 |   |   |
| Earnings per  share:(2)                 |       |                  |       |                           |       |                |       |   |   |   |   |   |   |   |   |   |
| Basic                                   |       | $                     | 2.29       |                           | $          | 1.94                |       | $ | 1.93 |   |   | $ | 0.99 |   |   | $ | 1.65 |   | $ | 1.25 |   |   |
| Diluted                                 |       | 2.27                  |       | 1.93                           |       | 1.91                |       |   | 0.98 |   |   | 1.64 |   | 1.24 |   |   |
| Book value per  share(2)                |       | 16.25                 |       | 14.91                          |       | 13.82               |       |   | 13.53 |   |   | 12.99 |   | 12.01 |   |   |
| Dividends paid  per share(2)            |       | 0.71                  |       | 0.67                           |       | 0.64                |       |   | 0.30 |   |   | 0.59 |   | 0.59 |   |   |
| Dividend payout ratio                   |       | 31                    | %          | 35                             | %          | 33                  | %          |   | 30 | % |   | 36 | % | 48 | % |   |
| Return on average  assets               |       | 1.22                  | %          | 1.12                           | %          | 1.18                | %          |   | 1.31 | % |   | 1.19 | % | 0.95 | % |   |
| Average equity to  average assets  |       | 8.33                  | %          | 8.28                           | %          | 8.26                | %          |   | 8.77 | % |   | 9.10 | % | 8.97 | % |   |
| Return on average  equity               |       | 14.60                 | %          | 13.47                          | %          | 14.32               | %          |   | 14.89 | % |   | 13.08 | % | 10.62 | % |   |
| Efficiency ratio                        |       | 58                    | %          | 59                             | %          | 56                  | %          |   | 50 | % |   | 54 | % | 59 | % |   |

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(1)          Includes loans held forsale.

(2)          Amounts adjusted toreflect a 10% stock dividend declared April 16, 2003 and a 10% stockdividend declared September 20, 2005.

19

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**Item 7.**                        ManagementDiscussion and Analysis of Financial Condition and Results of Operations

Management’s Discussionand Analysis of Financial Condition and Results of Operations analyzes the majorelements of our balance sheets and statements of income. This section should beread in conjunction with the Company’s Consolidated Financial Statements andaccompanying Notes and other detailed information.

**OVERVIEW**

We conduct operations in 14 full-service bankingcenters in six contiguous counties in Kentucky along the Interstate 65 corridor.Our market presence ranges from the major metropolitan market of Louisville inJefferson County, Kentucky approximately 40 miles north of our headquarters inElizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles southof Elizabethtown. Our core markets have experienced a compound annual growthrate of 5% in deposits for the past four years. We anticipate a similar growthrate of our markets for the next few years and believe we are well positionedto benefit from this continued growth.

Our emphasis over the past several years has beenfocused on the enhancement and expansion of our retail and commercial bankingnetwork in our core markets as well as establishing our presence in the MetroLouisville market. Our five county core markets, where we have a combined 22%market share, has become increasingly competitive with several new bankbranches entering our markets in the past few years. In order to protect andgrow our market share, we enhanced several of our new facilities and anticipateseveral new facilities over the next few years. In addition to the enhancementand expansion in our core markets, we began establishing our presence in theMetro Louisville market.  The MetroLouisville market of Jefferson County is contiguous to our five county coremarkets. Approximately 75% of the deposit base in the Metro Louisville marketis controlled by six out-of-state banks. While the market is very competitive,we believe this creates an opportunity for smaller community banks with a muchmore empowered staff of associates. We believe our investment in theseinitiatives along with our continued commitment to world class customer servicewill enhance our existing market share and effectively support our developmentin the Metro Louisville market.

The enhancement of our retail branch network continuesto produce positive results for 2005. Total deposits have grown at a 6%compound annual growth rate over the past four years. Total deposits were$591.1 million at December 31, 2005, an increase of $4.7 million from December 31,2004. We achieved this growth despite a $36.9 million decrease in public fundsdeposits as one of our county school district customers constructed three newschools during the year. For 2005, total retail and commercial deposits grew$41.6 million

The development of the retail branch network into theMetro Louisville market has also generated positive results. We have a combined$30.0 million in deposits in our two new full-service facilities in the MetroLouisville market representing a 71% increase in deposits for the year. Weopened these new facilities in the second quarter of 2004 to support ourgrowing commercial customer base in this market. Twenty-one percent of theloans in our portfolio are located in our Metro Louisville market.

We also have been significantly investing in ourbranch network outside of the Louisville metropolitan market, where we have acommanding 22% deposit market share. We have renovated several of our existingbranches and have under construction a new full-service banking center inHardin County opening in early 2006. The design of the new and enhancedfacilities represents our state of the art prototype branch with aretail-focused design, complimenting our commitment to providing world classcustomer service.

While we anticipate these facilities willsignificantly enhance the value of our franchise in the near future, theadditional expense in operating these new facilities will continue to placepressure on earnings. 

20

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We estimate new branchfacilities will reach break even in approximately 18 to 24 months. We areoptimistic that the growth in deposits and loans generated as a result of ourexpansion strategy will minimize this period and the long-term benefits willultimately outweigh the initial investment costs.

Our emphasis on commercial lending generated a 6%compound annual growth rate in the total loan portfolio and a 30% compoundannual growth rate in commercial loans over the past four years. Commercialloans were $403.2 million at December 31, 2005, an increase of $57.6million, or 17%, from December 31, 2004.

The growth in our commercial loan portfolio, coupledwith the rising interest rate environment, has increased interest income. Netinterest margin increased to 3.93% for the year ended December 31, 2005,compared to 3.76% a year ago. This has resulted in a $3.2 million increase innet interest income to $27.5 million for 2005, compared to 2004. Theincreasing interest rate environment improved net interest margin due to thegrowth in the adjustable rate commercial loans coupled with the decrease inresidential fixed rate loans in the loan portfolio.

Net interest margin has been favorably impacted sincethe Federal Open Market Committee began increasing short-term interest rates inJune 2004. We believe the Federal Open Market Committee will stopincreasing short term interest rates during 2006 and will likely decrease shortterm interest rates in late 2006 or into 2007. Our net interest margin and thelevel of net interest income will be negatively affected with a decrease inshort-term interest rates over the next several quarters. We continuallymonitor the effects rate changes will have on our level of net interest incomeand management works to structure the maturity and pricing of loans anddeposits to mitigate large swings in net interest income. During 2005, we madeefforts to increase the level of short-term deposits with a money marketpromotion as well as offering more attractive rates on short-term certificatesof deposit relative to long term maturities. In addition, 78% of the newlyoriginated or renewed loans during 2005 were fixed rates loans with theinterest rate fixed from three to five years. These efforts, in addition toother initiatives to structure funding and future liquidity needs will helpdecrease the negative impact flat or decreasing short-term interest rates mayhave on the level of net interest income.  More detailed information on the effects ofchanging interest rates on our level of interest income can be found in the “Asset/LiabilityManagement and Market Risk” section of Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.

Our asset quality remains favorable. Net charge-offsas a percent of total loans was 0.06% for the year ended December 31,2005, compared to 0.12% for the same period a year ago. The allowance for loanlosses as a percent of total loans, increased to 1.15% at December 31,2005 compared to 1.07% at December 31, 2004. The percentage ofnon-performing loans to total loans increased to 0.97% at December 31,2005, compared to 0.87% at December 31, 2004.

Provision for loan loss expense decreased $398,000 to$1.3 million for the year ended December 31, 2005, compared to $1.7million a year ago. The decrease in the provision for the year was related to adecrease in net charge offs of $365,000 to $370,000 for the year ended December 31,2005 compared to $735,000 the prior year.

Non-interest incomedecreased $37,000 to $8.1 million, while non-interest expense increased $1.5 millionto $20.8 million for 2005, compared to 2004. The primary contributingfactors to this increase were the additional operating and employeecompensation expenses related to the recent expansion efforts. Twenty-four retailstaff positions were added for the expansion into the Louisville metropolitanmarket, coupled with expanded facilities in Hardin County and Bullitt County,Kentucky. Additional increases in staff have taken place during 2004 and 2005to continue the transformation towards a stronger retail sales culture and toprovide expanded products and services to our retail and commercial customers. Non-interestexpense levels are often measured using an efficiency ratio (non-interestexpense divided by the sum of net interest income and non-interest income). Ourefficiency ratio was 58% for the year ended December 31, 2005 and 59% forthe year ended December 31, 2004.

21

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**APPLICATION OFCRITICAL ACCOUNTING POLICIES**

Our accounting and reporting policies comply with U.S.generally accepted accounting principles and conform to general practiceswithin the banking industry. The accounting policy relating to the allowancefor loan losses is critical to the understanding of our results of operationssince the application of this policy requires significant managementassumptions and estimates that could result in materially different amounts tobe reported if conditions or underlying circumstances were to change.

***Allowance for LoanLosses—******We***maintainan allowance sufficient to absorb probable incurred credit losses existing inthe loan portfolio and the Executive Loan Committee evaluates the allowance forloan losses on a quarterly basis. We estimate the allowance using past loanloss experience, known and inherent risks in the portfolio, adverse situationsthat may affect the borrower’s ability to repay, estimated value of theunderlying collateral, and current economic conditions. While we estimate theallowance for loan losses, in part, based on historical losses within each loancategory, estimates for losses within the commercial real estate portfolio aremore dependent upon credit analysis and recent payment performance. Allocationsof the allowance may be made for specific loans or loan categories, but theentire allowance is available for any loan that, in management’s judgment,should be charged off.

The allowance consists of specific and generalcomponents. The specific component relates to loans that are individuallyclassified as impaired or loans otherwise classified as substandard or doubtful.The general component covers non-classified loans and is based on historicalloss experience adjusted for current factors. Themethodology for allocating the allowance for loan and lease losses takes intoaccount our strategic plan to increase our emphasis on commercial and consumerlending. We increase the amount of the allowance allocated to commercial loansand consumer loans in response to the growth of the commercial and consumerloan portfolios and management’s recognition of the higher risks and loanlosses in these lending areas. Allowance estimates are developed withactual loss experience adjusted for current economic conditions. Allowance estimatesare considered a prudent measurement of the risk in the loan portfolio and areapplied to individual loans based on loan type.

Based on our calculation,an allowance of $7.4 million****or 1.15% of total loans was our estimateof probable losses within the loan portfolio as of December 31, 2005. Thisestimate resulted in a provision for loan losses on the income statement of$1.3 million during 2005. If the mix and amount of future charge offpercentages differ significantly from those assumptions used by management inmaking its determination, the allowance for loan losses and provision for loanlosses on the income statement could be materially affected.

**RESULTS OFOPERATIONS**

Net income for the period ended December 31, 2005was $9.1 million or $2.27 per share diluted compared to $7.8 million or $1.93per share diluted for the same period in 2004. The increase was primarily theresult of an increase in net interest income of $3.2 million and a decrease inprovision for loan loss expense of $398,000. Our book value per common shareincreased from $14.91 at December 31, 2004 to $16.25 at December 31,2005. Net income for 2005 generated a return on average assets of 1.22% and areturn on average equity of 14.60%. These compare with a return on averageassets of 1.12% and a return on average equity of 13.47% for the 2004 period.

Net income for the period ended December 31, 2004was $7.8 million or $1.93 per share diluted compared to $8.0 million or $1.91per share diluted for the same period in 2003. The increase in diluted earningsper share was due to a stock repurchase of 60,000 shares of our own commonstock, which decreased capital by $1.6 million. The decrease in earnings wasprimarily the result of an increase in non-interest expense of $2.0 million forthe 2004 period compared to 2003, the direct result of our expansion efforts. Ourbook value per common share increased from $13.82 at December 31, 2003 to$14.91 at December 31, 2004. Net income for 2004 generated a return onaverage assets of****1.12% and a return on 

22

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average equity of 13.47%. Thesecompare with a return on average assets of 1.18% and a return on average equityof 14.32% for the 2003 period.

We reported net income of $8.0 million during the yearended December 31, 2003 compared with $8.1 million for the 2002period. Diluted earnings per share increased 6% from $1.80 during 2002 to $1.91 for2003. Earnings remained relatively constant for the comparative periods.Favorable increases in non-interest income generated from the gain on sale ofmortgage loans, service charges on deposit accounts, and two lots held for salewere offset by a decline in net interest income as well as an increase innon-interest expense. Our book value per common share increased from $13.53 at December 31,2002 to $13.82 at December 31, 2003. Net income for 2003 generated returnon average assets of 1.18% and return on average equity of 14.32%. Thesecompare with return on average assets of 1.24% and return on average equity of13.87% for the 2002 period.

***Net Interest Income—******The*********principal source of our revenue isnet interest income. Net interest income is the difference between interestincome on interest-earning assets, such as loans and securities and theinterest expense on liabilities used to fund those assets, such asinterest-bearing deposits and borrowings. Net interest income is impacted byboth changes in the amount and composition of interest-earning assets andinterest-bearing liabilities as well as market interest rates.

Net interest margin as a percent of average earningassets increased by 17 basis points to 3.93% for the year ended December 31,2005 compared to 3.76% for the 2004 period. The increasing interest rateenvironment in conjunction with an increase in average earning assets improvednet interest margin for the periods presented. Average interest earning assetsincreased $52.1 million for the 2005 period compared to 2004. The yield onearning assets averaged 6.48% for the 2005 period compared to an average yieldon earning assets of 6.04% for the same period in 2004. The prime-lending rateincreased 325 basis points from the time the Federal Open Market Committeebegan increasing short-term interest rates in June 2004 through the end of2005.

Our cost of funds averaged 2.77% for the 2005 periodcompared to an average cost of funds of 2.45% for the same period in 2004. Depositcosts have accelerated due to the re-pricing of certificate of depositmaturities rolling off at lower rates into current higher interest rates inaddition to our higher rates paid on our money market products. Going forward,our cost of funds is expected to increase as the general market deposit rateshave become increasingly competitive with the recent upward trend in interestrates.

Net interest margin has been favorably impacted sincethe Federal Open Market Committee began increasing short-term interest rates inJune 2004. We believe the Federal Open Market Committee will stopincreasing short term interest rates during 2006, and will likely decreaseshort term interest rates in late 2006 or into 2007. Our net interest marginand the level of net interest income will be negatively affected with adecrease in short-term interest rates. We continually monitor the effects ratechanges will have on our level of net interest income and management works tostructure the maturity and pricing of loans and deposits to mitigate largeswings in net interest income. During 2005, we made efforts to increase thelevel of short-term deposits with a money market promotion as well as offeringmore attractive rates on short-term certificates of deposit. In addition, 78%of the newly originated or renewed loans during 2005 were fixed rates loanswith the interest rate fixed from three to five years. These efforts, in additionto other initiatives to structure funding and future liquidity needs will helpdecrease the negative impact flat or decreasing short-term interest rates mayhave on the level of net interest income.  More detailed information on the effects ofchanging interest rates on our level of interest income can be found in the “Asset/LiabilityManagement and Market Risk” section of Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.

23

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Comparativeinformation regarding net interest income follows:

| ** **                                 | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | **2005/2004** | ** ** | **2003/2004** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|---------------|------------|---------------|------------|
| ** **                                 | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **2003**   | ** ** | **Change**    | ** ** | **Change**    | ** ** |
| ** **                                 | ** ** | **(Dollars in thousands)** | ** ** |
| Net interest  income, tax equivalent basis |       | $                                    | 45,431     |       | $          | 39,165     |       | $             | 39,361     |          |       | 16.0 | % |   |   |   |   | -0.5 | % |   |   |   |
| Net interest  spread                       |       | 3.71                                 | %          | 3.58       | %          | 3.37       | %          |          | 13         |          |       | bp |   |   | 21 |   |   | bp |   |
| Net interest  margin                       |       | 3.93                                 | %          | 3.76       | %          | 3.61       | %          |          | 17         |          |       | bp |   |   | 15 |   |   | bp |   |
| Average Earnings  Assets                   |       | $                                    | 700,849    |       | $          | 648,703    |       | $             | 636,624    |          |       | 8.0 | % |   |   |   |   | 1.9 | % |   |   |   |
| Prime rate a year  end                     |       | 7.25                                 | %          | 5.25       | %          | 4.00       | %          |          | 200        |          |       | bp |   |   | 125 |   |   | bp |   |
| Average prime rate                         |       | 6.19                                 | %          | 4.34       | %          | 4.12       | %          |          | 185        |          |       | bp |   |   | 22 |   |   | bp |   |

----

**bp = basis point =1/100th of a percent**

Prime rate is included above to provide a generalindication of the interest rate environment in which we operate. A largeportion of our variable rate loans were indexed to the prime rate and re-priceas the prime rate changes, unless they reach a contractual floor or ceiling.

24

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**AVERAGE BALANCE SHEETS**

The following tableprovides information relating to the Bank’s average balance sheet and reflectsthe average yield on assets and average cost of liabilities for the periodsindicated. Dividing income or expense by the average monthly balance of assetsor liabilities, respectively, derives such yields and costs for the periodspresented.

| ** **                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                        | ** ** | ** **                                 | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                                        | ** ** | **Average  Balance**                       | ** ** | **Interest** | ** ** | **Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Yield/  Cost** | ** ** |
| ** **                                                                        | ** ** | **(Dollars in thousands)**       | ** ** |
| **ASSETS**                                                                        |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest earning assets:                                                          |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and  agencies                                                       |       | $                                          | 48,063     |   | $ | 1,319 |   |   | 2.74 | % |   | $ | 26,761 |   | $ | 728 |   |   | 2.72 | % |   | $ | 12,766 |   | $ | 367 |   |   | 2.87 | % |   |
| Mortgage-backed  securities                                                       |       | 12,714                                     |       | 516 |   |   | 4.06 | % |   | 9,343 |   | 352 |   |   | 3.77 | % |   | 6,976 |   | 269 |   |   | 3.86 | % |   |
| Equity securities                                                                 |       | 2,063                                      |       | 93 |   |   | 4.51 | % |   | 3,215 |   | 124 |   |   | 3.86 | % |   | 2,073 |   | 79 |   |   | 3.81 | % |   |
| State and  political subdivision securities(1)                                    |       | 2,971                                      |       | 186 |   |   | 6.26 | % |   | 1,058 |   | 67 |   |   | 6.33 | % |   | 1,083 |   | 67 |   |   | 6.19 | % |   |
| Corporate bonds                                                                   |       | 3,547                                      |       | 181 |   |   | 5.10 | % |   | 2,000 |   | 66 |   |   | 3.30 | % |   | 2,000 |   | 64 |   |   | 3.20 | % |   |
| Loans(2)(3)(4)                                                                    |       | 613,185                                    |       | 42,481 |   |   | 6.93 | % |   | 583,020 |   | 37,364 |   |   | 6.41 | % |   | 531,750 |   | 37,413 |   |   | 7.04 | % |   |
| FHLB stock                                                                        |       | 6,967                                      |       | 349 |   |   | 5.01 | % |   | 6,671 |   | 275 |   |   | 4.12 | % |   | 6,421 |   | 257 |   |   | 4.00 | % |   |
| Interest bearing  deposits                                                        |       | 11,339                                     |       | 306 |   |   | 2.70 | % |   | 16,635 |   | 189 |   |   | 1.14 | % |   | 73,555 |   | 845 |   |   | 1.15 | % |   |
| **Total  interest earning assets**                                                |       | 700,849                                    |       | 45,431 |   |   | 6.48 | % |   | 648,703 |   | 39,165 |   |   | 6.04 | % |   | 636,624 |   | 39,361 |   |   | 6.18 | % |   |
| Less: Allowance  for loan losses                                                  |       | (6,794                                     | )          |   |   |   |   |   |   | (5,890 | ) |   |   |   |   |   |   | (5,006 | ) |   |   |   |   |   |   |
| Non-interest  earning assets                                                      |       | 57,632                                     |       |   |   |   |   |   |   | 55,760 |   |   |   |   |   |   |   | 45,075 |   |   |   |   |   |   |   |
| **Total  assets**                                                                 |       | $                                          | 751,687    |   |   |   |   |   |   |   | $ | 698,573 |   |   |   |   |   |   |   | $ | 676,693 |   |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                     | ** ** | ** **                                 | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                                                     | ** ** | ** **                                 | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                                                  |       | $                                          | 90,941     |   | $ | 1,678 |   |   | 1.85 | % |   | $ | 84,089 |   | $ | 783 |   |   | 0.93 | % |   | $ | 77,905 |   | $ | 799 |   |   | 1.03 | % |   |
| NOW and money  market accounts                                               |       | 147,731                                    |       | 2,093 |   |   | 1.42 | % |   | 135,265 |   | 1,156 |   |   | 0.85 | % |   | 115,785 |   | 959 |   |   | 0.83 | % |   |
| Certificates of  deposit and other time deposits                                  |       | 312,807                                    |       | 9,428 |   |   | 3.01 | % |   | 291,486 |   | 8,539 |   |   | 2.93 | % |   | 301,730 |   | 10,366 |   |   | 3.44 | % |   |
| Federal funds  purchased                                                          |       | 3,655                                      |       | 148 |   |   | 4.05 | % |   | 3,424 |   | 47 |   |   | 1.37 | % |   | — |   | — |   |   | — |   |   |
| FHLB Advances                                                                     |       | 78,629                                     |       | 3,803 |   |   | 4.84 | % |   | 78,543 |   | 3,738 |   |   | 4.76 | % |   | 77,726 |   | 3,738 |   |   | 4.81 | % |   |
| Subordinated  debentures                                                          |       | 10,000                                     |       | 712 |   |   | 7.12 | % |   | 10,000 |   | 529 |   |   | 5.29 | % |   | 10,000 |   | 503 |   |   | 5.03 | % |   |
| **Total  interest bearing liabilities**                                      |       | 643,763                                    |       | 17,862 |   |   | 2.77 | % |   | 602,807 |   | 14,792 |   |   | 2.45 | % |   | 583,146 |   | 16,365 |   |   | 2.81 | % |   |
| Non-interest bearing liabilities:                                                 |       |                                       |       |   | ** ** |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest  bearing deposits                                                    |       | 41,505                                     |       |   |   |   |   |   |   | 34,925 |   |   |   |   |   |   |   | 34,075 |   |   |   |   |   |   |   |
| Other liabilities                                                                 |       | 3,780                                      |       |   |   |   |   |   |   | 3,014 |   |   |   |   |   |   |   | 3,594 |   |   |   |   |   |   |   |
| **Total  liabilities**                                                            |       | 689,048                                    |       |   |   |   |   |   |   | 640,746 |   |   |   |   |   |   |   | 620,815 |   |   |   |   |   |   |   |
| Stockholders’  equity                                                        |       | 62,639                                     |       |   |   |   |   |   |   | 57,827 |   |   |   |   |   |   |   | 55,878 |   |   |   |   |   |   |   |
| **Total  liabilities and stockholders’ equity**                              |       | $                                          | 751,687    |   |   |   |   |   |   |   | $ | 698,573 |   |   |   |   |   |   |   | $ | 676,693 |   |   |   |   |   |   |   |
| **Net  interest income**                                                          |       |                                       | ** ** | $ | 27,569 |   |   |   |   | ** ** | ** ** |   | $ | 24,373 |   |   |   |   |   |   |   | $ | 22,996 |   |   |   |   |   |
| **Net  interest spread**                                                          | ** ** | ** **                                 |       |   | ** ** |   | 3.71 | % |   |   |   |   |   |   | 3.58 | % |   |   |   |   |   |   | 3.37 | % |   |
| **Net  interest margin**                                                          | ** ** | ** **                                 |       |   | ** ** |   | 3.93 | % |   |   |   |   |   |   | 3.76 | % |   |   |   |   |   |   | 3.61 | % |   |
| Ratio of average  interest earning assets to average interest bearing liabilities | ** ** | ** **                                 |       |   | ** ** |   | 108.87 | % |   |   |   |   |   |   | 107.61 | % |   |   |   |   |   |   | 109.17 | % |   |

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(1)             Taxable equivalent yields are calculated assuming a 34%federal income tax rate.

(2)             Includes loan fees, immaterial in amount, in bothinterest income and the calculation of yield on loans.

(3)             Calculations include non-accruing loans in the averageloan amounts outstanding.

(4)             Includes loans held for sale.

25

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**RATE/VOLUME ANALYSIS**

Thetable below provides information regarding changes in interest income andinterest expense of the Bank for the periods indicated. For each category ofinterest-earning assets and interest-bearing liabilities, information isprovided on changes attributable to (1) changes in rate (changes in ratemultiplied by old volume); (2) changes in volume (change in volumemultiplied by old rate); and (3) changes in rate-volume (change in ratemultiplied by change in volume). Changes in rate-volume are proportionatelyallocated between rate and volume variance.

| ** **                                       | ** ** | **Year Ended**                  | ** ** | **Year Ended**                 | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                       | ** ** | **December 31,**                | ** ** | **December 31,**               | ** ** |
| ** **                                       | ** ** | **2005 vs. 2004**          | ** ** | **2004 vs. 2003**         | ** ** |
| ** **                                       | ** ** | **Increase (decrease)**         | ** ** | **Increase (decrease)**        | ** ** |
| ** **                                       | ** ** | **Due to change in**  | ** ** | **Due to change in** | ** ** |
| ** **                                       | ** ** | ** **                           | ** ** | ** **                          | ** ** | **Net** | ** ** | ** ** | ** ** | ** ** | ** ** | **Net** | ** ** |
| ** **                                       | ** ** | **Rate**                             | ** ** | **Volume**                          | ** ** | **Change** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Change** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)** | ** ** |
| **Interest income:**                             |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and  agencies                      |       | $                                    | 6          |                                |       | $ | 585 |   |   |   | $ | 591 |   |   | $ | (22 | ) |   | $ | 383 |   |   | $ | 361 |   |
| Mortgage-backed  securities                      |       | 29                                   |       |                                | 135        |   |   |   | 164 |   |   | (6 | ) |   | 89 |   |   | 83 |   |
| Equity securities                                |       | 19                                   |       |                                | (50        | ) |   |   | (31 | ) |   | 1 |   |   | 44 |   |   | 45 |   |
| State and  political subdivision securities      |       | (1                                   | )          |                                | 120        |   |   |   | 119 |   |   | 2 |   |   | (2 | ) |   | — |   |
| Corporate bonds                                  |       | 115                                  |       |                                | —     |   |   |   | 115 |   |   | 2 |   |   | — |   |   | 2 |   |
| Loans                                            |       | 3,123                                |       |                                | 1,994      |   |   |   | 5,117 |   |   | (3,489 | ) |   | 3,440 |   |   | (49 | ) |
| FHLB stock                                       |       | 61                                   |       |                                | 13         |   |   |   | 74 |   |   | 8 |   |   | 10 |   |   | 18 |   |
| Interest bearing  deposits                       |       | 193                                  |       |                                | (76        | ) |   |   | 117 |   |   | (9 | ) |   | (647 | ) |   | (656 | ) |
| **Total  interest earning assets**               |       | 3,545                                |       |                                | 2,721      |   |   |   | 6,266 |   |   | (3,513 | ) |   | 3,317 |   |   | (196 | ) |
| **Interest expense:**                            | ** ** | ** **                           | ** ** |                                |       |   |   |   |   |   | ** ** | ** ** | ** ** |   |   |   | ** ** | ** ** | ** ** |
| Savings accounts                                 |       | 826                                  |       |                                | 69         |   |   |   | 895 |   |   | (77 | ) |   | 61 |   |   | (16 | ) |
| NOW and money  market accounts                   |       | 822                                  |       |                                | 115        |   |   |   | 937 |   |   | 31 |   |   | 166 |   |   | 197 |   |
| Certificates of  deposit and other time deposits |       | 251                                  |       |                                | 638        |   |   |   | 889 |   |   | (1,485 | ) |   | (342 | ) |   | (1,827 | ) |
| Federal funds  purchased                         |       | 101                                  |       |                                | —     |   |   |   | 101 |   |   | — |   |   | 47 |   |   | 47 |   |
| FHLB advances                                    |       | 61                                   |       |                                | 4          |   |   |   | 65 |   |   | (39 | ) |   | 39 |   |   | — |   |
| Subordinated  debentures                         |       | 183                                  |       |                                | —     |   |   |   | 183 |   |   | 26 |   |   | — |   |   | 26 |   |
| **Total  interest bearing liabilities**          |       | 2,244                                |       |                                | 826        |   |   |   | 3,070 |   |   | (1,544 | ) |   | (29 | ) |   | (1,573 | ) |
| **Net  change in net interest income**           |       | $                                    | 1,301      |                                |       | $ | 1,895 |   |   |   | $ | 3,196 |   |   | $ | (1,969 | ) |   | $ | 3,346 |   |   | $ | 1,377 |   |

 

26

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***Non-InterestIncome*** and Non-Interest Expense

Thefollowing tables provide a comparison of the components of non-interest incomeand expenses for the years ended December 31, 2005, 2004 and 2003. Thetables show the dollar and percentage change from 2004 to 2005 and from 2003 to2004. Below each table is a discussion of significant changes and trends.

| ** **                                       | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | **2005/2004** | ** ** | **2003/2004** | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|---------------|------------|---------------|------------|
| ** **                                       | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **2003**   | ** ** | **Change**    | ** ** | **%**         | ** ** | **Change** | ** ** | **%** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)** | ** ** |
| **Non-interest income**                          | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |          | ** ** | ** **    |       | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |
| Customer sevice fees on deposit accounts         |       | $                                    | 5,167      |       | $          | 4,913      |       | $             | 4,556      |          |       | $ | 254 |   |   | 5.2 | % |   | $ | 357 |   |   | 7.8 | % |
| Gain on sale of mortgage loans                   |       | 868                                  |       | 862        |       | 1,564      |       |          | 6          |          |       | 0.7 | % |   | (702 | ) |   | -44.9 | % |
| Gain on sale of investments                      |       | 381                                  |       | 202        |       | —     |       |          | 179        |          |       | 88.6 | % |   | 202 |   |   | 100.0 | % |
| Gain on sale of real estate held for development |       | 143                                  |       | 526        |       | 437        |       |          | (383       | )             |       | -72.8 | % |   | 89 |   |   | 20.4 | % |
| Brokerage commissions                            |       | 313                                  |       | 404        |       | 353        |       |          | (91        | )             |       | -22.5 | % |   | 51 |   |   | 14.4 | % |
| Other income                                     |       | 1,195                                |       | 1,197      |       | 1,071      |       |          | (2         | )             |       | -0.2 | % |   | 126 |   |   | 11.8 | % |
|                                             |       | $                                    | 8,067      |       | $          | 8,104      |       | $             | 7,981      |          |       | $ | (37 | ) |   | -0.5 | % |   | $ | 123 |   |   | 1.5 | % |

 

Growth in customer service fees on deposit accounts,our largest component of non-interest income, is primarily due to growth incustomer deposits, overdraft fee income on retail checking accounts and the saleof fee based products for both 2005 and 2004. We continue to increase ourcustomer base through cross-selling opportunities and marketing initiatives andpromotions. We undertook a renewed emphasis on growing our checking accountbase during 2005 to better enhance our profitability and franchise value andwill continue this emphasis going forward. This initiative initially began inlate 2004 with the introduction of 10 new checking account products and/orsignificant enhancements to existing products. We also introduced two newchecking account products in 2005 geared toward customers on check systems whowould not normally qualify for a standard checking account. We expect theincrease in checking accounts we experienced in 2005 to continue going forward.This will positively impact our level of customer service fees on depositaccounts.

Through our mortgage banking subsidiary, FirstHeartland Mortgage Company, we originate qualified VA, KHC, RHC andconventional secondary market loans and sell them into the secondary marketwith servicing rights released. For 2005, gain on sale of mortgage loansremained steady compared to 2004. However, due to a decline in refinancingactivity of 1-4 family loans, gain on sale of mortgage loans decreasedfor the 2004 period compared to 2003. We expect the gain on sale of mortgageloans to remain consistent with the levels reached in 2005 and 2004.

We invest in various types of liquid assets, includingUnited States Treasury obligations, securities of various federal agencies,obligations of states and political subdivisions, corporate bonds, mutualfunds, stocks and others. During the first quarter of 2005 we recorded a gainon sale of investments of $381,000. For 2004, gain on sale of investmentsincludes various other sales of equity investments. Gains on investmentsecurities are infrequent in nature and are not a consistent recurring sourceof income.

Through our subsidiary, First Federal Office Park, wehold commercial lots adjacent to our home office on Ring Road in Elizabethtown,that are available for sale. During 2005 we recorded $143,000 in gains from alot sale compared to $526,000 in gains from the sale of three properties heldfor development during 2004. Two properties were sold in 2003 for a recordedgain of $437,000. Currently, we are holding three lots for sale in thissubsidiary, of the initial nine lots held for sale.

27

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Duringthe fourth quarter of 2004 we made the decision to outsource our trustoperations and implemented this plan during 2005. Included in other income forthe 2005, 2004, and 2003 periods is income from trust operations of $93,000,$128,000, and $125,000 respectively. This source of non-interest income willlargely be eliminated going forward with our decision to outsource our trustoperations.

| ** **                             | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | **2005/2004** | ** ** | **2003/2004** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|---------------|------------|---------------|------------|
| ** **                             | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **2003**   | ** ** | **Change**    | ** ** | **%**         | ** ** | **Change** | ** ** | **%** | ** ** |
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** |
| **Non-interest expenses**              | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** **    | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Employee compensation and benefits     |       | $                                    | 11,126     |       | $          | 10,295     |       | $             | 9,446      |          | $          | 831 |   | 8.1 | % | $ | 849 |   | 9.0 | % |
| Office occupancy expense and equipment |       | 2,065                                |       | 1,833      |       | 1,534      |       | 232           |       | 12.7          | %          | 299 |   | 19.5 | % |
| Marketing and advertising              |       | 778                                  |       | 726        |       | 568        |       | 52            |       | 7.2           | %          | 158 |   | 27.8 | % |
| Outside services and data processing   |       | 2,393                                |       | 2,134      |       | 1,826      |       | 259           |       | 12.1          | %          | 308 |   | 16.9 | % |
| Bank franchise tax                     |       | 788                                  |       | 822        |       | 623        |       | (34           | )          | -4.1          | %          | 199 |   | 31.9 | % |
| Other expense                          |       | 3,609                                |       | 3,464      |       | 3,295      |       | 145           |       | 4.2           | %          | 169 |   | 5.1 | % |
|                                   |       | $                                    | 20,759     |       | $          | 19,274     |       | $             | 17,292     |          | $          | 1,485 |   | 7.7 | % | $ | 1,982 |   | 11.5 | % |

 

Employee compensation and benefits is the largestcomponent of non-interest expense. Twenty-four retail staff positions wereadded for the expansion into the Louisville metropolitan market, coupled withexpanded facilities in Hardin County and Bullitt County, Kentucky. Additionalincreases in staff have taken place during 2005, 2004 and 2003 to continue thetransformation towards a stronger retail sales culture and to provide expandedproducts and services to our retail and commercial customers. We look for acontinued increase in employee compensation and benefits expense in line withrecent trends, as we progress with our retail expansion and market protectionefforts.

Office occupancy expense and equipment, marketing andadvertising, and outside services and data processing increased due toadditional operating expenses related to our expansion efforts for 2005, 2004and 2003. The two full service branch openings in 2004 contributed to higheroperating costs including additional postage for promotions and direct mailingsfor marketing, along with increased communications and supplies expense. Welook for a continuation of these trends as we continue our retail expansion andmarket protection efforts.

Bank franchise tax expense increased $199,000 in 2004 from2003 due to a higher tax expense accrual resulting from the conversion from afederally chartered thrift to a Kentucky state-chartered commercial bank. Thestate tax expense for a bank charter is calculated based upon different rules.

We anticipate theincreased level of non-interest expense to continue into 2006 with continuedretail expansion and market share protection efforts. We started constructionon a new full service-banking center in Elizabethtown, KY with plans of openingin early 2006. We will begin construction on a third facility in JeffersonCounty to begin in the first quarter of 2006 with the anticipation of openingin early 2007. We are also considering other possible locations within the coremarket area to protect and grow our 22% market share. Despite the increase innon-interest expense for 2005, our efficiency ratio was 58% compared to 59% forthe 2004 period.

28

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**ANALYSIS OF FINANCIAL CONDITION**

Total assets at December 31, 2005 increased to$766.5 million compared to $737.6 million at December 31, 2004, anincrease of $28.9 million. The increase was primarily driven by an increase ininvestment securities of $4.7 million and an increase in net loans of $36.3million. The growth in investment securities and loans was principally fundedwith cash and cash equivalents, which decreased by $15.5 million, deposits,which increased by $4.7 million, and federal funds purchased, which increasedby $19.5 million.

Total assets at December 31,2004 increased to $737.6 million compared to $676.3 million at December 31,2003, an increase of $61.3 million.  Theincrease was primarily related to an increase in investment securities of $21.9million and an increase in net loans receivable of $49.3 million. The growth ininvestment securities and loans was principally funded with cash and cashequivalents, which decreased by $12.1 million, and deposits, which increased by$57.2 million.

***Loans***

Net loans increased $36.3 million or 6% to $635.7million at December 31, 2005 compared to $599.4 million at December 31,2004. Our commercial, commercial real estate and real estate constructionportfolios increased $57.6 million, a 17% increase in these loans to****$403.2 million at December 31, 2005. Forthe 2005 period, these loans comprised 63% of the total loan portfolio comparedto****57% of the loan portfolio at December 31,2004, and 49% of the loan portfolio at December 31, 2003. Offsetting thisgrowth was a $16.8 million, or 11% decrease in the residential mortgage loanportfolio to $142.7 million at December 31, 2005, compared to $159.6million****at December 31, 2004.Consumer and home equity loans also decreased for the 2005 period by $3.9million to $66.2 million at December 31, 2005. For 2006, the growth incommercial loans is expected to continue in line with recent trends.

Residential mortgage loans decreased by $31.4 millionduring the 2004 period as declining market interest rates caused an increase in1-4 family refinancing activity into fixed-rate, secondary market loanproducts. Our emphasis on commercial lending continued to produce positiveresults generating a $73.4 million,or 27% increase in commercial loans****to $345.6 millionat December 31, 2004,****compared to$272.2 million at December 31, 2003. Our consumer, home equity andindirect consumer loan portfolios increased $7.9 million to $100.9 millionat December 31, 2004.

***Loan Portfolio Composition.******  ***The following tablepresents a summary of the loan portfolio, net of deferred loan fees, by type. Thereare no foreign loans in our portfolio and other than the categories noted;there is no concentration of loans in any industry exceeding 10% of total loans.

| ** **               | ** ** | **December 31,**                | ** ** | **June 30,** | ** ** |
|--------------------------|------------|--------------------------------------|------------|-------------------|------------|
| ** **               | ** ** | **2005**                             | ** ** | **2004**          | ** ** | **2003** | ** ** | **2002** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **               | ** ** | **Amount**                           | ** ** | **%**             | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **               | ** ** | **(Dollars in thousands)** | ** ** |
| Type of Loan:            |       |                                 |       |              |       |   |   |   |   |   |   |   |   |   | ** ** | ** ** |   |   |   |   |   |   |   |   |   |
| Real Estate:             |       |                                 |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential              |       | $                                    | 142,359    |              | 22.14      | % | $ | 158,966 |   | 26.23 | % | $ | 190,088 |   | 34.21 | % | $ | 262,990 |   | 49.34 | % | $ | 291,668 |   | 55.66 | % | $ | 320,860 |   | 61.70 | % |
| Construction             |       | 13,579                               |       | 2.11              |       | 10,850 |   | 1.79 |   | 9,952 |   | 1.79 |   | 12,857 |   | 2.41 |   | 10,805 |   | 2.06 |   | 9,205 |   | 1.77 |   |
| Commercial               |       | 353,637                              |       | 54.99             |       | 302,567 |   | 49.94 |   | 230,964 |   | 41.56 |   | 133,328 |   | 25.01 |   | 111,502 |   | 21.28 |   | 84,378 |   | 16.22 |   |
| Consumer and home equity |       | 66,207                               |       | 10.29             |       | 70,141 |   | 11.58 |   | 64,759 |   | 11.65 |   | 67,398 |   | 12.64 |   | 67,882 |   | 12.95 |   | 66,492 |   | 12.79 |   |
| Indirect consumer        |       | 31,577                               |       | 4.91              |       | 30,798 |   | 5.08 |   | 28,279 |   | 5.09 |   | 20,594 |   | 3.86 |   | 19,640 |   | 3.75 |   | 21,822 |   | 4.20 |   |
| Commercial, other        |       | 35,161                               |       | 5.47              |       | 31,376 |   | 5.18 |   | 30,658 |   | 5.52 |   | 32,268 |   | 6.05 |   | 20,988 |   | 4.01 |   | 16,662 |   | 3.20 |   |
| Loans held for sale      |       | 597                                  |       | 0.09              |       | 1,219 |   | 0.20 |   | 1,021 |   | 0.18 |   | 3,676 |   | 0.69 |   | 1,511 |   | 0.29 |   | 632 |   | 0.12 |   |
| Total loans              |       | $                                    | 643,117    |              | 100.00     | % | $ | 605,917 |   | 100.00 | % | $ | 555,721 |   | 100.00 | % | $ | 533,111 |   | 100.00 | % | $ | 523,996 |   | 100.00 | % | $ | 520,051 |   | 100.00 | % |

 

29

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***Loan Maturity Schedule.******  ***The following tablesets forth information at December 31, 2005, regarding the dollar amountof loans, net of deferred loan fees, maturing in the loan portfolio based ontheir contractual terms to maturity.

| ** **                                   | ** ** | ** **                           | ** ** | **Due after**          | ** ** | ** **                | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|---------------------------|------------|------------|------------|
| ** **                                   | ** ** | **Due during**                  | ** ** | **1 through**          | ** ** | **Due after 5** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **the year ended**         | ** ** | **5 years after** | ** ** | **years after**      | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **December 31,**                | ** ** | **December 31,**       | ** ** | **December 31,**     | ** ** | **Total**  | ** ** |
| ** **                                   | ** ** | **2006**                             | ** ** | **2005**                    | ** ** | **2005**                  | ** ** | **Loans**  | ** ** |
| ** **                                   | ** ** | **(Dollars in thousands)** | ** ** |
| Residential  mortgage                        |       |                                 | $          | 4,933                       |       |                      |       | $          | 24,394     |   |   |   | $ | 113,032 |   |   | $ | 142,359 |   |
| Real estate  construction                    |       |                                 | 13,579     |                        |       |                      | —     |       |       |   | — |   |   | 13,579 |   |
| Real estate  commercial                      |       |                                 | 119,455    |                        |       |                      | 199,142    |       |       |   | 35,040 |   |   | 353,637 |   |
| Consumer, home  equity and indirect consumer |       |                                 | 8,586      |                        |       |                      | 50,533     |       |       |   | 38,665 |   |   | 97,784 |   |
| Commercial, other                            |       |                                 | 12,305     |                        |       |                      | 20,085     |       |       |   | 2,771 |   |   | 35,161 |   |
| Loans held for  sale                         |       |                                 | 597        |                        |       |                      | —     |       |       |   | — |   |   | 597 |   |
| Total                                        |       |                                 | $          | 159,455                     |       |                      |       | $          | 294,154    |   |   |   | $ | 189,508 |   |   | $ | 643,117 |   |

 

Thefollowing table breaks down loans maturing after one year, by fixed andadjustable rates.

| ** **              | ** ** | ** **                           | ** ** | **Floating or**      | ** ** | ** ** | ** ** |
|-------------------------|------------|--------------------------------------|------------|---------------------------|------------|------------|------------|
| ** **              | ** ** | **Fixed Rates**                 | ** ** | **Adjustable Rates** | ** ** | **Total**  | ** ** |
| ** **              | ** ** | **(Dollars in thousands)** | ** ** |
| Residential  mortgage   |       |                                 | $          | 77,350                    |       |       |       | $ | 60,076 |   |   | $ | 137,426 |   |
| Real estate  commercial |       |                                 | 67,918     |                      |       |       | 166,264    |   |   | 234,182 |   |
| Consumer, home equity   | ** ** |                                 |       |                      |       |       |       |   | ** ** | ** ** | ** ** |
| and indirect  consumer  |       |                                 | 46,758     |                      |       |       | 42,440     |   |   | 89,198 |   |
| Commercial, other       |       |                                 | 14,883     |                      |       |       | 7,973      |   |   | 22,856 |   |
| Total                   |       |                                 | $          | 206,909                   |       |       |       | $ | 276,753 |   |   | $ | 483,662 |   |

 

***Allowance and Provision for Loan Losses***

Our financial performance depends on the quality ofthe loans we originate and management’s ability to assess the degree of risk inexisting loans when it determines the allowance for loan losses. An increase inloan charge-offs or non-performing loans or an inadequate allowance for loanlosses could reduce net interest income, net income and capital and limit therange of products and services we can offer.

The Allowance for Loan Loss Review Committee evaluatesthe allowance for loan losses quarterly to maintain a level sufficient toabsorb probable incurred credit losses existing in the loan portfolio. Periodicprovisions to the allowance are made as needed. The allowance is determinedbased on the application of loss estimates to graded loans by categories. Theamount of the provision for loan losses necessary to maintain an adequateallowance is also based upon an analysis of such factors as changes in lendingpolicies and procedures; underwriting standards; collection; charge-off andrecovery history; changes in national and local economic business conditionsand developments; changes in the characteristics of the portfolio; ability anddepth of lending management and staff; changes in the trend of the volume andseverity of past due, non-accrual and classified loans; troubled debtrestructuring and other loan modifications; and results of regulatoryexaminations.

The methodology for allocating the allowance for loanand lease losses takes into account our strategic plan to increase our emphasison commercial and consumer lending. We increase the amount of the allowanceallocated to commercial loans and consumer loans in response to the growth ofthe commercial and consumer loan portfolios and management’s recognition of thehigher risks and loan losses in these lending areas. The indirect consumer loanprogram is comprised of new and used automobile, motorcycle and all terrainvehicle loans originated on our behalf by a select group of auto 

30

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dealers within the ourservice area.  The indirect loan programinvolves a greater degree of risk and is evaluated quarterly and monitored bythe Board of Directors. In light of the greater charge-offs from indirectconsumer loans compared to direct consumer loans, proportionally more of theallowance for consumer loans is allocated for indirect loans than direct loans.As the indirect loan program has evolved, dealer analysis and underwritingstandards have been refined to improve the loan loss experience of the program.Estimating the allowance is a continuous process. In this regard, the Allowancefor Loan Loss Review Committee continues to monitor the performance of indirectconsumer loans as well as our other loan products and updates estimates as theevidence warrants.

Thefollowing table sets forth an analysis of loan loss experience for the periodsindicated.

| ** **                                                                | ** ** | ** **                                 | ** ** | ** **            | ** ** | ** **                             | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------|------------|----------------------------------------|------------|--------------------------------|------------|------------|------------|------------|------------|
| ** **                                                                | ** ** | **Year Ended December 31,** | ** ** | **December 31,** | ** ** | **Year Ended June 30,** | ** ** |
| ** **                                                                | ** ** | **2005**                                   | ** ** | **2004**              | ** ** | **2003**                               | ** ** | **2002**                       | ** ** | **2002**   | ** ** | **2001**   | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)**       | ** ** |
| Balance at  beginning of period                                           |       | $                                          | 6,489      |                  | $          | 5,568                                  |       | $                              | 4,576      |       |       | $          | 3,735      |   |   | $ | 2,906 |   | $ | 2,252 |   |
| Loans charged-off:                                                        |       |                                       |       |                  |       |                                   |       |                           |       |       |       |       |       |   |   |
| Real estate mortgage                                                      |       | 15                                         |       | 41                    |       | 60                                     |       |                           | 5          |       |       | 25         |       | 2 |   |
| Consumer                                                                  |       | 584                                        |       | 702                   |       | 721                                    |       |                           | 419        |       |       | 635        |       | 482 |   |
| Commercial                                                                |       | 67                                         |       | 206                   |       | 76                                     |       |                           | —     |       |       | 256        |       | 15 |   |
| Total charge-offs                                                         |       | 666                                        |       | 949                   |       | 857                                    |       |                           | 424        |       |       | 916        |       | 499 |   |
| Recoveries:                                                               |       |                                       |       |                  |       |                                   |       |                           |       |       |       |       |       |   |   |
| Real estate mortgage                                                      |       | 4                                          |       | —                |       | —                                 |       |                           | —     |       |       | 6          |       | 4 |   |
| Consumer                                                                  |       | 290                                        |       | 214                   |       | 190                                    |       |                           | 74         |       |       | 97         |       | 63 |   |
| Commercial                                                                |       | 2                                          |       | —                |       | 3                                      |       |                           | 30         |       |       | 38         |       | — |   |
| Total recoveries                                                          |       | 296                                        |       | 214                   |       | 193                                    |       |                           | 104        |       |       | 141        |       | 67 |   |
| Net loans charged-off                                                     |       | 370                                        |       | 735                   |       | 664                                    |       |                           | 320        |       |       | 775        |       | 432 |   |
| Provision for loan losses                                                 |       | 1,258                                      |       | 1,656                 |       | 1,656                                  |       |                           | 1,161      |       |       | 1,604      |       | 1,086 |   |
| Balance at end of period                                                  |       | $                                          | 7,377      |                  | $          | 6,489                                  |       | $                              | 5,568      |       |       | $          | 4,576      |   |   | $ | 3,735 |   | $ | 2,906 |   |
| Allowance for loan losses to total loans (excluding  loans held for sale) |       | 1.15                                       | %          | 1.07                  | %          | 1.00                                   | %          |                           | 0.86       | %          |       | 0.71       | %          | 0.56 | % |
| Net charge-offs  to average loans outstanding                             |       | 0.06                                       | %          | 0.13                  | %          | 0.12                                   | %          |                           | 0.12       | %          |       | 0.15       | %          | 0.09 | % |
| Allowance for loan  losses to total non-performing loans                  |       | 118                                        | %          | 124                   | %          | 105                                    | %          |                           | 100        | %          |       | 100        | %          | 88 | % |

 

The provision for loan losses decreased $398,000, or24% to $1.3 million for the year ended December 31, 2005, compared to the2004 period. The decrease in the provision for the year was related to adecrease in net charge offs of $365,000 to $370,000 for the year ended December 31,2005 compared to $735,000 the prior year due to lower commercial and indirectconsumer loan charge-offs. The total allowance for loan losses increased$888,000 to $7.4 million from December 31, 2004 to December 31, 2005.The increase in the allowance was related to a $37.8 million increase in netloans at 2005 compared to 2004, in conjunction with a $2.8 million increase inclassified loans for the 2005 period compared to the 2004 period.

The provision for loan losses remained constant at$1.7 million for the year ended December 31, 2004, compared to the 2003period. The total allowance for loan losses increased $921,000 to $6.5 millionor 1.07% of total loans for December 31, 2004 compared to 1.00% of totalloans for December 31, 2003. The increased allowance was primarily due toincreases in commercial loans during the 2004 period. Net loan 

31

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charge-offs increased$71,000 to $735,000 during 2004 compared to $664,000 during 2003, due to anincrease in commercial loan net charge-offs.

The provision for loan losses decreased 17% to $1.7million for the fiscal year ended December 30, 2003 compared to $2.0million for the 2002 period. The higher provision expense for 2002 was due to achange in loan types. The total allowance for loan losses increased $992,000 to$5.6 million from December 31, 2002 to December 31, 2003. Weincreased the allowance for loan losses due to the continued strong growth incommercial real estate lending and changes in the product mix within the loanportfolios. Net loan charge-offs decreased $49,000 to $664,000 during 2003compared to $713,000 during 2002. The decrease in charge-offs is primarilyrelated to a decrease in charge-offs of indirect consumer loans during the 2003period.

Thefollowing table depicts management’s allocation of the allowance for loanlosses by loan type. Allowance funding and allocation is based on management’scurrent evaluation of risk in each category, economic conditions, past lossexperience, loan volume, past due history and other factors. Since thesefactors and management’s assumptions are subject to change, the allocation isnot necessarily predictive of future portfolio performance.

| ** **            | ** ** | **December 31,**                | ** ** |
|-----------------------|------------|--------------------------------------|------------|
| ** **            | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **            | ** ** | **Amount of   Allowance**  | ** ** | **Percent of  Total  loans** | ** ** | **Amount of   Allowance** | ** ** | **Percent of  Total  loans** | ** ** | **Amount of   Allowance** | ** ** | **Percent of  Total  loans** | ** ** | **Amount of   Allowance** | ** ** | **Percent of  Total  loans** | ** ** |
| ** **            | ** ** | **(Dollars in thousands)** | ** ** |
| Residential  mortgage |       |                                 | $          | 373 |   |   |   | 22 | % |   |   | $ | 413 |   |   |   | 26 | % |   |   | $ | 456 |   |   |   | 34 | % |   |   | $ | 608 |   |   |   | 49 | % |   |
| Consumer              |       |                                 | 1,372      |   |   |   | 15 |   |   |   | 1,345 |   |   |   | 17 |   |   |   | 1,235 |   |   |   | 17 |   |   |   | 1,096 |   |   |   | 17 |   |   |
| Commercial            |       |                                 | 5,632      |   |   |   | 63 |   |   |   | 4,731 |   |   |   | 57 |   |   |   | 3,877 |   |   |   | 49 |   |   |   | 2,872 |   |   |   | 34 |   |   |
| Total                 |       |                                 | $          | 7,377 |   |   |   | 100 | % |   |   | $ | 6,489 |   |   |   | 100 | % |   |   | $ | 5,568 |   |   |   | 100 | % |   |   | $ | 4,576 |   |   |   | 100 | % |   |

 

| ** **           | ** ** | **June 30,**                    | ** ** |
|----------------------|------------|--------------------------------------|------------|
| ** **           | ** ** | **2002**                             | ** ** | **2001** | ** ** |
| ** **           | ** ** | **Amount of   Allowance**  | ** ** | **Percent of  Total  loans** | ** ** | **Amount of   Allowance** | ** ** | **Percent of  Total  loans** | ** ** |
| ** **           | ** ** | **(Dollars in thousands)** | ** ** |
| Residential mortgage |       |                                 | $          | 645 |   |   |   | 56 | % |   |   | $ | 884 |   |   |   | 62 | % |   |
| Consumer             |       |                                 | 1,023      |   |   |   | 17 |   |   |   | 953 |   |   |   | 17 |   |   |
| Commercial           |       |                                 | 2,067      |   |   |   | 27 |   |   |   | 1,069 |   |   |   | 21 |   |   |
| Total                |       |                                 | $          | 3,735 |   |   |   | 100 | % |   |   | $ | 2,906 |   |   |   | 100 | % |   |

 

Federal regulations require insured institutions toclassify their own assets on a regular basis. The regulations provide for threecategories of classified loans—substandard, doubtful and loss. Assetsclassified as substandard or doubtful require the institution to establishgeneral allowances for loan losses. If an asset or portion thereof isclassified as loss, the insured institution must either establish specifiedallowances for loan losses in the amount of 100% of the portion of the assetclassified loss, or charge off such amount. At December 31, 2005, on thebasis of management’s review of the loan portfolio, we had $9.8 million of assets classifiedsubstandard, $933,000 classified as doubtful, and $21,000 of assets classifiedas loss. At December 31, 2004, on the basis of management’s review of theloan portfolio, we had $6.9 million assets classified substandard, $1.0 millionclassified as doubtful, and $35,000 of assets classified as loss. The $2.9million increase in substandard assets for December 31, 2005 was primarilythe result of two credit relationships. These credit relationships were a $1.5million commercial real estate relationship and a $763,000 commercialrelationship. Both relationships were classified as substandard in September of2005.

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Loans are classifiedaccording to estimated loss as follows: Substandard-2.5% to 35%; Doubtful-5% to 75%; and Loss-100%.We additionally provide an allowance estimate for probable incurred losses innon-classified loans ranging from .20% to 6.00%. Although we may allocate aportion of the allowance to specific loans or loan categories, the entireallowance is available for active charge-offs. Allowance estimates aredeveloped with actual loss experience adjusted for current economic conditions.Allowance estimates are considered a prudent measurement of the risk in theloan portfolio and are applied to individual loans based on loan type.

***Non-Performing Assets***

Non-performing assets consist of certain restructuredloans for which interest rate or other terms have been renegotiated, loans onwhich interest is no longer accrued, real estate acquired through foreclosureand repossessed assets.  We do not haveany loans greater than 90 days past due still on accrual. Loans, includingimpaired loans under SFAS 114, are placed on non-accrual status when theybecome past due 90 days or more as to principal or interest, unless they areadequately secured and in the process of collection. Loans are consideredimpaired if full principal or interest payments are not anticipated inaccordance with the contractual loan terms. Impaired loans are carried at thepresent value of expected future cash flows discounted at the loan’s effectiveinterest rate or at the fair value of the collateral if the loan is collateral dependent.

Loans are reviewed on a regular basis and normalcollection procedures are implemented when a borrower fails to make a requiredpayment on a loan. If the delinquency on a mortgage loan exceeds 90 days and isnot cured through normal collection procedures or an acceptable arrangement isnot worked out with the borrower, we institute measures to remedy the default,including commencing a foreclosure action. Consumer loans generally are chargedoff when a loan is deemed uncollectible by management and any availablecollateral has been disposed of. Commercial business and real estate loandelinquencies are handled on an individual basis by management with the adviceof legal counsel.

Interest income on loans is recognized on the accrualbasis except for those loans in a non-accrual of income status. The accrual ofinterest on impaired loans is discontinued when management believes, afterconsideration of economic and business conditions and collection efforts thatthe borrowers’ financial condition is such that collection of interest isdoubtful, typically after the loan becomes 90 days delinquent. When interestaccrual is discontinued, existing accrued interest is reversed and interestincome is subsequently recognized only to the extent cash payments arereceived.

Real estate acquired as a result of foreclosure or bydeed in lieu of foreclosure is classified as real estate owned until such timeas it is sold. New and used automobile, motorcycle and all terrain vehiclesacquired as a result of foreclosure are classified as repossessed assets untilthey are sold. When such property is acquired it is recorded at the lower ofthe unpaid principal balance of the related loan or its fair market value. Anywrite-down of the property at the time of acquisition is charged to theallowance for loan losses. Subsequent gains and losses are included innon-interest income and non-interest expense.

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Thefollowing table sets forth information with respect to non-performing assets asof the periods indicated.

| ** **                                                            | ** ** | **December 31,**               | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------|------------|
| ** **                                                            | ** ** | **2005**                            | ** ** | **2004**          | ** ** | **2003** | ** ** | **2002** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                            | ** ** | **(Dollar in thousands)** | ** ** |
| Restructured                                                          |       | $                                   | 3,104      |              | $          | 3,218 |   | $ | 3,037 |   | $ | 3,325 |   | $ | 3,350 |   | $ | — |   |
| Past due 90 days  still on accrual                                    | ** ** | —                              |       | —            |       | — |   | — |   | — |   | — | ** ** |
| Loans on  non-accrual status                                          |       | 3,128                               |       | 2,022             |       | 2,281 |   | 1,259 |   | 386 |   | 3,309 |   |
| Total non-performing loans                                            |       | 6,232                               |       | 5,240             |       | 5,318 |   | 4,584 |   | 3,736 |   | 3,309 |   |
| Real estate  acquired through foreclosure                             |       | 1,022                               |       | 681               |       | 387 |   | 510 |   | 660 |   | 296 |   |
| Other repossessed  assets                                             |       | 119                                 |       | 40                |       | 62 |   | 119 |   | 119 |   | 70 |   |
| Total non-performing assets                                           |       | $                                   | 7,373      |              | $          | 5,961 |   | $ | 5,767 |   | $ | 5,213 |   | $ | 4,515 |   | $ | 3,675 |   |
| Interest income  that would have been earned on non-performing loans  |       | $                                   | 432        |              | $          | 336 |   | $ | 374 |   | $ | 177 |   | $ | 300 |   | $ | 276 |   |
| Interest income  recognized on non-performing loans                   |       | 219                                 |       | 197               |       | 227 |   | 126 |   | 201 | ** ** | — | ** ** |
| Ratios:                                                               |       |                                |       |              |       |   |   |   |   |   |   |   |   |
| Non-performing loans to total loans (excluding loans  held for sale)  |       | 0.97                                | %          | 0.87              | %          | 0.96 | % | 0.87 | % | 0.72 | % | 0.64 | % |
| Non-performing  assets to total loans (excluding loans held for sale) |       | 1.15                                | %          | 0.99              | %          | 1.04 | % | 0.98 | % | 0.86 | % | 0.71 | % |

 

Included in non-performing assets for the 2005 periodis $3.1 million in restructured commercial and residential mortgage loans. Therestructured loans primarily consist of three credit relationships aggregating$2.9 million, including a $2.2 million commercial relationship, a $210,000commercial relationship****and a$452,000 residential mortgage relationship.  The terms of these loans have beenrenegotiated to reduce the rate of interest and extend the term thus reducingthe amount of cash flow required from the borrower to service the loans. Theterms of the restructured loans are currently being met.

Non-accrual loansincreased $1.1 million from December 31, 2004. Included in this increasewas a $1.5 million commercial real estate relationship, which becamenon-accrual in September of 2005. The relationship is collateralized byreal estate with a value of $1.9 million. Management has proceeded withforeclosure action and does not anticipate a loss resulting from the credit.

***Investment Securities***

Interest on securities provides us our largest sourceof interest income after interest on loans, constituting 6.4% of the totalinterest income for the year ended December 31, 2005. The securities portfolio serves as a source ofliquidity and earnings and contributes to the management of interest rate risk.We have the authority to invest in various types of liquid assets,including short-term United States Treasury obligations and securities ofvarious federal agencies, obligations of states and political subdivisions,corporate bonds, certificates of deposit at insured savings and loans andbanks, bankers’ acceptances, and federal funds. We may also invest a portion ofour assets in certain commercial paper and corporate debt securities. We arealso authorized to invest in mutual funds and stocks whose assets conform tothe investments that we are authorized to make directly. The available-for-saleand held-to-maturity investment portfolios increased by $4.7 million or 8%during the 2005 period due to investments in U.S. agencies, mortgage-backedsecurities, state and municipal obligations and a corporate bond. We purchasedthe short-term U.S. agency and mortgage-backed securities as a source ofliquidity for funding future loan growth. The corporate bond re-pricesquarterly with three-month LIBOR and was purchased 

34

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to enhance our earnings. Thestate and municipal obligations have an average life of 10 years. We purchasedthese securities to enhance earnings and manage interest rate risk by placinglonger-dated assets on the balance sheet. See Note 2 of the Notes toConsolidated Financial Statements for further information concerning theinvestment portfolio.

Thefollowing table sets forth the carrying value of our securities portfolio atthe dates indicated.

| ** **                          | ** ** | **December 31,**                | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|
| ** **                          | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                          | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities  available-for-sale:** |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies          |       |                                 | $          | 6,437 |   |   |   | $ | 15,929 |   |   |   | $ | — |   |   |
| Mortgage-backed                     |       |                                 | 11,302     |   |   |   | 1,879 |   |   |   | — |   |   |
| Equity                              |       |                                 | 1,991      |   |   |   | 3,079 |   |   |   | 2,939 |   |   |
| State and municipal                 |       |                                 | 5,558      |   |   |   | 1,041 |   |   |   | 1,070 |   |   |
| Corporate                           |       |                                 | 3,036      |   |   |   | — |   |   |   | — |   |   |
| Total                               |       |                                 | $          | 28,324 |   |   |   | $ | 21,928 |   |   |   | $ | 4,009 |   |   |
| **Securities  held-to-maturity:**   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies          |       |                                 | $          | 26,095 |   |   |   | $ | 26,095 |   |   |   | $ | 19,999 |   |   |
| Mortgage-backed                     |       |                                 | 5,136      |   |   |   | 6,820 |   |   |   | 8,930 |   |   |
| Corporate                           |       |                                 | 2,000      |   |   |   | 2,000 |   |   |   | 2,000 |   |   |
| Total                               |       |                                 | $          | 33,231 |   |   |   | $ | 34,915 |   |   |   | $ | 30,929 |   |   |

 

Thefollowing table sets forth the scheduled maturities, amortized cost, fair valueand weighted average yields for our securities at December 31, 2005.

| ** **                             | ** ** | **Amortized  Cost**                  | ** ** | **Fair  Value** | ** ** | **Weighted  Average  Yield*** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|-----------------|------------|-------------------------------|------------|
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities  available-for-sale:**    |       |                                 |       |            |       |                          |       |   |   |   |   |   |   |
| Due in one year or less                |       |                                 | $          | 3,215           |       |                          |       | $ | 3,194 |   |   |   | 2.50 | % |   |
| Due after one year through five years  |       |                                 | 3,584      |            |       |                          | 3,579      |   |   |   | 4.06 |   |   |
| Due after five years through ten years |       |                                 | 6,192      |            |       |                          | 6,057      |   |   |   | 4.31 |   |   |
| Due after ten years                    |       |                                 | 13,892     |            |       |                          | 13,503     |   |   |   | 4.48 |   |   |
| Equity                                 |       |                                 | 1,353      |            |       |                          | 1,991      |   |   |   | 4.51 |   |   |
| Total                                  |       |                                 | $          | 28,236          |       |                          |       | $ | 28,324 |   |   |   | 4.17 |   |   |
| **Securities  held-to-maturity:**      |       |                                 |       |            |       |                          |       |   |   |   |   |   |   |
| Due in one year or less                |       |                                 | $          | 8,000           |       |                          |       | $ | 7,892 |   |   |   | 2.44 | % |   |
| Due after one year through five years  |       |                                 | 22,937     |            |       |                          | 22,231     |   |   |   | 3.47 |   |   |
| Due after ten years                    |       |                                 | 2,294      |            |       |                          | 2,311      |   |   |   | 5.62 |   |   |
| Total                                  |       |                                 | $          | 33,231          |       |                          |       | $ | 32,434 |   |   |   | 3.37 |   |   |

----

*                    Theweighted average yields are calculated on amortized cost on a nontax-equivalent basis.

***Deposits***

We attract both short-term and long-term deposits fromthe general public by offering a wide range of deposit accounts and interestrates. In recent years we have been required by market conditions to relyincreasingly on short-term certificate accounts and other deposit alternativesthat are more responsive to market interest rates. We use forecasts based oninterest rate risk simulations to assist management in 

35

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monitoring our use ofcertificates of deposit and other deposit products as funding sources and theimpact of their use on interest income and net interest margin in various rateenvironments.

We rely primarily on customer service andlong-standing relationships with customers to attract and retain deposits.Market interest rates and rates on deposit products offered by competingfinancial institutions can significantly affect our ability to attract andretain deposits. In conjunction with our initiatives to expand and enhance ourretail branch network we have undertaken a renewed emphasis on growing ourcustomer checking account base to better enhance profitability and franchisevalue, as well as lower our dependence on certificate of deposit funding. Aheightened level of advertising and promotions coupled with associate incentiveplans designed to encourage the sale of checking account were successful inattracting deposits during 2005. We plan to continue these efforts during 2006and anticipate continued progress.

The combination of our long-standing relationships inaddition to promotions of money market and checking account products enabled usto increase total deposits by $4.7 million at December 31, 2005, comparedto the 2004 period. We were able to achieve this increase despite the decreaseof $36.9 million in public funds deposits during the year. Total retail andcommercial deposits increased $41.6 million during the year, offsetting thedecrease in public funds. Checking balances grew $4.5 million, or 6% at December 31,2005, compared to December 31, 2004. Money market and savings depositsgrew $25.5 million, or 18% for December 31, 2005, compared to the 2004period and certificates of deposit grew $11.6 million, or 4% for December 31,2005, compared to December 31, 2004. The decrease in public funds was theresult of one of our county school district customers using the deposits toconstruct three new schools during the year. The deposit growth in ourLouisville Metropolitan market was across all deposit categories. Checkingdeposit balances increased 31%, savings and money market balances increased139%, and certificate of deposit balances increased 59%.

To evaluate our funding needs in light of deposittrends resulting from these changing conditions, management and Boardcommittees evaluate simulated performance reports that forecast changes inmargins. We continue to offer attractive certificate rates for various terms toallow us to retain deposit customers and reduce interest rate risk during thecurrent rate environment, while protecting the margin as interest ratesincrease and the economy recovers.

We offer statement and passbook savings accounts, NOWaccounts, money market accounts and fixed and variable rate certificates withvarying maturities. We also offer tax-deferred individual retirement accounts.The flow of deposits is influenced significantly by general economicconditions, changes in interest rates and competition. As of December 31,2005, approximately 48% of our deposits consisted of various savings and demanddeposit accounts from which customers can withdraw funds at any time withoutpenalty. Interest rates paid, maturity terms, service fees and withdrawalpenalties are established by management on a periodic basis.

We also offer certificates of deposit with a varietyof terms and interest rates. These certificates have minimum depositrequirements as well. The variety of deposit accounts allows us to compete moreeffectively in obtaining funds and to respond with more flexibility to the flowof funds away from depository institutions into direct investment vehicles suchas government and corporate securities. However, our ability to attract andmaintain deposits and its cost of funds has been, and will continue to be,significantly affected by market conditions.

As of December 31, 2005, the holders of ourcertificates of deposits in amounts of $100,000 or more were $101.6 million in****non-brokered deposits, most of who residewithin our service areas. Certificates of deposits in amounts of $100,000 ormore obtained from deposit brokers were $490,000 for the 2005 period. Brokereddeposits consist of certificates of deposit placed by deposit brokers for a feeand can be utilized to support our asset growth.

36

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Thefollowing table breaks down our deposits.

| ** **               | ** ** | **December 31,**                | ** ** |
|--------------------------|------------|--------------------------------------|------------|
| ** **               | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **               | ** ** | **(Dollars in thousands)** | ** ** |
| Non-interest  bearing    |       |                                 | $          | 39,145 |   |   |   | $ | 38,441 |   |   |   | $ | 28,632 |   |   |
| NOW demand               |       |                                 | 76,848     |   |   |   | 73,801 |   |   |   | 67,504 |   |   |
| Savings                  |       |                                 | 99,879     |   |   |   | 78,499 |   |   |   | 86,419 |   |   |
| Money market             |       |                                 | 66,175     |   |   |   | 85,418 |   |   |   | 51,773 |   |   |
| Certificates of  deposit |       |                                 | 309,059    |   |   |   | 310,227 |   |   |   | 294,834 |   |   |
| Total                    |       |                                 | $          | 591,106 |   |   |   | $ | 586,386 |   |   |   | $ | 529,162 |   |   |

 

Thefollowing table shows at December 31, 2005 the amount of our certificatesof deposit of $100,000 or more by time remaining until maturity.

| **Maturity Period**   | ** ** | ** **              | ** ** | **Certificates  of Deposit** | ** ** |
|----------------------------|------------|-------------------------|------------|-----------------------------------|------------|
| ** **                 | ** ** | **(In Thousands)** | ** ** |
| Three months or  less      |       |                    | $          | 9,339                             |       |   |
| Three through six  months  |       |                    | 20,570     |                              |       |
| Six through  twelve months |       |                    | 29,074     |                              |       |
| Over twelve  months        |       |                    | 42,634     |                              |       |
| Total                      |       |                    | $          | 101,617                           |       |   |

 

***Borrowings***

Deposits are the primary source of funds for ourlending and investment activities and for our general business purposes. We canalso use advances (borrowings) from the FHLB of Cincinnati to supplement oursupply of lendable funds, meet deposit withdrawal requirements and extend theterm of its liabilities. Advances from the FHLB are secured by our stock in theFHLB, certain commercial real estate loans and substantially all of our firstmortgage loans. At December 31, 2005 we had $78.4 million in advancesoutstanding from the FHLB and the capacity to increase our borrowings anadditional $30 million. We also had $19.5 million in federal funds purchasedfrom the FHLB at December 31, 2005.

The FHLB of Cincinnati functions as a central reservebank providing credit for savings banks and other member financial institutions.As a member, we are required to own capital stock in the FHLB and areauthorized to apply for advances on the security of such stock and certain ofour home mortgages and other assets (principally, securities which areobligations of, or guaranteed by, the United States) provided that we meetcertain standards related to creditworthiness. For further information, seeNote 6 of the Notes to Consolidated Financial Statements in this Annual Report.

Thefollowing table sets forth information about our FHLB advances and federalfunds purchased as of and for the periods ended.

| ** **                                                     | ** ** | **December 31,**                | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Average balance  outstanding                                   |       |                                 | $          | 82,284 |   |   |   | $ | 78,543 |   |   |   | $ | 77,726 |   |   |
| Maximum amount  outstanding at any month-end during the period |       |                                 | 97,875     |   |   |   | 78,974 |   |   |   | 78,283 |   |   |
| Year end balance                                               |       |                                 | 97,875     |   |   |   | 78,904 |   |   |   | 78,283 |   |   |
| Weighted average  interest rate:                               | ** ** |                                 |       |   |   |   |   |   |   |   |   |   |   |
| At end of year                                                 |       |                                 | 4.76       | % |   |   | 4.87 | % |   |   | 4.88 | % |   |
| During the year                                                |       |                                 | 4.80       | % |   |   | 4.76 | % |   |   | 4.81 | % |   |

 

37

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**LIQUIDITY**

Liquidity risk arises from the possibility we may notbe able to satisfy current or future financial commitments, or may becomeunduly reliant on alternative funding sources. The objective of liquidity riskmanagement is to ensure that the cash flow requirements of depositors andborrowers, as well as our operating cash needs, are met, taking into accountall on- and off-balance sheet funding demands. Liquidity risk management alsoincludes ensuring cash flow needs are met at a reasonable cost. We maintain aninvestment and funds management policy, which identifies the primary sources ofliquidity, establishes procedures for monitoring and measuring liquidity, andestablishes minimum liquidity requirements in compliance with regulatoryguidance. The liquidity position is continually monitored and reviewed by theAsset Liability Committee.

Funds are available from a number of sources,including the sale of securities in the available-for-sale portion of theinvestment portfolio, principal pay-downs on loans and mortgage-backedsecurities, proceeds realized from loans held for sale, brokered deposits andother wholesale funding. At December 31, 2005, we had brokered depositstotaling $490,000. We also secured federal funds borrowing lines from two ofour correspondent banks totaling $15 million each. Our banking centers alsoprovide access to retail deposit markets. If large certificate depositors shiftto our competitors or other markets in response to interest rate changes, wehave the ability to replenish those deposits through alternative fundingsources. Traditionally, we have also utilized borrowings from the FHLB tosupplement our funding requirements. At December 31, 2005, we had anunused approved line of credit in the amount of $118.6 million and****sufficient collateral available to borrow,approximately, an additional $30 million in advances from the FHLB. We believeour sources of liquidity are adequate to meet expected cash needs for theforeseeable future.

At the holding company level, the Corporation usescash to pay dividends to stockholders, repurchase common stock, make selectedinvestments and acquisitions, and service debt. The main sources of funding forthe holding company include dividends and returns of investment from the Bank,and access to the capital markets.

The primary source offunding for the Corporation has been dividends and returns of investment fromthe Bank. As discussed in Note 9 to the consolidated financial statements,banking regulations limit the amount of dividends that may be paid. Accordingly,consolidated cash flows as presented in the consolidated statements of cashflows may not represent cash immediately available to the Corporation. During2005, the Bank declared and paid dividends to the Corporation of $4.0 million.

**CAPITAL**

Stockholders’ equity increased $4.9 million for theperiod ended December 31, 2005 compared to December 31, 2004. Theincrease in capital was primarily attributable to net income during the period.This increase was offset by cash dividends declared,****thepurchase of 29,000 shares of our own common stock, and a decrease inaccumulated other comprehensive income, a result of temporary unrealized lossesrecorded on securities. Average stockholders’ equity to average assets ratioincreased to 8.33% for the year ended December 31, 2005 compared to 8.28%for 2004.

In March 2002, a trust formed by First FinancialService Corporation completed the private placement of 10,000 shares ofcumulative trust preferred securities with a liquidation preference of $1,000per security. The proceeds of the offering were loaned to us in exchange forfloating rate junior subordinated deferrable interest debentures. Distributionson the securities are payable quarterly at a rate per annum equal to the 3-monthLIBOR plus 3.60%. We issued these securities to enhance our regulatory capitalposition as the securities are considered as Tier I capital under currentregulatory guidelines.

38

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Kentucky banking laws limit the amount of dividendsthat may be paid to First Financial Service Corporation by First FederalSavings Bank without prior approval of the KOFI. Under these laws, the amountof dividends that may be paid in any calendar year is limited to current year’snet income, as defined in the laws, combined with the retained net income ofthe preceding two years, less any dividends declared during those periods. At December 31,2005, without prior regulatory approval, we had approximately $8.9 million ofretained earnings that the Bank could pay as dividends to the Company ifauthorized by our board of directors.

Each of the federal bankregulatory agencies has established minimum leverage capital requirements forbanking organizations. Banking organizations must maintain a minimum ratio ofTier 1 capital to adjusted average quarterly assets equal to 3% to 5% subjectto federal bank regulatory evaluation of an organization’s overall safety andsoundness. We intend to maintain a capital position that meets or exceeds the “wellcapitalized” requirements as defined for banks by the FDIC. The following tableshows the ratios of Tier 1 capital and total capital to risk-adjusted assetsand the leverage ratios for the Corporation and the Bank as of December 31,2005.

**CapitalAdequacy Ratios as ofDecember 31, 2005**

| ** **                              | ** ** | **Regulatory** | ** ** | **Well-Capitalized** | ** ** | ** **   | ** ** | ** **               | ** ** |
|-----------------------------------------|------------|----------------|------------|----------------------|------------|--------------|------------|--------------------------|------------|
| **Risk-Based Capital Ratios** | ** ** | ** **     | ** ** | **Minimums**         | ** ** | **Minimums** | ** ** | **The Corporation** | ** ** | **The Bank** | ** ** |
| Tier 1 capital(1)                       |       |           | 4.0        | %                    |       |         | 6.0        | %                        |       |   | 10.4 | % |   |   | 10.0 | % |   |
| Total risk-based  capital(2)            |       |           | 8.0        | %                    |       |         | 10.0       | %                        |       |   | 11.5 | % |   |   | 11.1 | % |   |
| Tier 1 leverage ratio(3)                |       |           | 4.0        | %                    |       |         | 5.0        | %                        |       |   | 8.8 | % |   |   | 8.5 | % |   |
|                                         |            |                |            |                      |            |              |            |                          |            |  |  |  |  |  |  |  |  |  |  |

----

(1)          Shareholders’ equityplus corporation-obligated mandatory redeemable capital securities, lessunrealized gains (losses) on debt securities available for sale, net ofdeferred income taxes, less nonqualifying intangible assets; computed as aratio of risk-weighted assets, as defined in the risk-based capital guidelines.

(2)          Tier 1 capital plusqualifying loan loss allowance and subordinated debt; computed as a ratio ofrisk-weighted assets, as defined in the risk-based capital guidelines.

(3)          Tier1 capital computed as a percentage of fourth quarter average assets lessnonqualifying intangibles.

**OFF BALANCE SHEET ARRANGEMENTS**

We have no off balancesheet arrangements other than as disclosed in Note 16 to the consolidatedfinancial statements.

**AGGREGATECONTRACTUAL OBLIGATIONS**

| ** **                              | ** **                      | ** **                           | ** ** | ** **         | ** ** | **Greater than**     | ** ** | **Greater than**    | ** ** | ** **         | ** ** |
|-----------------------------------------|---------------------------------|--------------------------------------|------------|--------------------|------------|---------------------------|------------|--------------------------|------------|--------------------|------------|
| ** **                              | ** **                      | ** **                           | ** ** | **Less than** | ** ** | **one year to** | ** ** | **3 years to** | ** ** | **More than** | ** ** |
| ** **                              | **December 31, 2005** | ** **                           | ** ** | **Total**          | ** ** | **one year**         | ** ** | **3 years**         | ** ** | **5 years**   | ** ** | **5 years** | ** ** |
| ** **                              | ** **                      | **(Dollars in thousands)** | ** ** |
| **Aggregate  Contractual Obligations:** |                            |                                 |       |               |       |                      |       |                     |       |               |       |   |   |   |   |   |   |
| Time deposits                           |                            | $                                    | 309,059    |               | $          | 171,555                   |       |                     | $          | 113,930            |       |   |   | $ | 23,071 |   |   |   | $ | 503 |   |   |
| FHLB borrowings                         |                            | 78,375                               |       | 146                |       |                      | 281        |                     |       |               | 262        |   |   |   | 77,686 |   |   |
| Federal funds purchased                 |                            | 19,500                               |       | 19,500             |       |                      | —     |                     |       |               | —     |   |   |   | — |   |   |
| Subordinated debentures                 |                            | 10,000                               |       | —             |       |                      | —     |                     |       |               | —     |   |   |   | 10,000 |   |   |
| Lease commitments                       |                            | 1,900                                |       | 345                |       |                      | 577        |                     |       |               | 566        |   |   |   | 412 |   |   |
|                                         |                                 |                                      |            |                    |            |                           |            |                          |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

39

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FHLB borrowings represent the amounts that are due tothe FHLB of Cincinnati. These amounts have fixed maturity dates. Some of theseborrowings, although fixed, are subject to conversion provisions at the optionof the FHLB. The FHLB has the right to convert these advances to variable ratesor we can prepay the advance at no penalty. There is a substantial penalty ifwe prepay the advance before the FHLB exercises its right. We do not believethese advances will be converted in the near term.

The subordinated debentures, which mature March 26,2032, are redeemable prior to the maturity date at our option on or after March 26,2007 at their principal amount plus accrued interest. The subordinateddebentures are also redeemable in whole or in part from time to time, upon theoccurrence of specific events defined within the trust indenture. The interestrate on our subordinated debentures adjusts quarterly at three-month LIBOR plus3.60%. These debt instruments are currently being issued as spreads tothree-month LIBOR which are more favorable than our 3.60% spread. If thispricing continues through March 26, 2007, we will likely exercise ouroption to redeem these subordinated debentures on or after March 26, 2007.We have the option to defer distributions on the subordinated debentures fromtime to time for a period not to exceed 20 consecutive quarters.

Lease commitmentsrepresent the total future minimum lease payments under non-cancelableoperating leases.

**IMPACT OF INFLATION & CHANGING PRICES**

The financial statements and related data presented hereinhave been prepared in accordance with U.S. generally accepted accountingprinciples, which require the measurement of financial position and operatingresults in historical dollars without considering changes in the relativepurchasing power of money over time due to inflation.

We have an asset andliability structure that is essentially monetary in nature. As a result,interest rates have a more significant impact on our performance than theeffects of general levels of inflation. Periods of high inflation are oftenaccompanied by relatively higher interest rates, and periods of low inflationare accompanied by relatively lower interest rates. As market interest ratesrise or fall in relation to the rates earned on our loans and investments, thevalue of these assets decreases or increases respectively.

40

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**Item 7A.**                Quantitativeand Qualitative Disclosures About Market Risk

**ASSET/LIABILITYMANAGEMENT AND MARKET RISK**

To minimize the volatility of net interest income andexposure to economic loss that may result from fluctuating interest rates, wemanage our exposure to adverse changes in interest rates through asset andliability management activities within guidelines established by our AssetLiability Committee (“ALCO”). The ALCO, which includes senior managementrepresentatives, has the responsibility for approving and ensuring compliancewith asset/liability management polices. Interest rate risk is the exposure toadverse changes in the net interest income as a result of market fluctuationsin interest rates. The ALCO, on an ongoing basis, monitors interest rate andliquidity risk in order to implement appropriate funding and balance sheetstrategies. Management considers interest rate risk to be our most significantmarket risk.

We utilize an earnings simulation model to analyze netinterest income sensitivity. Potential changes in market interest rates andtheir subsequent effects on net interest income are then evaluated. The modelprojects the effects of movements in interest rates of both 100 and 200 basispoints over a twelve month period. Assumptions based on the historical behaviorof our deposit rates and balances in relation to changes in interest rates arealso incorporated into the model. These assumptions are inherently uncertainand, as a result, the model cannot precisely measure future net interest incomeor precisely predict the impact of fluctuations in market interest rates on netinterest income. Actual results will differ from the model’s simulated resultsdue to timing, magnitude and frequency of interest rate changes as well aschanges in market conditions and the application and timing of variousmanagement strategies.

Our interest sensitivity profile was asset sensitiveat both December 31, 2005 and December 31, 2004. Given a sustained100 basis point decrease in rates, our base net interest income would decreaseby an estimated 2.03% at December 31, 2005 compared to a decrease of 2.38%at December 31, 2004. Given a 100 basis point increase in interest ratesour base net interest income would increase by an estimated 1.92% at December 31,2005 compared to an increase of 2.19% at December 31, 2004.

Our interest sensitivity at any point in time will beaffected by a number of factors. These factors include the mix of interestsensitive assets and liabilities as well as their relative pricing schedules. Itis also influenced by market interest rates, deposit growth, loan growth, decayrates and prepayment speed assumptions.

As demonstrated by the December 31, 2005 and December 31,2004 sensitivity tables, we are in an asset sensitive position. This means thatour earning assets, which consist of loans and investment securities, willchange in price at a faster rate than our deposits and borrowings. Therefore,as short term interest rates increase, our net interest income will alsoincrease. Likewise, as short term interest rates decrease, our net interestincome will decrease.

The Federal Open Market Committee began increasingshort-term interest rates in June 2004. We believe the Federal Open MarketCommittee will stop increasing short term interest rates during 2006 and willlikely decrease short term interest rates in late 2006 or into 2007. Our netinterest margin and the level of net interest income would be negativelyaffected with a decrease in short-term interest rates. We continually monitorthe effects rate changes will have on our level of net interest income andmanagement works to structure the maturity and pricing of loans and deposits tomitigate large swings in net interest income. During 2005, we made efforts toincrease the level of short-term deposits with a money market promotion as wellas offering more attractive rates on short-term certificates of deposit. Inaddition, 78% of the newly originated or renewed loans during 2005 were fixedrates loans with the interest rate fixed from three to five years. Theseefforts, in addition to other initiatives to structure funding and futureliquidity needs will decrease our asset sensitivity. This will help decreasethe negative impact flat or decreasing short-term interest rates may have onthe level of net interest income.

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Oursensitivity to interest rate changes is presented based on data as of December 31,2005 and December 31, 2004.

| ** **                     | ** ** | **December 31, 2005.**     | ** ** |
|--------------------------------|------------|--------------------------------------|------------|
| ** **                     | ** ** | **Decrease in Rates**      | ** ** | ** ** | ** ** | **Increase in Rates** | ** ** |
| ** **                     | ** ** | **200**                              | ** ** | **100** | ** ** | ** ** | ** ** | **100** | ** ** | **200** | ** ** |
| ** **                     | ** ** | **Basis Points**                | ** ** | **Basis Points** | ** ** | **Base** | ** ** | **Basis Points** | ** ** | **Basis Points** | ** ** |
| ** **                     | ** ** | **(Dollars in thousands)** | ** ** |
| **Projected  interest income** |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans                          |       |                                 | $          | 48,350 |   |   |   | $ | 49,818 |   |   | $ | 51,077 |   |   | $ | 52,281 |   |   |   | $ | 53,539 |   |   |
| Investments                    |       |                                 | 2,703      |   |   |   | 2,846 |   |   | 2,948 |   |   | 2,995 |   |   |   | 3,062 |   |   |
| **Total  interest income**     |       |                                 | 51,053     |   |   |   | 52,664 |   |   | 54,025 |   |   | 55,276 |   |   |   | 56,601 |   |   |
| **Projected interest expense** | ** ** |                                 |       |   |   |   |   |   | ** ** | ** ** | ** ** |   |   |   |   |   |   |   |   |
| Deposits                       |       |                                 | 12,738     |   |   |   | 13,319 |   |   | 13,900 |   |   | 14,421 |   |   |   | 14,941 |   |   |
| Borrowed funds                 |       |                                 | 4,697      |   |   |   | 4,782 |   |   | 4,845 |   |   | 4,896 |   |   |   | 4,947 |   |   |
| Total interest  expense        |       |                                 | 17,435     |   |   |   | 18,101 |   |   | 18,745 |   |   | 19,317 |   |   |   | 19,888 |   |   |
| **Net interest income**        |       |                                 | $          | 33,618 |   |   |   | $ | 34,563 |   |   | $ | 35,280 |   |   | $ | 35,959 |   |   |   | $ | 36,713 |   |   |
| Change from base               |       |                                 | $          | (1,662 | ) |   |   | $ | (717 | ) |   |   |   |   | $ | 679 |   |   |   | $ | 1,433 |   |   |
| % Change from base             |       |                                 | (4.71      | )% |   |   | (2.03 | )% |   |   |   |   | 1.92 | % |   |   | 4.06 | % |   |

 

| ** **                     | ** ** | **December 31, 2004**      | ** ** |
|--------------------------------|------------|--------------------------------------|------------|
| ** **                     | ** ** | **Decrease in Rates**      | ** ** | ** ** | ** ** | **Increase in Rates** | ** ** |
| ** **                     | ** ** | **200**                              | ** ** | **100** | ** ** | ** ** | ** ** | **100** | ** ** | **200** | ** ** |
| ** **                     | ** ** | **Basis Points**                | ** ** | **Basis Points** | ** ** | **Base** | ** ** | **Basis Points** | ** ** | **Basis Points** | ** ** |
| ** **                     | ** ** | **(Dollars in thousands)** | ** ** |
| **Projected  interest income** |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans                          |       |                                 | $          | 38,503 |   |   |   | $ | 39,834 |   |   | $ | 40,943 |   |   | $ | 41,960 |   |   |   | $ | 42,995 |   |   |
| Investments                    |       |                                 | 1,963      |   |   |   | 2,332 |   |   | 2,517 |   |   | 2,667 |   |   |   | 2,820 |   |   |
| **Total  interest income**     |       |                                 | 40,466     |   |   |   | 42,166 |   |   | 43,460 |   |   | 44,627 |   |   |   | 45,815 |   |   |
| **Projected interest expense** |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                       |       |                                 | 10,215     |   |   |   | 10,805 |   |   | 11,395 |   |   | 11,914 |   |   |   | 12,433 |   |   |
| Borrowed funds                 |       |                                 | 4,262      |   |   |   | 4,307 |   |   | 4,352 |   |   | 4,393 |   |   |   | 4,434 |   |   |
| Total interest  expense        |       |                                 | 14,477     |   |   |   | 15,112 |   |   | 15,747 |   |   | 16,307 |   |   |   | 16,867 |   |   |
| **Net interest income**        |       |                                 | $          | 25,989 |   |   |   | $ | 27,054 |   |   | $ | 27,713 |   |   | $ | 28,320 |   |   |   | $ | 28,948 |   |   |
| Change from base               |       |                                 | $          | (1,724 | ) |   |   | $ | (659 | ) | ** ** | ** ** |   |   | $ | 607 |   |   |   | $ | 1,235 |   |   |
| % Change from base             |       |                                 | (6.22      | )% |   |   | (2.38 | )% | ** ** | ** ** |   |   | 2.19 | % |   |   | 4.46 | % |   |

 

 

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**Item 8.**                        FinancialStatements and Supplementary Data

**FIRST FINANCIALSERVICE CORPORATION**

**Tableof Contents**

| Audited Consolidated  Financial Statements:                                                                |   |   |   |
|------------------------------------------------------------------------------------------------------------|--------|--------|--------|
| Report on Management’s  Assessment of Internal Control Over Financial Reporting                       |   | 44     |   |
| Report of Independent Registered Public Accounting  Firm on Internal Control Over Financial Reporting |   | 45     |   |
| Report of Independent Registered Public Accounting  Firm on Financial Statements                           |   | 47     |   |
| Consolidated Balance Sheets                                                                                |   | 48     |   |
| Consolidated Statements of Income                                                                          |   | 49     |   |
| Consolidated Statements of Comprehensive Income                                                            |   | 50     |   |
| Consolidated Statements of Changes in Stockholders’  Equity                                           |   | 51     |   |
| Consolidated Statements of Cash Flows                                                                      |   | 52     |   |
| Notes to Consolidated  Financial Statements                                                                |   | 53-75  |   |

 

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**Report on Management’s Assessment of Internal ControlOver Financial Reporting**

First Financial Service Corporation is responsible forthe preparation, integrity, and fair presentation of the consolidated financialstatements included in this annual report. We, as management of First FinancialService Corporation, are responsible for establishing and maintaining effectiveinternal control over financial reporting that is designed to produce reliablefinancial statements in conformity with U.S. generally accepted accountingprinciples. Because of its inherent limitations, internal control overfinancial reporting may not prevent or detect misstatements. Also, projectionsof and evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

Managementassessed the system of internal control over financial reporting as of December 31,2005, in relation to criteria for effective internal control over financialreporting as described in “Internal Control—Integrated Framework,” issued bythe Committee of Sponsoring Organizations of the Treadway Commission. Based onthis assessment, management concludes that, as of December 31, 2005, itssystem of internal control over financial reporting is effective and meets thecriteria of the “Internal Control—Integrated Framework”. Crowe Chizek andCompany LLC, independent registered public accounting firm, has issued anattestation report on management’s assessment of the Corporation’s internalcontrol over financial reporting dated March 3, 2006.
| Date: March 15, 2006  | By:      | /s/ B. KEITH  JOHNSON                              |
|----------------------------|----------|---------------------------------------------------------|
|                       |     | B. Keith Johnson                                   |
|                       | * * | *President and Chief Executive Officer*                 |
| Date: March 15,  2006 | By:      | /S/  GREGORY SCHREACKE                                  |
|                       |     | Gregory Schreacke                                       |
|                       | * * | *Chief Financial Officer  Principal Accounting Officer* |

 

44

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**Reportof Independent Registered Public Accounting Firm On Internal Control OverFinancial Reporting**

We have audited management’s assessment, included inthe accompanying Report on Management’s Assessment of Internal Control OverFinancial Reporting, that First Financial Service Corporation maintainedeffective internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO). First Financial Service Corporation’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting. Ourresponsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operating effectivenessof internal control, and performing such other procedures as we considerednecessary in the circumstances. We believe that our audit provides a reasonablebasis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with U.S. generally accepted accounting principles. Acompany’s internal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with U.S. generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that FirstFinancial Service Corporation maintained effective internal control overfinancial reporting as of December 31, 2005 is fairly stated, in allmaterial respects, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO). Also, in our opinion, First Financial Service Corporationmaintained, in all material respects, effective internal control over financialreporting as of December 31, 2005 based on criteria established inInternal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

45

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We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the accompanying consolidated statements of financialcondition of First Financial Service Corporation as of December 31, 2005and 2004 and the related statements of income and comprehensive income,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2005 and our report dated March 3, 2006 expressedan unqualified opinion.

|            | ** ** | ****                          |
|------------|------------|-------------------------------|
| ** ** | ** ** | Crowe Chizek and  Company LLC |

 

Louisville, KentuckyMarch 3, 2006

46

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**Report of Independent Registered Public AccountingFirm On Financial Statements**

Board of Directors and StockholdersFirst Financial Service CorporationElizabethtown, Kentucky

We have audited the accompanying consolidated balancesheets of First Financial Service Corporation as of December 31, 2005 and2004, and the related consolidated statements of income, comprehensive income,changes in stockholders’ equity and cash flows for each of the three years inthe period ended December 31, 2005. These financial statements are theresponsibility of the Corporation’s management. Our responsibility is toexpress an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditingstandards of the Public Company Accounting Oversight Board  (United States). Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of First Financial Service Corporation as of December 31, 2005and 2004, and the results of its operations and its cash flows for each of thethree years in the period ended December 31, 2005, in conformity with U.S.generally accepted accounting principles.

Wealso have audited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the effectiveness of First Financial ServiceCorporation’s internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commissionand our report dated March 3, 2006 expressed an unqualified opinionthereon.

|  |   |                               |
|--|--------|-------------------------------|
|  |   | Crowe Chizek and Company  LLC |

 

Louisville, KentuckyMarch 3, 2006

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**FIRST FINANCIAL SERVICE CORPORATIONConsolidated Balance Sheets**

| ** **                                                                                                                                         | ** ** | **December 31,**                                              | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                                                         | ** ** | **2005**                                                           | ** ** | **2004** | ** ** |
| ** **                                                                                                                                         | ** ** | **(Dollars In Thousands,  Except Share Data)** | ** ** |
| **ASSETS**                                                                                                                                         |       |                                                               |       |   |   |
| Cash and due from banks                                                                                                                            |       | $                                                                  | 20,451     |   | $ | 27,910 |   |
| Federal funds sold                                                                                                                                 |       | —                                                             |       | 8,000 |   |
| Cash and cash equivalents                                                                                                                          |       | 20,451                                                             |       | 35,910 |   |
| Securities  available-for-sale                                                                                                                     |       | 28,324                                                             |       | 21,928 |   |
| Securities  held-to-maturity, fair value of $32,434 (2005) and $34,557 (2004)                                                                      |       | 33,231                                                             |       | 34,915 |   |
| Total securities                                                                                                                                   |       | 61,555                                                             |       | 56,843 |   |
| Loans held for sale                                                                                                                                |       | 597                                                                |       | 1,219 |   |
| Loans, net of unearned  fees                                                                                                                       |       | 642,520                                                            |       | 604,698 |   |
| Allowance for loan losses                                                                                                                          |       | (7,377                                                             | )          | (6,489 | ) |
| Net loans receivable                                                                                                                               |       | 635,740                                                            |       | 599,428 |   |
| Federal Home Loan Bank  stock                                                                                                                      |       | 7,194                                                              |       | 6,845 |   |
| Cash surrender value of  life insurance                                                                                                            |       | 7,637                                                              |       | 7,353 |   |
| Premises and equipment,  net                                                                                                                       |       | 19,134                                                             |       | 17,469 |   |
| Real estate owned:                                                                                                                                 |       |                                                               |       |   |   |
| Acquired through  foreclosure                                                                                                                      |       | 1,022                                                              |       | 681 |   |
| Held for development                                                                                                                               |       | 337                                                                |       | 389 |   |
| Other repossessed assets                                                                                                                           |       | 119                                                                |       | 40 |   |
| Goodwill                                                                                                                                           |       | 8,384                                                              |       | 8,384 |   |
| Accrued interest  receivable                                                                                                                       |       | 3,051                                                              |       | 2,487 |   |
| Other assets                                                                                                                                       |       | 1,889                                                              |       | 1,817 |   |
| **TOTAL  ASSETS**                                                                                                                                  |       | $                                                                  | 766,513    |   | $ | 737,646 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                     |       |                                                               |       |   |   |
| **LIABILITIES:**                                                                                                                                   |       |                                                               |       |   |   |
| Deposits:                                                                                                                                          |       |                                                               |       |   |   |
| Non-interest bearing                                                                                                                               |       | $                                                                  | 39,145     |   | $ | 38,441 |   |
| Interest bearing                                                                                                                                   |       | 551,961                                                            |       | 547,945 |   |
| Total deposits                                                                                                                                     |       | 591,106                                                            |       | 586,386 |   |
| Federal funds purchased                                                                                                                            |       | 19,500                                                             |       | — |   |
| Advances from Federal  Home Loan Bank                                                                                                              |       | 78,375                                                             |       | 78,904 |   |
| Subordinated debentures                                                                                                                            |       | 10,000                                                             |       | 10,000 |   |
| Accrued interest payable                                                                                                                           |       | 389                                                                |       | 413 |   |
| Accounts payable and  other liabilities                                                                                                            |       | 1,023                                                              |       | 637 |   |
| Deferred income taxes                                                                                                                              |       | 1,379                                                              |       | 1,505 |   |
| **TOTAL  LIABILITIES**                                                                                                                             |       | 701,772                                                            |       | 677,845 |   |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                     |       |                                                               |       |   |   |
| Serial preferred stock,  5,000,000 shares authorized and unissued                                                                                  |       | —                                                             |       | — |   |
| Common stock, $1 par  value per share; authorized 10,000,000 shares; issued and outstanding,  3,983,530 shares (2005), and 3,645,438 shares (2004) |       | 3,984                                                              |       | 3,645 |   |
| Additional paid-in  capital                                                                                                                        |       | 16,409                                                             |       | 8,226 |   |
| Retained earnings                                                                                                                                  |       | 44,291                                                             |       | 47,174 |   |
| Accumulated other  comprehensive income                                                                                                            |       | 57                                                                 |       | 756 |   |
| **TOTAL  STOCKHOLDERS’ EQUITY**                                                                                                               |       | 64,741                                                             |       | 59,801 |   |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                |       | $                                                                  | 766,513    |   | $ | 737,646 |   |

 

See notes to consolidated financial statements.

48

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**FIRST FINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Income**

| ** **                                          | ** ** | **Year Ended December 31,**                                  | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                          | ** ** | **(Dollars in thousands,  except per share data)** | ** ** |
| **Interest  Income:**                               |       |                                                                        |       |   |   |   |   |
| Interest and fees on loans                          |       | $                                                                           | 42,481     |   | $ | 37,364 |   | $ | 37,413 |   |
| Interest and dividends on investments and deposits  |       | 2,887                                                                       |       | 1,779 |   | 1,926 |   |
| Total interest income                               |       | 45,368                                                                      |       | 39,143 |   | 39,339 |   |
| **Interest  Expense:**                              |       |                                                                        |       |   |   |   |   |
| Deposits                                            |       | 13,199                                                                      |       | 10,478 |   | 12,124 |   |
| Federal funds purchased                             |       | 148                                                                         |       | 47 |   | - |   |
| Federal Home Loan Bank advances                     |       | 3,803                                                                       |       | 3,738 |   | 3,738 |   |
| Subordinated debentures                             |       | 712                                                                         |       | 529 |   | 503 |   |
| Total interest expense                              |       | 17,862                                                                      |       | 14,792 |   | 16,365 |   |
| Net interest income                                 |       | 27,506                                                                      |       | 24,351 |   | 22,974 |   |
| Provision for loan losses                           |       | 1,258                                                                       |       | 1,656 |   | 1,656 |   |
| Net interest income after provision for loan losses |       | 26,248                                                                      |       | 22,695 |   | 21,318 |   |
| **Non-interest  Income:**                           |       |                                                                        |       |   |   |   |   |
| Customer service fees on deposit accounts           |       | 5,167                                                                       |       | 4,913 |   | 4,556 |   |
| Gain on sale of mortgage loans                      |       | 868                                                                         |       | 862 |   | 1,564 |   |
| Gain on sale of investments                         |       | 381                                                                         |       | 202 |   | - |   |
| Gain on sale of real estate held for development    |       | 143                                                                         |       | 526 |   | 437 |   |
| Brokerage commissions                               |       | 313                                                                         |       | 404 |   | 353 |   |
| Other income                                        |       | 1,195                                                                       |       | 1,197 |   | 1,071 |   |
| Total non-interest income                           |       | 8,067                                                                       |       | 8,104 |   | 7,981 |   |
| **Non-interest  Expense:**                          |       |                                                                        |       |   |   |   |   |
| Employee compensation and benefits                  |       | 11,126                                                                      |       | 10,295 |   | 9,446 |   |
| Office occupancy expense and equipment              |       | 2,065                                                                       |       | 1,833 |   | 1,534 |   |
| Marketing and advertising                           |       | 778                                                                         |       | 726 |   | 568 |   |
| Outside services and data processing                |       | 2,393                                                                       |       | 2,134 |   | 1,826 |   |
| Bank franchise tax                                  |       | 788                                                                         |       | 822 |   | 623 |   |
| Other expense                                       |       | 3,609                                                                       |       | 3,464 |   | 3,295 |   |
| Total non-interest expense                          |       | 20,759                                                                      |       | 19,274 |   | 17,292 |   |
| Income before income taxes                          |       | 13,556                                                                      |       | 11,525 |   | 12,007 |   |
| Income taxes                                        |       | 4,412                                                                       |       | 3,735 |   | 4,004 |   |
| **Net Income**                                      |       | $                                                                           | 9,144      |   | $ | 7,790 |   | $ | 8,003 |   |
| Shares applicable to basic income per share         |       | 3,998                                                                       |       | 4,025 |   | 4,158 |   |
| **Basic income per share**                          |       | $                                                                           | 2.29       |   | $ | 1.94 |   | $ | 1.93 |   |
| Shares applicable to diluted income per share       |       | 4,025                                                                       |       | 4,043 |   | 4,196 |   |
| **Diluted income per share**                        |       | $                                                                           | 2.27       |   | $ | 1.93 |   | $ | 1.91 |   |

 

See notes to consolidated financial statements.

49

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**FIRST FINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Comprehensive Income**

| ** **                                                     | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                     | ** ** | **(Dollars in thousands)**       | ** ** |
| **Net  Income**                                                |       | $                                          | 9,144      |   | $ | 7,790 |   | $ | 8,003 |   |
| Other comprehensive  income (loss):                            |       |                                       |       |   |   |   |   |
| Change in unrealized gain (loss) on securities                 |       | (678                                       | )          | 138 |   | 606 |   |
| Reclassification of realized amount                            |       | (381                                       | )          | (202 | ) | — |   |
| Net unrealized gain (loss) recognized in  comprehensive income |       | (1,059                                     | )          | (64 | ) | 606 |   |
| Tax effect                                                     |       | 360                                        |       | 22 |   | (206 | ) |
| Total other comphrehensive income (loss)                       |       | (699                                       | )          | (42 | ) | 400 |   |
| **Comphrehensive Income**                                      |       | $                                          | 8,445      |   | $ | 7,748 |   | $ | 8,403 |   |

 

See notes to consolidated financial statements.

50

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**FIRST FINANCIAL SERVICE CORPORATIONConsolidated Statementsof Changes in Stockholders’ EquityYears Ending December 31, 2005, 2004 and 2003(Dollars In Thousands, Except Per Share Amounts)**

| ** **                                                                                      | ** ** | **Common  Shares** | ** ** | **Stock  Amount** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income, Net of  Tax** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|----------------------------------------------------------------------|------------|-----------|------------|
| **Balance,  January 1, 2003**                                                              |       |               | 3,644      |              |       |                             | $          | 3,644                  |       |                                                                 |       | $         | —     |   |   | $ | 55,605 |   |   | $ | 398 |   |   | $ | 59,647 |   |
| Net income                                                                                      |       |               |       |              |       |                             |       |                   |       |                                                                 |       |      |       | 8,003 |   |   |   |   |   | 8,003 |   |
| Stock dividend—10%                                                                         |       |               | 337        |              |       |                             | 337        |                   |       |                                                                 | 10,213     |      |       | (10,550 | ) |   |   |   |   | — |   |
| Exercise of stock  options, net of redemptions                                                  |       |               | 34         |              |       |                             | 34         |                   |       |                                                                 | 525        |      |       |   |   |   |   |   |   | 559 |   |
| Net change in  unrealized gains (losses) on securities available-for-sale, net of tax |       |               |       |              |       |                             |       |                   |       |                                                                 |       |      |       |   |   |   | 400 |   |   | 400 |   |
| Cash dividends  declared ($.64 per share)                                        |       |               |       |              |       |                             |       |                   |       |                                                                 |       |      |       | (2,660 | ) |   |   |   |   | (2,660 | ) |
| Stock repurchased                                                                               |       |               | (310       | )                 |       |                             | (310       | )                      |       |                                                                 | (1,012     | )         |       | (8,306 | ) |   | — |   |   | (9,628 | ) |
| **Balance,  December 31, 2003**                                                            |       |               | 3,705      |              |       |                             | 3,705      |                   |       |                                                                 | 9,726      |      |       | 42,092 |   |   | 798 |   |   | 56,321 |   |
| Net income                                                                                      |       |               |       |              |       |                             |       |                   |       |                                                                 |       |      |       | 7,790 |   |   |   |   |   | 7,790 |   |
| Net change in  unrealized gains (losses) on securities available-for-sale, net of tax |       |               |       |              |       |                             |       |                   |       |                                                                 |       |      |       |   |   |   | (42 | ) |   | (42 | ) |
| Cash dividends  declared ($.67 per share)                                        |       |               |       |              |       |                             |       |                   |       |                                                                 |       |      |       | (2,708 | ) |   |   |   |   | (2,708 | ) |
| Stock repurchased                                                                               |       |               | (60        | )                 |       |                             | (60        | )                      |       |                                                                 | (1,500     | )         |       | — |   |   | — |   |   | (1,560 | ) |
| **Balance,  December 31, 2004**                                                            |       |               | 3,645      |              |       |                             | 3,645      |                   |       |                                                                 | 8,226      |      |       | 47,174 |   |   | 756 |   |   | 59,801 |   |
| Net income                                                                                      |       |               |       |              |       |                             |       |                   |       |                                                                 |       |      |       | 9,144 |   |   |   |   |   | 9,144 |   |
| Stock dividend—10%                                                                         |       |               | 363        |              |       |                             | 363        |                   |       |                                                                 | 8,834      |      |       | (9,197 | ) |   |   |   |   | — |   |
| Exercise of stock  options                                                                      |       |               | 5          |              |       |                             | 5          |                   |       |                                                                 | 80         |      |       |   |   |   |   |   |   | 85 |   |
| Net change in  unrealized gains (losses) on securities available-for-sale, net of tax |       |               |       |              |       |                             |       |                   |       |                                                                 |       |      |       |   |   |   | (699 | ) |   | (699 | ) |
| Cash dividends  declared ($.71 per share)                                        |       |               |       |              |       |                             |       |                   |       |                                                                 |       |      |       | (2,830 | ) |   |   |   |   | (2,830 | ) |
| Stock repurchased                                                                               |       |               | (29        | )                 |       |                             | (29        | )                      |       |                                                                 | (731       | )         |       | — |   |   | — |   |   | (760 | ) |
| **Balance, December 31, 2005**                                                             |       |               | $          | 3,984             |       |                             |       | $                      | 3,984      |                                                                 |       |      | $          | 16,409 |   |   | $ | 44,291 |   |   | $ | 57 |   |   | $ | 64,741 |   |
|                                                                                                 |            |                    |            |                   |            |                                  |            |                        |            |                                                                      |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See notes to consolidated financial statements.

51

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**FIRST FINANCIAL SERVICE CORPORATIONConsolidated Statementsof Cash Flows**

| ** **                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                         | ** ** | **(Dollars in thousands)**       | ** ** |
| **Operating Activities:**                                                          |       |                                       |       |   |   |   |   |
| Net income                                                                         |       | $                                          | 9,144      |   | $ | 7,790 |   | $ | 8,003 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Provision for loan losses                                                          |       | 1,258                                      |       | 1,656 |   | 1,656 |   |
| Depreciation on premises and equipment                                             |       | 1,298                                      |       | 1,119 |   | 981 |   |
| Federal Home Loan Bank stock dividends                                             |       | (349                                       | )          | (275 | ) | (256 | ) |
| Net amortization (accretion) available-for-sale                                    |       | 8                                          |       | 16 | ** ** | **—** | ** ** |
| Net amortization (accretion) held-to-maturity                                      |       | 55                                         |       | 71 |   | (204 | ) |
| Gain on sale of investments available-for-sale                                     |       | (381                                       | )          | (202 | ) | — |   |
| Gain on sale of real estate held for development                                   |       | (143                                       | )          | (526 | ) | (437 | ) |
| Gain on sale of mortgage loans                                                     |       | (868                                       | )          | (862 | ) | (1,564 | ) |
| Origination of loans held for sale                                                 |       | (45,446                                    | )          | (52,368 | ) | (87,233 | ) |
| Proceeds on sale of loans held for sale                                            |       | 46,936                                     |       | 53,032 |   | 91,452 |   |
| Deferred taxes                                                                     |       | 234                                        |       | 401 |   | 95 |   |
| Changes  in:                                                                       |       |                                       | ** ** | ** ** |   |   |   |
| Cash surrender value of life insurance                                             |       | (284                                       | )          | (286 | ) | (67 | ) |
| Interest receivable                                                                |       | (564                                       | )          | (556 | ) | (189 | ) |
| Other assets                                                                       |       | (72                                        | )          | 1,084 |   | (520 | ) |
| Interest payable                                                                   |       | (24                                        | )          | (3 | ) | (88 | ) |
| Accounts payable and other liabilities                                             |       | 386                                        |       | (150 | ) | 79 |   |
| Net cash from  operating activities                                                |       | 11,188                                     |       | 9,941 |   | 11,708 |   |
| **Investing  Activities:**                                                         |       |                                       | ** ** | ** ** |   |   |   |
| Sales of securities available-for-sale                                             |       | 1,431                                      |       | 745 |   | — |   |
| Purchases of securities available-for-sale                                         |       | (37,393                                    | )          | (18,640 | ) | (1,415 | ) |
| Maturities of securities available-for-sale                                        |       | 28,880                                     |       | — |   | — |   |
| Purchases of securities held-to-maturity                                           |       | —                                     |       | (24,100 | ) | (46,078 | ) |
| Maturities of securities held-to-maturity                                          |       | 1,629                                      |       | 20,141 |   | 31,940 |   |
| Investment in cash surrender value of life insurance                               |       | —                                     |       | — |   | (7,000 | ) |
| Net change in loans                                                                |       | (38,612                                    | )          | (51,005 | ) | (25,750 | ) |
| Net purchases of premises and equipment                                            |       | (2,963                                     | )          | (3,288 | ) | (4,603 | ) |
| Sales of real estate held for development                                          |       | 195                                        |       | 509 |   | 540 |   |
| Net cash from  investing activities                                                |       | (46,833                                    | )          | (75,638 | ) | (52,366 | ) |
| **Financing  Activities**                                                          |       |                                       | ** ** | ** ** |   |   |   |
| Net change in deposits                                                             |       | 4,720                                      |       | 57,224 |   | 8,041 |   |
| Change in federal funds purchased                                                  |       | 19,500                                     |       | — |   | — |   |
| Advances from Federal Home Loan Bank                                               |       | 450                                        |       | 821 |   | 844 |   |
| Repayments to Federal Home Loan Bank                                               |       | (979                                       | )          | (200 | ) | (244 | ) |
| Proceeds from stock options exercised                                              |       | 85                                         | ** ** | **—** |   | 559 |   |
| Dividends paid                                                                     |       | (2,830                                     | )          | (2,708 | ) | (2,660 | ) |
| Common stock repurchased                                                           |       | (760                                       | )          | (1,560 | ) | (9,628 | ) |
| Net cash from  financing activities                                                |       | 20,186                                     |       | 53,577 |   | (3,088 | ) |
| **(Decrease) in cash and cash equivalents**                                        |       | (15,459                                    | )          | (12,120 | ) | (43,746 | ) |
| **Cash and  cash equivalents, beginning of year**                                  |       | 35,910                                     |       | 48,030 |   | 91,776 |   |
| **Cash and cash equivalents, end  of year**                                        |       | $                                          | 20,451     |   | $ | 35,910 |   | $ | 48,030 |   |

 

See notes to consolidated financial statements.

52

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1. SUMMARY OF SIGNIFICANTACCOUNTING POLICIES**

The following is adescription of the significant accounting policies First Financial ServiceCorporation follows in preparing and presenting its consolidated financialstatements:

**Principles of Consolidation and Business**—The consolidated financial statements include theaccounts of First Financial Service Corporation and its wholly ownedsubsidiary, First Federal Savings Bank. First Federal Savings Bank has threewholly owned subsidiaries, First Service Corporation of Elizabethtown, FirstHeartland Mortgage Company and First Federal Office Park, LLC. Unless the textclearly suggests otherwise, references to “us,” “we,” or “our” include FirstFinancial Service Corporation and its wholly-owned subsidiary. All significantintercompany transactions and balances have been eliminated.

On January 8, 2003,the First Federal Savings Bank converted from a federal savings bank, regulatedby the Office of Thrift Supervision (OTS), to a commercial bank chartered underKentucky banking laws regulated by the Federal Deposit Insurance Corporation(FDIC) and the Kentucky Department of Financial Institutions (KDFI). At thesame time, the First Financial Service Corporation became a bank holdingcompany regulated by the Federal Reserve and changed its fiscal year from June 30to December 31.

Our business consistsprimarily of attracting deposits from the general public and origination ofmortgage loans on commercial property, single-family residences andmulti-family housing. We also make home improvement loans, consumer loans andcommercial business loans. Our primary lending area is a region within NorthCentral Kentucky. The economy within this region is diversified with a varietyof medical service, manufacturing, and agricultural industries, and Fort Knox,a military installation.

The principal sources offunds for our lending and investment activities are deposits, repayment ofloans and Federal Home Loan Bank advances. Our principal source of income isinterest on loans. In addition, other income is derived from loan originationfees, service charges, returns on investment securities, gain on sale ofmortgage loans, and brokerage and insurance commissions.

First Service Corporationacts as a broker for the purpose of selling investment services to ourcustomers in the area of tax-deferred annuities, government securities andstocks and bonds. First Heartland Mortgage Company, through the secondarymortgage lending department, originates qualified government and conventionalsecondary market loans on the behalf of the investors. First Federal OfficePark, LLC holds commercial lots adjacent to our home office on Ring Road inElizabethtown, which are available for sale.

**Estimates and Assumptions**—The preparation of consolidated financialstatements in conformity with U.S. generally accepted accounting principlesrequires us to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of the amount of revenues and expensesduring the reporting period. Actual results could differ from those estimates. Theallowance for loan losses and the fair value of financial instruments areparticularly subject to change.

**Cash Flows**—Forpurposes of the statement of cash flows, we consider all highly liquid debtinstruments purchased with an original maturity of three months or less to becash equivalents. Cash and cash equivalents include cash on hand, amounts duefrom banks, federal funds sold and certain interest bearing deposits. Net cashflows are reported for interest-bearing deposits, loans, premises and equipmentand deposits.

53

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued)**

**Securities**—We classify investments into held-to-maturity andavailable-for-sale. Debt securities in which management has a positive intentand ability to hold are classified as held-to-maturity and are carried at costadjusted for the amortization of premiums and discounts using the interestmethod over the terms of the securities. Debt and equity securities, which donot fall into this category, nor held for the purpose of selling in the nearterm, are classified as available-for-sale. Unrealized holding gains andlosses, net of tax, on available-for-sale securities are reported as acomponent of other comprehensive income.

Interest income includes amortization of purchasepremium or discount. Premiums and discounts on securities are amortized on thelevel-yield method. Gains and losses on sales are recorded on the trade dateand determined using the specific identification method.

Declines in the fair value of securities below theircost that are other than temporary are reflected as realized losses. Inestimating other-than-temporary losses, management considers: (1) thelength of time and extent that fair value has been less than cost, (2) thefinancial condition and near term prospects of the issuer, and (3) ourability and intent to hold the security for a period sufficient to allow forany anticipated recovery in fair value.

**Loans**—Loans are stated at unpaid principal balances, lessundistributed construction loans, and net deferred loan origination fees. Wedefer loan origination fees and discounts net of certain direct originationcosts. These net deferred fees are amortized using the level yield method on aloan-by-loan basis over the lives of the underlying loans.

Interest income on loans is accrued on the unpaid principalbalance except for those loans in nonaccrual status. The accrual of interest isdiscontinued when a loan becomes 90 or more days delinquent. When interestaccrual is discontinued, interest income is subsequently recognized only to theextent cash payments are received. Interest accruals resume when the loanbecomes less than 90 days delinquent.

**Allowance for Loan Losses**—The allowance for loan losses is a valuationallowance for probable incurred credit losses. Loan losses are charged againstthe allowance when we believe the uncollectibility of a loan balance isconfirmed. Subsequent recoveries, if any, are credited to the allowance. Ourperiodic evaluation of the allowance is based on our past loan loss experience,known and inherent risks in the portfolio, adverse situations that may affectthe borrower’s ability to repay, estimated value of any underlying collateral,and current economic conditions. Allocations of the allowance may be made forspecific loans, but the entire allowance is available for any loan that, inmanagement’s judgment, should be charged-off.

The allowance consists of specific and generalcomponents. The specific component relates to loans that are individuallyclassified as impaired or loans otherwise classified as substandard or doubtful.The general component covers non-classified loans and is based on historicalloss experience adjusted for current factors.

Loans are considered impaired when, based on currentinformation and events, it is probable that full principal or interest paymentsare not anticipated in accordance with the contractual loan terms. Factorsconsidered by management in determining impairment include payment status,collateral value, and the probability of collecting scheduled principal and interestpayments when due. Loans that experience insignificant payment delays andpayment shortfalls generally are not classified as impaired. Impaired loans arecarried at the present value of expected future cash flows discounted at theloan’s effective 

54

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**1. SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)**

interest rate or at thefair value of the collateral if the loan is collateral dependent. Commercialand commercial real estate loans are individually evaluated for impairment. Largegroups of smaller balance homogeneous loans, such as consumer and residentialreal estate loans, are collectively evaluated for impairment and are separatelyidentified for impairment disclosures. A portion of the allowance for loanlosses is allocated to impaired loans if the value of such loans is less thanthe unpaid balance. If these allocations cause the allowance for loan losses torequire an increase, such increase is reported in the provision for loanlosses.

**Mortgage Banking Activities**—Mortgage loans originated and intended for sale inthe secondary market are carried at the lower of aggregate cost or market value.To deliver closed loans to the secondary market and to control its interestrate risk prior to sale, we enter into “best efforts” agreements to sell loans.The aggregate market value of mortgage loans held for sale considers the priceof the sales contracts. The loans are sold with servicing released.

Loan commitments related to the origination ofmortgage loans held for sale are accounted for as derivative instruments. Ourcommitments are for fixed rate mortgage loans, generally lasting 60 to 90 daysand are at market rates when initiated. Considered derivatives, we hadcommitments to originate $1.2 million****and$3.3 million in loans at December 31, 2005 and 2004, which we intend tosell after the loans are closed.

The fair value was not material and substantially allof the gain on sale generated from mortgage banking activities continues to berecorded when closed loans are delivered into the sales contracts.

**Federal Home Loan Bank Stock**—The Bank is a member of the FHLB system. Membersare required to own a certain amount of stock based on the level of borrowingsand other factors, and may invest in additional amounts. Investment in stock ofFederal Home Loan Bank is carried at cost, and periodically evaluated forimpairment. Both cash and stock dividends are reported as income.

**Cash Surrender Value of LifeInsurance**—We have purchasedlife insurance policies on certain key executives. The life insurance isrecorded at its cash surrender value, or the amount that can be realized.

**Premises and Equipment**—Land is carried cost. Premises and equipment arestated at cost less accumulated depreciation. Buildings and related componentsare depreciated using the straight-line method with useful lives ranging from 5to 40 years. Furniture, fixtures and equipment are depreciated using thestraight-line method with useful lives ranging from 3 to 15 years.

**Real Estate Owned**—Real estate properties acquired through foreclosureand in settlement of loans are stated at lower of cost or fair value lessestimated selling costs at the date of foreclosure. The excess of cost overfair value less the estimated costs to sell at the time of foreclosure ischarged to the allowance for loan losses. Costs relating to development andimprovement of property are capitalized, whereas costs relating to holdingproperty are not capitalized and are charged against operations in the currentperiod.

**Real Estate Held forDevelopment**—Real estateproperties held for development and sale are carried at the lower of cost,including cost of development and improvement subsequent to acquisition, orfair value less estimated selling costs. The portion of interest costs relatingto the development of real estate is capitalized.

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**1. SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)**

**Other Repossessed Assets**—Consumer assets acquired through repossession and insettlement of loans, typically automobiles, are carried at lower of cost or fairvalue at the date of repossession. The excess cost over fair value at time ofrepossession is charged to the allowance for loan losses.

**Stock Dividends**—We declared a 10% stock dividend on April 16,2003 to our shareholders of record as of April 28, 2003, payable on May 14,2003. In addition, we declared another 10% stock dividend on September 20,2005 to our shareholders of record as of October 7, 2005, payable on October 21,2005. The payment of these dividends is in addition to the regular quarterly cashdividends. Per share amounts have been restated for the impact of the stockdividends.

**Brokerage and InsuranceCommissions**—Brokerage commissions arerecognized as income on settlement date. Insurance commissions on loan products(credit life, mortgage life, accidental death, and guaranteed auto protection)are recognized as income over the life of the loan.

**Stock Option Plans**—Employee compensation expense under stock optionplans is reported using the intrinsic value method. No stock-based compensationcost is reflected in net income, as all options granted had an exercise priceequal to the market price of the underlying common stock at date of grant. Thefollowing table illustrates the effect on net income and earnings per share ifexpense was measured using the fair value recognition provisions of FASBStatement No. 123, Accounting for Stock-Based Compensation.

| ** **                                                                                                                                    | ** ** | **Year Ended December 31,**                                 | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2005**                                                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                    | ** ** | **(Dollars in thousands  except per share data)** | ** ** |
| Net income:                                                                                                                                   |       |                                                                       |       |   |   |   |   |
| As reported                                                                                                                                   |       | $                                                                          | 9,144      |   | $ | 7,790 |   | $ | 8,003 |   |
| Deduct: Stock-based compensation expense determined  under fair value based method                                                            |       | (89                                                                        | )          | (190 | ) | (108 | ) |
| Pro-forma                                                                                                                                     |       | $                                                                          | 9,055      |   | $ | 7,600 |   | $ | 7,895 |   |
| Earnings per share:                                                                                                                           | ** ** | ** **                                                                 |       |   |   |   |   |
| Basic  As       Reported                                                                                   |       | $                                                                          | 2.29       |   | $ | 1.94 |   | $ | 1.93 |   |
|                       Pro-forma |       | 2.26                                                                       |       | 1.89 |   | 1.90 |   |
| Diluted As   Reported                                                                                                               |       | $                                                                          | 2.27       |   | $ | 1.93 |   | $ | 1.91 |   |
|                       Pro-forma |       | 2.25                                                                       |       | 1.88 |   | 1.88 |   |

 

56

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**1. SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES (Continued)**

The weighted-averageassumptions for options granted during the year ended December 31, 2004and the resulting estimated weighted average fair value per share used incomputing the pro forma disclosures is presented below. There were no optionsgranted for the years ended December 31, 2005 and 2003.

| ** **                                    | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2004**              | ** ** |
| Assumptions:                                  |       |                  |       |   |   |
| Risk-free interest rate                       |       |                  | 4.13       | % |   |
| Expected dividend yield                       |       |                  | 2.84       | % |   |
| Expected life (years)                         |       |                  | 10         |   |   |
| Expected common stock market price volatility |       |                  | 26         | % |   |
| Estimated fair value per  share               |       |                  | $          | 7.03 |   |   |
|                                               |            |                       |            |  |  |  |

 

**Income Taxes**—Deferred income tax assets and liabilities aredetermined using the liability method. Under this method, the net deferred taxasset or liability is determined based on the tax effects of the differencesbetween the book and tax basis of the various balance sheet assets andliabilities.

**Employee Stock OwnershipPlan**—Compensation expense is based onthe market price of shares as they are committed to be released to participantaccounts. Dividends on allocated ESOP shares reduce retained earnings. Sincethe ESOP has not acquired shares in advance of allocation to participantaccounts, the plan has no unallocated shares.

**Earnings Per Common Share**—Basic earnings per common share is net incomedivided by the weighted average number of common shares outstanding during theperiod. Diluted earnings per common share include the dilutive effect ofadditional potential common shares issuable under stock options.

**Loss Contingencies**—In the normal course of business, there are variousoutstanding legal proceedings and claims. In the opinion of management thedisposition of such legal proceedings and claims will not materially affect ourconsolidated financial position, results of operations or liquidity.

**Comprehensive Income**—Comprehensive income consists of net income andother comprehensive income. Other comprehensive income includes unrealizedgains and losses on securities available-for-sale, which are also recognized asa separate component of equity, net of tax.

**Derivatives**—The Corporation only uses derivative instruments asdescribed in “Mortgage Banking Activities.”

**Effect of Newly Issued But Not Yet Effective Accounting Standards**—In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”)No. 123 (Revised 2004) (“SFAS No. 123R”), “Share-Based Payment.”  SFAS No. 123R is a revision of FASBStatement 123, “Accounting for Stock-Based Compensation” and supersedes APBOpinion No. 25, “Accounting for Stock Issued to Employees,” and itsrelated implementation guidance. SFAS No. 123R requires all publiccompanies to record compensation cost for stock options provided to employeesin return for employee service. The cost is measured at the fair value of theoptions when granted, and this cost is expensed over the employee serviceperiod, which is normally the vesting period of the options. This will apply toawards granted or modified for the year beginning January 1, 2006. Compensationcost will also be recorded for prior option grants that vest after the date ofadoption. The effect on results of operations will depend on the level offuture option grants and the calculation of the fair value of the optionsgranted at such future date, as well as the vesting periods provided, and sothey cannot currently be predicted. Existing options that will vest afteradoption date are expected to result in additional 

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued)**

**compensation expense ofapproximately $62,000 in 2006, $56,000 in 2007, $56,000 in 2008 and $42,000 in2009. There will be no significant effect on financial position as total equitywill not change.**

In May 2005, the FASB issued Statement ofFinancial Accounting Standards No. 154 (“SFAS No. 154”), “AccountingChanges and Error Corrections.” This statement replaces Accounting PrinciplesBoard Opinion No. 20 “Accounting Changes”, and FASB Statement No. 3, “ReportingAccounting Changes in Interim Financial Statements” and changes therequirements for the accounting for and reporting of a change in accountingprinciple. SFAS No. 154 shall be effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005.

**Operating Segments**—Segments are parts of a company evaluated bymanagement with separate financial information. Our internal financialinformation is primarily reported and evaluated in three lines of business,banking, mortgage banking, and brokerage. These segments are dominated bybanking at a magnitude for which separate individual segment disclosures arenot required.

**Reclassifications**—Some items in the prior year financial statementswere re-classified to conform to the current presentation.

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SECURITIES**

The amortized cost basis and fair values of securitiesare as follows:

| ** **                         | ** ** | **Amortized  Cost**                  | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|------------------------------|------------|-------------------------------|------------|---------------------|------------|
| ** **                         | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities available-for-sale:** |       |                                 |       |                         |       |                          |       |                |       |   |   |   |   |   |   |   |   |
| **December 31, 2005:**        |       |                                 |       |                         |       |                          |       |                |       |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies         |       |                                 | $          | 6,486                        |       |                          |       | $                   | —     |   |   |   | $ | (49 | ) |   |   | $ | 6,437 |   |   |
| Mortgage-backed                    |       |                                 | 11,558     |                         |       |                          | —     |                |       |   | (256 | ) |   |   | 11,302 |   |   |
| Equity                             |       |                                 | 1,353      |                         |       |                          | 638        |                |       |   | — |   |   |   | 1,991 |   |   |
| State and municipal                |       |                                 | 5,803      |                         |       |                          | 14         |                |       |   | (259 | ) |   |   | 5,558 |   |   |
| Corporate                          |       |                                 | 3,036      |                         |       |                          | —     |                |       |   | — |   |   |   | 3,036 |   |   |
| Total                              |       |                                 | $          | 28,236                       |       |                          |       | $                   | 652        |   |   |   | $ | (564 | ) |   |   | $ | 28,324 |   |   |
| **December 31, 2004:**        |       |                                 |       |                         |       |                          |       |                |       |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies         |       |                                 | $          | 15,985                       |       |                          |       | $                   | —     |   |   |   | $ | (56 | ) |   |   | $ | 15,929 |   |   |
| Mortgage-backed                    |       |                                 | 1,901      |                         |       |                          | —     |                |       |   | (22 | ) |   |   | 1,879 |   |   |
| Equity                             |       |                                 | 1,898      |                         |       |                          | 1,181      |                |       |   | — |   |   |   | 3,079 |   |   |
| State and municipal                |       |                                 | 999        |                         |       |                          | 42         |                |       |   | — |   |   |   | 1,041 |   |   |
| Total                              |       |                                 | $          | 20,783                       |       |                          |       | $                   | 1,223      |   |   |   | $ | (78 | ) |   |   | $ | 21,928 |   |   |

 

| ** **                        | ** ** | **Amortized  Cost**                  | ** ** | **Gross  Unrecognized  Gains** | ** ** | **Gross  Unrecognized  Losses** | ** ** | **Fair Value** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|---------------------|------------|
| ** **                        | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities  held-to-maturity:** |       |                                 |       |                           |       |                            |       |                |       |   |   |   |   |   |   |   |   |
| **December 31,  2005:**      |       |                                 |       |                           |       |                            |       |                |       |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies        |       |                                 | $          | 26,095                         |       |                            |       | $                   | —     |   |   |   | $ | (607 | ) |   |   | $ | 25,488 |   |   |
| Mortgage-backed                   |       |                                 | 5,136      |                           |       |                            | 2          |                |       |   | (207 | ) |   |   | 4,931 |   |   |
| Corporate                         |       |                                 | 2,000      |                           |       |                            | 15         |                |       |   | — |   |   |   | 2,015 |   |   |
| Total                             |       |                                 | $          | 33,231                         |       |                            |       | $                   | 17         |   |   |   | $ | (814 | ) |   |   | $ | 32,434 |   |   |
| **December 31,  2004:**      |       |                                 |       |                           |       |                            |       |                |       |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies        |       |                                 | $          | 26,095                         |       |                            |       | $                   | 3          |   |   |   | $ | (244 | ) |   |   | $ | 25,854 |   |   |
| Mortgage-backed                   |       |                                 | 6,820      |                           |       |                            | 7          |                |       |   | (124 | ) |   |   | 6,703 |   |   |
| Corporate                         |       |                                 | 2,000      |                           |       |                            | —     |                |       |   | — |   |   |   | 2,000 |   |   |
| Total                             |       |                                 | $          | 34,915                         |       |                            |       | $                   | 10         |   |   |   | $ | (368 | ) |   |   | $ | 34,557 |   |   |

 

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SECURITIES(Continued)**

The amortized cost andfair value of securities at December 31, 2005, by contractual maturity,are shown below. Securities not due at a single maturity date, primarily mortgage-backedand equity securities, are shown separately.

| ** **                              | ** ** | **Available for Sale**     | ** ** | **Held-to-Maturity** | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|----------------------|------------|
| ** **                              | ** ** | **Amortized**                        | ** ** | **Fair**             | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                              | ** ** | **Cost**                             | ** ** | **Value**            | ** ** | **Cost** | ** ** | **Value** | ** ** |
| ** **                              | ** ** | **(Dollars in thousands)** | ** ** |
| Due in one year  or less                |       |                                 | $          | 3,215                |       |   | $ | 3,194 |   |   | $ | 8,000 |   |   | $ | 7,892 |   |
| Due after one  year through five years  |       |                                 | 3,584      |                 |       | 3,579 |   |   | 18,095 |   |   | 17,596 |   |
| Due after five  years through ten years |       |                                 | 611        |                 |       | 602 |   |   | — |   | ** ** | — | ** ** |
| Due after ten  years                    |       |                                 | 7,915      |                 |       | 7,656 |   |   | 2,000 |   |   | 2,015 |   |
| Mortgage-backed                         |       |                                 | 11,558     |                 |       | 11,302 |   |   | 5,136 |   |   | 4,931 |   |
| Equity                                  |       |                                 | 1,353      |                 |       | 1,991 |   |   | — |   |   | — |   |
|                                    |       |                                 | $          | 28,236               |       |   | $ | 28,324 |   |   | $ | 33,231 |   |   | $ | 32,434 |   |

 

Thefollowing schedule sets forth the proceeds from sales of available-for-salesecurities and the gross realized gains on those sales:

| ** **           | ** ** | **Year Ended December 31,** | ** ** |
|----------------------|------------|--------------------------------------------|------------|
| ** **           | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **           | ** ** | **(Dollars in thousands)**       | ** ** |
| Proceeds from  sales |       | $                                          | 1,431      |   | $ | 745 |   |   | — |   |   |
| Gross realized gains |       | 381                                        |       | 202 |   |   | — |   |   |
|                      |            |                                            |            |  |  |  |  |  |  |  |  |

 

The tax expense related to these realized gains was$130,000 and $69,000, respectively.

Investment securities having an amortized cost of$36.7 million and fair value of $35.8 million and $34.5 million amortizedcost and $36.1 fair value at December 31, 2005 and 2004 were pledged tosecure public deposits.

Securitieswith unrealized losses at year-end 2005 and 2004 not recognized in income areas follows:

| **December 31, 2005**         | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**            | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|----------------------|------------|
| **Description of Securities** | ** ** | ** **                             | ** ** | **Fair  Value**                      | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** |
| U. S. Treasury  and agencies            |       | $                                      | 6,377      |                                 |       | $                    | (104       | ) |   | $ | 25,548 |   |   | $ | (552 | ) |   | $ | 31,925 | ** ** |   | $ | (656 | ) |   |
| Mortgage-backed                         |       | 10,239                                 |       |                                 | (218       | )                    |       | 5,753 |   |   | (245 | ) |   | 15,992 | ** ** |   | (463 | ) |   |
| State and  municipal                    |       | 4,620                                  |       |                                 | (259       | )                    |       | — |   |   | — |   |   | 4,620 | ** ** |   | (259 | ) |   |
| Total temporarily  impaired             |       | $                                      | 21,236     |                                 |       | $                    | (581       | ) |   | $ | 31,301 |   |   | $ | (797 | ) |   | $ | 52,537 | ** ** |   | $ | (1,378 | ) |   |
|                                         |            |                                        |            |                                      |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| **December 31, 2004**         | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**            | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|----------------------|------------|
| **Description of Securities** | ** ** | ** **                             | ** ** | **Fair  Value**                      | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** |
| U. S. Treasury  and agencies            |       | $                                      | 41,783     |                                 |       | $                    | (300       | ) |   | $ | — |   |   | $ | — |   |   | $ | 41,783 |   |   | $ | (300 | ) |   |
| Mortgage-backed                         |       | 1,879                                  |       |                                 | (22        | )                    |       | 6,703 |   |   | (124 | ) |   | 8,582 |   |   | (146 | ) |   |
| Total temporarily  impaired             |       | $                                      | 43,662     |                                 |       | $                    | (322       | ) |   | $ | 6,703 |   |   | $ | (124 | ) |   | $ | 50,365 |   |   | $ | (446 | ) |   |
|                                         |            |                                        |            |                                      |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**2. SECURITIES(Continued)**

Allunrealized losses are reviewed at least on a quarterly basis to determinewhether the losses are other than temporary and more frequently when economicor market concerns warrant such evaluation. Consideration is given to thelength of time and the extent to which the fair value has been less than cost,the financial condition and near-term prospects of the issuer, and our intentand ability to retain the investment in the issuer for a period of timesufficient to allow for any anticipated recovery in fair value. In analyzing anissuer’s financial condition, we may consider whether the securities are issuedby the federal government or its agencies, whether downgrades by bond ratingagencies have occurred, and the results of reviews of the issuer’s financialcondition. The unrealized losses on our investments in U.S. Treasury andagencies, mortgage-backed securities and obligations of state and politicalsubdivisions were caused by interest rate increases. Because the decline inmarket value is attributable to changes in interest rates and not creditquality, and because we have the ability and intent to hold these investmentsuntil recovery of fair value, which may be maturity, we do not consider theseinvestments to be other-than-temporarily impaired at December 31, 2005 and2004.

**3. LOANS**

Loans aresummarized as follows:

| ** **                          | ** ** | **2005**                             | ** ** | **2004** | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|----------|------------|
| ** **                          | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial                          |       | $                                    | 36,004     |     | $          | 32,228 |   |
| Real estate  commercial             |       | 353,637                              |       | 302,567  |       |
| Real estate  construction           |       | 13,579                               |       | 10,850   |       |
| Residential  mortgage               |       | 142,727                              |       | 159,550  |       |
| Consumer and home  equity           |       | 66,208                               |       | 70,143   |       |
| Indirect consumer                   |       | 31,577                               |       | 30,798   |       |
| Loans held for  sale                |       | 597                                  |       | 1,219    |       |
|                                |       | 644,329                              |       | 607,355  |       |
| Less:                               |       |                                 |       |     |       |
| Net deferred loan  origination fees |       | (1,212                               | )          | (1,438   | )          |
| Allowance for  loan losses          |       | (7,377                               | )          | (6,489   | )          |
|                                |       | (8,589                               | )          | (7,927   | )          |
| Loans Receivable                    |       | $                                    | 635,740    |     | $          | 599,428 |   |

 

We utilize eligible real estate loans to collateralizeadvances and letters of credit from the Federal Home Loan Bank.****We had $369 and****$342million in residential mortgage loans and commercial real estate loans pledgedunder this arrangement at December 31, 2005 and 2004.

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**3. LOANS(Continued)**

The allowance for loanloss is summarized as follows:

| ** **                  | ** ** | **As of and For the  Years Ended December 31,** | ** ** |
|-----------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                  | ** ** | **(Dollars in thousands)**                                               | ** ** |
| Balance,  beginning of year |       | $                                                                                  | 6,489      |   | $ | 5,568 |   | $ | 4,576 |   |
| Provision for  loan losses  |       | 1,258                                                                              |       | 1,656 |   | 1,656 |   |
| Charge-offs                 |       | (666                                                                               | )          | (949 | ) | (857 | ) |
| Recoveries                  |       | 296                                                                                |       | 214 |   | 193 |   |
| Balance, end of year        |       | $                                                                                  | 7,377      |   | $ | 6,489 |   | $ | 5,568 |   |

 

Impairedloans are summarized below. There were no impaired loans for the periodspresented without an allowance allocation.

| ** **                                   | ** ** | **As of and For the  Years Ended December 31,** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                   | ** ** | **(Dollars in thousands)**                                               | ** ** |
| Year-end impaired  loans                     |       | $                                                                                  | 6,232      |   | $ | 5,240 |   | $ | 5,318 |   |
| Amount of  allowance for loan loss allocated |       | 1,445                                                                              |       | 928 |   | 911 |   |
| Average impaired  loans outstanding          |       | 5,647                                                                              |       | 4,783 |   | 4,804 |   |
| Interest income  recognized                  |       | 219                                                                                |       | 197 |   | 227 |   |
| Interest income received                     |       | 219                                                                                |       | 197 |   | 227 |   |
|                                              |            |                                                                                    |            |  |  |  |  |  |  |  |

 

Wereport non-performing loans as impaired. Our non-performing loans at year-endby source were as follows:

| ** **                                    | ** ** | **December 31,**                | ** ** |
|-----------------------------------------------|------------|--------------------------------------|------------|
| ** **                                    | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                                    | ** ** | **(Dollars in thousands)** | ** ** |
| Restructured                                  |       | $                                    | 3,104      |   | $ | 3,218 |   |
| Loans past due  over 90 days still on accrual |       | —                               |       | — |   |
| Non accrual loans                             |       | 3,128                                |       | 2,022 |   |
| Total                                         |       | $                                    | 6,232      |   | $ | 5,240 |   |

 

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**4. PREMISES AND EQUIPMENT**

Premisesand equipment consist of the following:

| ** **                         | ** ** | **December 31,**                | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)** | ** ** |
| Land                               |       | $                                    | 3,675      |   | $ | 2,902 |   |
| Buildings                          |       | 15,826                               |       | 13,468 |   |
| Furniture,  fixtures and equipment |       | 8,649                                |       | 9,280 |   |
|                               |       | 28,150                               |       | 25,650 |   |
| Less accumulated  depreciation     |       | (9,016                               | )          | (8,181 | ) |
|                               |       | $                                    | 19,134     |   | $ | 17,469 |   |

 

Certainpremises are leased under various operating leases. Rental expense was$274,000, $259,000 and $278,000, for the years ended December 31, 2005,2004 and 2003, respectively. Future minimum commitments under these leases are:

| ** ** | ** ** | **Year Ended  December 31,** | ** ** |
|------------|------------|----------------------------------------|------------|
| ** ** | ** ** | **(Dollars in thousands)**   | ** ** |
| 2006       |       |                                   | $          | 345 |   |   |
| 2007       |       |                                   | 296        |   |   |
| 2008       |       |                                   | 281        |   |   |
| 2009       |       |                                   | 283        |   |   |
| 2010       |       |                                   | 283        |   |   |
| Thereafter |       |                                   | 412        |   |   |
|       |       |                                   | $          | 1,900 |   |   |

 

**5. DEPOSITS**

TimeDeposits of $100,000 or more were $101.6 million and $104.9 million atDecember 31, 2005 and 2004, respectively. At December 31, 2005,scheduled maturities of time deposits are as follows:

| ** ** | ** ** | **Amount**                           | ** ** |
|------------|------------|--------------------------------------|------------|
| ** ** | ** ** | **(Dollars in thousands)** | ** ** |
| 2006       |       |                                 | $          | 171,555 |   |   |
| 2007       |       |                                 | 92,831     |   |   |
| 2008       |       |                                 | 21,099     |   |   |
| 2009       |       |                                 | 16,531     |   |   |
| 2010       |       |                                 | 6,540      |   |   |
| Thereafter |       |                                 | 503        |   |   |
|       |       |                                 | $          | 309,059 |   |   |

 

63

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**6. ADVANCES FROM FEDERALHOME LOAN BANK**

Under the collateral requirements of the Federal HomeLoan Bank (FHLB) of Cincinnati we have available collateral to borrow anadditional $30 million from the FHLB at December 31, 2005. During January 2001,we entered into $75 million in convertible fixed rate advances with a maturityof ten years. These advances are fixed for periods of two to three years. Atthe end of the fixed term and quarterly thereafter, the FHLB has the right toconvert these advances to variable rate advances tied to the three-month LIBORindex or the Corporation can prepay the advance at no penalty. There is asubstantial penalty if we prepay the advance before the FHLB exercises itsright.

Advancesfrom the FHLB at year-end are as follows:

| ** **                                                                                | ** ** | **December 31,**                | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                                                                                | ** ** | **Weighted-  Average  Rate**         | ** ** | **Amount** | ** ** | **Weighted-  Average  Rate** | ** ** | **Amount** | ** ** |
| ** **                                                                                | ** ** | **(Dollars in Thousands)** | ** ** |
| Fixed rate advances:                                                                      | ** ** |                                 | ** ** |   |   |   |   |   |   |   |   |   |   |
| Mortgage matched  advances with interest rates from 5.30% to 7.80% due through 2009       |       |                                 | 6.35       | % |   | $ | 42 |   |   | 6.45 | % |   | $ | 80 |   |
| Convertible fixed  rate advances with interest rates from 4.86% to 5.05% due through 2011 |       |                                 | 4.92       | % |   | 75,000 |   |   | 4.92 | % |   | 75,000 |   |
| Other fixed rate  advances with interest rates from 4.19% to 5.72% due through 2019       |       |                                 | 4.93       | % |   | 3,333 |   |   | 4.86 | % |   | 3,824 |   |
| Total borrowings                                                                          |       |                                 |       |   |   | $ | 78,375 |   |   |   |   |   | $ | 78,904 |   |

 

The aggregate minimumannual repayments of borrowings as of December 31, 2005 is as follows:

| ** ** | ** ** | **(Dollars in thousands)** | ** ** |
|------------|------------|--------------------------------------|------------|
| 2006       |       |                                 | $          | 146 |   |   |
| 2007       |       |                                 | 142        |   |   |
| 2008       |       |                                 | 139        |   |   |
| 2009       |       |                                 | 131        |   |   |
| 2010       |       |                                 | 131        |   |   |
| Thereafter |       |                                 | 77,686     |   |   |
|       |       |                                 | $          | 78,375 |   |   |

 

**7. SUBORDINATED DEBENTURES**

On March 26, 2002, a trust formed by the FirstFinancial Service Corporation, First Federal Statutory Trust I (Trust), issued$10.0 million of Floating Rate Capital Securities (Trust Preferred Securities).The proceeds of the offering were loaned by the Trust to us in exchange forsubordinated debentures with terms that are identical to the Trust PreferredSecurities. Issuance costs of $302,000 paid from the proceeds are beingamortized to maturity. The subordinated debentures and deferred issue costs arethe sole assets of the Trust. Distributions on the Trust Preferred Securitiesare payable quarterly in arrears at the annual rate (adjusted quarterly) ofthree-month LIBOR plus 3.60% (7.56% as of the last adjustment), and areincluded in interest expense. The annual rate cannot exceed 11% prior to March 26,2007.

64

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**7. SUBORDINATEDDEBENTURES (Continued)**

The subordinated debentures, which mature March 26,2032, are redeemable prior to the maturity date at our option on or after March 26,2007 at their principal amount plus accrued interest. The subordinateddebentures are also redeemable in whole or in part from time to time, upon theoccurrence of specific events defined within the trust debenture. We have theoption to defer distributions on the subordinated debentures from time to timefor a period not to exceed 20 consecutive quarters. The Trust PreferredSecurities are subject to mandatory redemption, in whole or in part, uponrepayment of the subordinated debentures.

The SubordinatedDebentures are considered as Tier I capital for the Corporation under currentregulatory guidelines.

**8.**INCOME TAXES

Wefile a consolidated federal income tax return and income tax is apportionedamong all companies based on their taxable income or loss. Provision for incometaxes is as follows:

| ** **               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|
| ** **               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **               | ** ** | **(Dollars in thousands)**       | ** ** |
| Current                  |       |                                       | $          | 4,178 |   |   |   | $ | 3,334 |   |   |   | $ | 3,909 |   |   |
| Deferred                 |       |                                       | 234        |   |   |   | 401 |   |   |   | 95 |   |   |
| Total income tax expense |       |                                       | $          | 4,412 |   |   |   | $ | 3,735 |   |   |   | $ | 4,004 |   |   |

 

The provision for incometaxes differs from the amount computed at the statutory rates as follows:

| ** **                                          | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                          | ** ** | **(Dollars in thousands)**       | ** ** |
| Federal statutory  rate                             |       |                                       | 34.0       | % |   |   | 34.0 | % |   |   | 34.0 | % |   |
| Tax-exempt  interest income                         |       |                                       | (0.3       | ) |   |   | (0.1 | ) |   |   | (0.2 | ) |   |
| Increase in cash  surrender value of life insurance |       |                                       | (0.7       | ) |   |   | (0.9 | ) |   |   | (0.2 | ) |   |
| Dividends to ESOP                                   |       |                                       | (0.3       | ) |   |   | (0.4 | ) |   |   | (0.4 | ) |   |
| Other                                               |       |                                       | (0.2       | ) |   |   | (0.2 | ) |   |   | 0.1 |   |   |
| Effective rate                                      |       |                                       | 32.5       | % |   |   | 32.4 | % |   |   | 33.3 | % |   |

 

65

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**8. INCOMETAXES (Continued)**

Temporary differencesbetween the financial statements carrying amounts and tax bases of assets andliabilities that give rise to significant portions of deferred income taxesrelate to the following:

| ** **                                           | ** ** | **December 31,**                | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                           | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)** | ** ** |
| **Deferred  tax assets:**                            |       |                                 |       |   |   |   |   |   |   |
| Allowance for loan losses                            |       |                                 | $          | 2,508 |   |   |   | $ | 2,206 |   |   |
| Accrued liabilities and other                        |       |                                 | 109        |   |   |   | 127 |   |   |
|                                                 |       |                                 | 2,617      |   |   |   | 2,333 |   |   |
| **Deferred  tax liabilities:**                       |       |                                 |       |   |   |   |   |   |   |
| Depreciation                                         |       |                                 | $          | 1,509 |   |   |   | $ | 1,360 |   |   |
| Net unrealized gain on securities available-for-sale |       |                                 | 30         |   |   |   | 389 |   |   |
| Federal Home Loan Bank stock                         |       |                                 | 1,304      |   |   |   | 1,185 |   |   |
| Intangibles                                          |       |                                 | 704        |   |   |   | 503 |   |   |
| Deferred gain on like-kind exchange                  |       |                                 | 30         |   |   |   | 34 |   |   |
| Other                                                |       |                                 | 419        |   |   |   | 367 |   |   |
|                                                 |       |                                 | 3,996      |   |   |   | 3,838 |   |   |
| **Net deferred tax liability**                       |       |                                 | $          | 1,379 |   |   |   | $ | 1,505 |   |   |

 

Federal income tax lawsprovided savings banks with additional bad debt deductions through 1987,totaling $9.3 million for us. Accounting standards do not require a deferredtax liability to be recorded on this amount, which would otherwise total $3.2million at December 31, 2005 and 2004. If we were liquidated or otherwiseceased to be a bank or if tax laws were to change, the $3.2 million would berecorded as a liability with an offset to expense.

**9. STOCKHOLDERS’ EQUITY**

**(a)**Charter Conversion—On October 22, 2002, our Board of Directorsadopted a plan to convert from a federal savings bank to a commercial bankchartered under Kentucky banking laws. The plan also provided that First FinancialService Corporation would become a bank holding company. Effective January 8,2003, we became a Kentucky State Chartered Commercial Bank and First FinancialService Corporation became a bank holding company regulated by the FederalReserve Board. Expenses of $16,300 were recognized during 2003 associated withthe conversion.

**(b)**Regulatory Capital Requirements—The Corporation and the Bank are subject toregulatory capital requirements administered by federal banking agencies. Capitaladequacy guidelines and, additionally for banks, prompt corrective actionregulations involve quantitative measures of assets, liabilities, and certainoff-balance-sheet items calculated under regulatory accounting practices. Capitalamounts and classifications are also subject to qualitative judgments byregulators. Failure to meet capital requirements can initiate regulatoryaction.

Quantitative measures established by regulation toensure capital adequacy require the Corporation and the Bank to maintainminimum amounts and ratios (set forth in the following table) of Total and TierI capital (as defined in the regulations) to risk weighted assets (as defined)and of Tier I capital (as 

66

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**9. STOCKHOLDERS’EQUITY (Continued)**

defined) to average assets(as defined). As of December 31, 2005, the Corporation and the Bank metall capital adequacy requirements to which they are subject.

The most recent notification from the FDIC categorizedthe Bank as well capitalized under the regulatory framework for promptcorrective action. To be categorized as well capitalized, we must maintainminimum Total Risk Based, Tier I Risk Based and Tier I Leverage rations as setforth in the table. There are no conditions or events since that notificationthat management believes have changed our capital ratings.

Theactual and required capital amounts and ratios are presented below.

| ** **                                         | ** ** | **Actual**                           | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Considered  Well Capitalized  Under Prompt  Correction  Action Provisions** | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **Amount**                           | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                                   | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                                         | ** ** | **(Dollars in thousands)** | ** ** |
| **As of  December 31, 2005:**                 |       |                                 |       |                                         |       |                                                                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total risk-based capital (to risk-weighted assets) |       |                                 |       |                                         |       |                                                                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Consolidated                                       |       | $                                    | 73,678     |                                         |       | 11.5                                                                                                         | %          |   | $ | 51,185 |   |   | 8.0 | % |   | N/A |   |   | N/A |   |   |
| Bank                                               |       | 71,070                               |       |                                         | 11.1       |                                                                                                         |       | 51,026 |   |   | 8.0 |   |   | 63,782 |   |   | 10.0 |   |   |
| Tier I capital (to risk-weighted assets)           | ** ** | ** **                           | ** ** |                                         |       |                                                                                                         | ** ** | ** ** | ** ** |   |   |   | ** ** | ** ** | ** ** |   |   |   |   |
| Consolidated                                       |       | 66,300                               |       |                                         | 10.4       |                                                                                                         |       | 25,592 |   |   | 4.0 |   |   | N/A |   |   | N/A |   |   |
| Bank                                               |       | 63,692                               |       |                                         | 10.0       |                                                                                                         |       | 25,513 |   |   | 4.0 |   |   | 38,269 |   |   | 6.0 |   |   |
| Tier I capital (to average assets)                 | ** ** | ** **                           | ** ** |                                         |       |                                                                                                         | ** ** | ** ** | ** ** |   |   |   | ** ** | ** ** | ** ** |   |   |   |   |
| Consolidated                                       |       | 66,300                               |       |                                         | 8.8        |                                                                                                         |       | 30,011 |   |   | 4.0 |   |   | N/A |   |   | N/A |   |   |
| Bank                                               |       | 63,692                               |       |                                         | 8.5        |                                                                                                         |       | 29,926 |   |   | 4.0 |   |   | 37,408 |   |   | 5.0 |   |   |
|                                                    |            |                                      |            |                                              |            |                                                                                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                         | ** ** | **Actual**                           | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Considered  Well Capitalized  Under Prompt  Correction  Action Provisions** | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **Amount**                           | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                                   | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                                         | ** ** | **(Dollars in thousands)** | ** ** |
| **As of  December 31, 2004:**                 |       |                                 |       |                                         |       |                                                                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total risk-based capital (to risk-weighted assets) |       |                                 |       |                                         |       |                                                                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Consolidated                                       |       | $                                    | 67,798     |                                         |       | 11.6                                                                                                         | %          |   | $ | 46,793 |   |   | 8.0 | % |   | N/A |   |   | N/A |   |   |
| Bank                                               |       | 65,087                               |       |                                         | 11.2       |                                                                                                         |       | 46,600 |   |   | 8.0 |   |   | 58,250 |   |   | 10.0 |   |   |
| Tier I capital (to risk-weighted assets)           | ** ** | ** **                           | ** ** |                                         |       |                                                                                                         | ** ** | ** ** | ** ** |   |   |   | ** ** | ** ** | ** ** |   |   |   |   |
| Consolidated                                       |       | 61,029                               |       |                                         | 10.4       |                                                                                                         |       | 23,397 |   |   | 4.0 |   |   | N/A |   |   | N/A |   |   |
| Bank                                               |       | 58,318                               |       |                                         | 10.0       |                                                                                                         |       | 23,300 |   |   | 4.0 |   |   | 34,950 |   |   | 6.0 |   |   |
| Tier I capital (to average assets)                 | ** ** | ** **                           | ** ** |                                         |       |                                                                                                         | ** ** | ** ** | ** ** |   |   |   | ** ** | ** ** | ** ** |   |   |   |   |
| Consolidated                                       |       | 61,029                               |       |                                         | 8.5        |                                                                                                         |       | 28,860 |   |   | 4.0 |   |   | N/A |   |   | N/A |   |   |
| Bank                                               |       | 58,318                               |       |                                         | 8.1        |                                                                                                         |       | 28,762 |   |   | 4.0 |   |   | 35,953 |   |   | 5.0 |   |   |
|                                                    |            |                                      |            |                                              |            |                                                                                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**9. STOCKHOLDERS’EQUITY (Continued)**

**(c)**Dividend Restrictions—Our principal source of funds for dividend paymentsis dividends received from the Bank. Banking regulations limit the amount ofdividends that may be paid without prior approval of regulatory agencies. Underthese regulations, the amount of dividends that may be paid in any calendaryear is limited to the current year’s net profits, combined with the retainednet profits of the preceding two years, subject to the capital requirementsdescribed above. During 2006, the Bank could, without prior approval, declaredividends of approximately $8.9 million plus any 2006 net profits retained tothe date of the dividend declaration.

**(d)**Liquidation Account—In connection with our conversion from mutual tostock form of ownership during 1987, we established a “liquidation account”,currently in the amount of $621,737 for the purpose of granting to eligibledeposit account holders a priority in the event of future liquidation. Only insuch an event, an eligible account holder who continues to maintain a depositaccount will be entitled to receive a distribution from the liquidation account.The total amount of the liquidation account decreases in an amountproportionately corresponding to decreases in the deposit account balances ofthe eligible account holders.

**10. EARNINGS PER SHARE**

Thereconciliation of the numerators and denominators of the basic and diluted EPSis as follows:

| ** **                                     | ** ** | **Year Ended  December 31,**                             | ** ** |
|------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                     | ** ** | **(In thousands, except per share data)** | ** ** |
| Net income  available to common shareholders   |       |                                                               | $          | 9,144 |   |   |   | $ | 7,790 |   |   |   | $ | 8,003 |   |   |
| Basic EPS:                                     | ** ** |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Weighted average common shares                 |       |                                                               | 3,998      |   |   |   | 4,025 |   |   |   | 4,158 |   |   |
| Diluted EPS:                                   | ** ** |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Weighted average common shares                 |       |                                                               | 3,998      |   |   |   | 4,025 |   |   |   | 4,158 |   |   |
| Dilutive effect of stock options               |       |                                                               | 27         |   |   |   | 18 |   |   |   | 38 |   |   |
| Weighted average common and incremental shares |       |                                                               | 4,025      |   |   |   | 4,043 |   |   |   | 4,196 |   |   |
| Earnings Per  Share:                           | ** ** |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Basic                                          |       |                                                               | $          | 2.29 |   |   |   | $ | 1.94 |   |   |   | $ | 1.93 |   |   |
| Diluted                                        |       |                                                               | $          | 2.27 |   |   |   | $ | 1.93 |   |   |   | $ | 1.91 |   |   |

 

Stock options for 10,000shares of common stock were not included in the December 31, 2004computation of diluted earnings per share because their impact wasanti-dilutive.  All of the outstandingstock options for the year ended December 31, 2005 and 2003 were includedin the computation of diluted earnings per share.

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**11. EMPLOYEE BENEFIT PLANS**

**(a)**Pension Plans—We are aparticipant in the Financial Institutions Retirement Fund, a multiple-employerdefined benefit pension plan, covering employees hired before June 1, 2002.Because the plan was curtailed, employees hired on or after that date are noteligible for membership in the fund. Eligible employees are 100% vested at thecompletion of five years of participation in the plan. Our policy is tocontribute annually the minimum funding amounts. Employer contributions andadministrative expenses charged to operations for the years ended December 31,2005, 2004 and 2003 totaled $210,000, $253,000, and $250,000, respectively. Accruedliabilities associated with the plan as of December 31, 2005 were $52,000.There were no accrued liabilities associated with the plan as of December 31,2004.

**(b) **We have a contributory thrift plan as well as a 401 (k) plan,which covers substantially all of the employees. Under the terms of the thriftplan, voluntary employee after tax contributions are matched by up to 6% of theemployee base pay and employees are 100% vested at the completion of threeyears of participation in the plan. Under the terms of the 401 (k) plan,voluntary employee pre tax contributions are matched by up to 6% of theemployee base pay and employees are 100% vested at the completion of threeyears of participation in the plan. Though the employee may participate in oneor both plans, the employer will match voluntary contributions on only one ofthe two plans. Employer contributions and administrative expenses charged tooperationsfor these plansfor theyears ended December 31, 2005, 2004 and 2003 were $334,000, $302,000, and$270,000, respectively.

**(c)**Employee Stock Ownership Plan—Wehave a non-contributory employee stock ownership plan (ESOP) in which employeesare eligible to participate upon completion of one year of service. Employeesare vested in accordance with a schedule, which provides for 100% vesting uponcompletion of seven years of service.

Shares of our common stock are acquired innon-leveraged transactions. At the time of purchase, the shares are releasedand allocated to eligible employees determined by a formula specified in theplan agreement. Accordingly, the plan has no unallocated shares. The number ofshares to be purchased and allocated is at the Board of Directors discretion.

Sharesin the plan and the fair value of shares released during the year charged tocompensation expense were as follows:

| ** **            | ** ** | **Year Ended  December 31,** | ** ** |
|-----------------------|------------|----------------------------------------|------------|
| ** **            | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| ESOP shares  (ending) |       |                                   | 178,803    |   |   |   | 182,709 |   |   |   | 185,291 |   |   |
| Shares released       |       |                                   | 2,923      |   |   |   | 2,148 |   |   |   | 2,048 |   |   |
| Compensation expense  |       |                                   | $          | 83,081 |   |   |   | $ | 54,000 |   |   |   | $ | 54,000 |   |   |
|                       |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**11. EMPLOYEEBENEFIT PLANS (Continued)**

**(d)**Stock Option Plan—Under the 1998 Stock Option and Incentive Plan, wemay grant either incentive or non-qualified stock options to key employees foran aggregate of 182,600 shares of our common stock at not less than fair marketvalue at the date such options are granted. The option to purchase shares vestover periods of one to five years and expire ten years after the date of grant.At December 31, 2005 options available for future grant under the 1998Stock Option Plan totaled 35,640. A summary of option transactions is asfollows:

| ** **                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                           | ** ** | **Number  of  Options**                    | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding,  beginning of period    |       | 135,817                                    |       |   | $ | 20.16 |   |   | 75,867 |   |   | $ | 17.60 |   |   | 119,790 |   |   | $ | 16.13 |   |   |
| Granted during  period               | ** ** | —                                     |       |   | — |   |   | 59,950 |   |   | $ | 23.41 |   |   | — |   |   | — |   |   |
| Exercised during  the period         |       | (4,840                                     | )          |   | 17.52 |   |   | — |   |   | — |   |   | (43,923 | ) |   | 13.33 |   |   |
| Outstanding, end  of period          |       | 130,977                                    |       |   | $ | 20.26 |   |   | 135,817 |   |   | $ | 20.16 |   |   | 75,867 |   |   | $ | 17.60 |   |   |
| Eligible for exercise at  period end |       | 78,177                                     |       |   | $ | 18.13 |   |   | 71,148 |   |   | $ | 17.86 |   |   | 54,329 |   |   | $ | 18.12 |   |   |

 

Thefollowing table summarizes information about stock options outstanding at December 31,2005:

| ** **        | ** **                    | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-------------------|-------------------------------|-------------------------|------------|-------------------------|------------|
| ** **        | **Range of  Exercise Prices** | ** **              | ** ** | **Number  Outstanding** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $13.41  to $14.05 |                          |                    | 14,762     | ** **              |       |   | 5.5 |  years |   |   | $ | 13.66 | ** ** |   |   | 14,762 |   |   |   | $ | 13.66 |   |   |
| $18.49  to $18.70 |                          |                    | 55,055     | ** **              |       |   | 3.6 |   |   |   | 18.61 | ** ** |   |   | 55,055 |   |   |   | 18.61 |   |   |
| $20.25            |                          |                    | 1,210      | ** **              |       |   | 3.2 |   |   |   | 20.25 | ** ** |   |   | 1,210 |   |   |   | 20.25 |   |   |
| $23.31  to $23.85 |                          |                    | 59,950     | ** **              |       |   | 8.8 |   |   |   | 23.41 | ** ** |   |   | 7,150 |   |   |   | 23.31 |   |   |
| ** **        |                          |                    | 130,977    | ** **              |       |   | 6.2 |   |   |   | $ | 20.26 | ** ** |   |   | 78,177 |   |   |   | $ | 18.13 |   |   |
|                   |                               |                         |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**12. CASH FLOW ACTIVITIES**

The following informationis presented as supplemental disclosures to the statement of cash flows.

**(a) Cash Paidfor:**

| ** **       | ** ** | **Year Ended**                  | ** ** |
|------------------|------------|--------------------------------------|------------|
| ** **       | ** ** | **December 31,**                | ** ** |
| ** **       | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **       | ** ** | **(Dollars in thousands)** | ** ** |
| Interest expense |       | $                                    | 17,886     |   | $ | 14,795 |   | $ | 16,453 |   |
| Income taxes     |       | $                                    | 4,625      |   | $ | 3,532 |   | $ | 4,203 |   |

 

**(b) Supplementaldisclosure of non-cash activities:**

| ** **                                                                               | ** ** | **Year Ended**                  | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                               | ** ** | **December 31,**                | ** ** |
| ** **                                                                               | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                               | ** ** | **(Dollars in thousands)** | ** ** |
| Loans to  facilitate sales of real estate owned and repossessed assets                   |       | $                                    | 1,561      |   | $ | 1,124 |   | $ | 1,123 |   |
| Transfers from loans to  real estate acquired through foreclosure and repossessed assets |       | $                                    | 1,981      |   | $ | 1,396 |   | $ | 944 |   |

 

**13. CONDENSED FINANCIALINFORMATION (PARENT COMPANY ONLY)****

The following condensedstatements summarize the balance sheets, operating results and cash flows ofFirst Financial Service Corporation (Parent Company only).

**CondensedBalance Sheets**

| ** **                                     | ** ** | **December 31,**                | ** ** |
|------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                     | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                                     | ** ** | **(Dollars in thousands)** | ** ** |
| **Assets**                                     |       |                                 |       |   |   |
| Cash and interest  bearing deposits            |       | $                                    | 179        |   | $ | 157 |   |
| Investment in  Bank                            |       | 72,077                               |       | 67,089 |   |
| Securities  available-for sale                 |       | 1,431                                |       | 2,447 |   |
| Land                                           |       | 752                                  |       | — |   |
| Other assets                                   |       | 328                                  |       | 270 |   |
|                                           |       | $                                    | 74,767     |   | $ | 69,963 |   |
| **Liabilities and Stockholders’  Equity** |       |                                 |       |   |   |
| Subordinated  debentures                       |       | $                                    | 10,000     |   | $ | 10,000 |   |
| Other liabilities                              |       | 26                                   |       | 162 |   |
| Stockholders’  equity                     |       | 64,741                               |       | 59,801 |   |
|                                           |       | $                                    | 74,767     |   | $ | 69,963 |   |

 

71

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**13. CONDENSED FINANCIAL INFORMATION (PARENT COMPANY ONLY)(Continued)**

**CondensedStatements of Income**

| ** **                                                | ** ** | **Year Ended**             | ** ** |
|-----------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                | ** ** | **December 31,**      | ** ** |
| ** **                                                | ** ** | **2005**                   | ** ** | **2004** | ** ** | ** ** | **2003** | ** ** |
| ** **                                                | ** ** | **(Dollars in thousands)** | ** ** |
| Dividend from Bank                                        |       | $4,022                     |       | $4,500 |   |   | $6,318 |   |
| Interest income                                           |       | 80                         |       | 114 |   |   | 88 |   |
| Interest expense                                          |       | (712                       | )          | (529 | ) |   | (503 | ) |
| Gain on sale of  investments                              |       | 381                        |       | 202 |   |   | — |   |
| Other expenses                                            |       | (223                       | )          | (223 | ) |   | (253 | ) |
| Income before income tax  benefit                         |       | 3,548                      |       | 4,064 |   |   | 5,650 |   |
| Income tax benefit                                        |       | 222                        |       | 220 |   |   | 286 |   |
|                                                      | ** ** | ** **                 |       |   |   |   |   |   |
| Income before equity in  undistributed net income of Bank |       | 3,770                      |       | 4,284 |   |   | 5,936 |   |
| Equity in undistributed  net income of Bank               |       | 5,374                      |       | 3,506 |   |   | 2,067 |   |
| Net income                                                |       | $9,144                     |       | $7,790 |   |   | $8,003 |   |

 

**CondensedStatements of Cash Flows**

| ** **                                                                     | ** ** | **Year Ended**                  | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                     | ** ** | **December 31,**                | ** ** |
| ** **                                                                     | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Operating Activities:                                                          |       |                                 |       |   |   |   |   |
| Net income                                                                     |       | $                                    | 9,144      |   | $ | 7,790 |   | $ | 8,003 |   |
| Adjustments to reconcile net income to cash provided  by operating activities: |       |                                 |       |   |   |   |   |
| Equity in undistributed  net income of Bank                                    |       | (5,374                               | )          | (3,506 | ) | (2,067 | ) |
| Gain on sale of  investments available-for-sale                                |       | (381                                 | )          | (202 | ) | — |   |
| Changes in:                                                                    |       |                                 |       |   |   |   |   |
| Other assets                                                                   |       | 101                                  |       | 10 |   | 18 |   |
| Accounts payable and  other liabilities                                        |       | (136                                 | )          | (106 | ) | (265 | ) |
| Net cash from operating  activities                                            |       | 3,354                                |       | 3,986 |   | 5,689 |   |
| Investing Activities:                                                          |       |                                 |       |   |   |   |   |
| Purchases of securities  available-for-sale                                    |       | (506                                 | )          | (640 | ) | (1,415 | ) |
| Sales of securities  available-for-sale                                        |       | 1,431                                |       | 745 |   | — |   |
| Net purchases of  premises and equipment                                       |       | (752                                 | )          | — |   | — |   |
| Net change in receivable  from Bank                                            | ** ** | **—**                           |       | 165 |   | 433 |   |
| Net cash from investing  activities                                            |       | 173                                  |       | 270 |   | (982 | ) |
| Financing Activities:                                                          |       |                                 |       |   |   |   |   |
| Proceeds from stock  options exercised                                         |       | 85                                   |       | — |   | 559 |   |
| Dividends paid                                                                 |       | (2,830                               | )          | (2,708 | ) | (2,660 | ) |
| Common stock repurchases                                                       |       | (760                                 | )          | (1,560 | ) | (9,628 | ) |
| Net cash from financing  activities                                            |       | (3,505                               | )          | (4,268 | ) | (11,729 | ) |
| Net change in cash and  interest bearing deposits                              |       | 22                                   |       | (12 | ) | (7,022 | ) |
| Cash and interest  bearing deposits, beginning of year                         |       | 157                                  |       | 169 |   | 7,191 |   |
| Cash and interest bearing deposits, end of year                                |       | $                                    | 179        |   | $ | 157 |   | $ | 169 |   |

 

72

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**14. FAIR VALUES OFFINANCIAL INSTRUMENTS**

Theestimated fair value of financial instruments is as follows:

| ** **                           | ** ** | **December 31, 2005**      | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **Carrying**                         | ** ** | **Fair**                        | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                           | ** ** | **Value**                            | ** ** | **Value**                       | ** ** | **Value** | ** ** | **Value** | ** ** |
| ** **                           | ** ** | **(Dollars in thousands)** | ** ** |
| **Financial assets:**                |       |                                 |       |                            |       |   |   |   |   |
| Cash and cash equivalents            |       | $                                    | 20,451     |                            | $          | 20,451 |   | $ | 35,910 |   | $ | 35,910 |   |
| Securities available-for-sale        |       | 28,324                               |       | 28,324                          |       | 21,928 |   | 21,928 |   |
| Securities held-to-maturity          |       | 33,231                               |       | 32,434                          |       | 34,915 |   | 34,557 |   |
| Loans held for sale                  |       | 597                                  |       | 608                             |       | 1,219 |   | 1,239 |   |
| Loans, net                           |       | 635,143                              |       | 640,079                         |       | 598,209 |   | 603,134 |   |
| Federal Home Loan Bank stock         |       | 7,194                                |       | 7,194                           |       | 6,845 |   | 6,845 |   |
| Accrued interest receivable          |       | 3,051                                |       | 3,051                           |       | 2,487 |   | 2,487 |   |
| **Financial  liabilities:**          | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                             |       | 591,106                              |       | 587,642                         |       | 586,386 |   | 581,477 |   |
| Federal funds purchased              |       | 19,500                               |       | 19,500                          |       | — |   | — |   |
| Advances from Federal Home Loan Bank |       | 78,375                               |       | 78,703                          |       | 78,904 |   | 82,409 |   |
| Subordinated debentures              |       | 10,000                               |       | 10,000                          |       | 10,000 |   | 10,000 |   |
| Accrued interest  payable            |       | 389                                  |       | 389                             |       | 413 |   | 413 |   |
|                                      |            |                                      |            |                                 |            |  |  |  |  |  |  |  |  |

 

The methods and assumptions used in estimating fairvalue disclosures for financial instruments are presented below:

Carrying amount is theestimated fair value for cash and cash equivalents, interest bearing deposits,Federal Home Loan Bank stock, accrued interest receivable and payable, demanddeposits, short-term debt and variable rate loans or deposits that repricefrequently and fully. Security fair values are based on market prices or dealerquotes and if no such information is available, on the rate and term of thesecurity and information about the issuer. The value of loans held for sale isbased on the underlying sale commitments. For fixed rate loans or deposits andfor variable rate loans or deposits with infrequent reprising or reprisinglimits, fair value is based on discounted cash flows using current market ratesapplied to the estimated life and credit risk. Fair values for impaired loansare estimated using discounted cash flow analysis or underlying collateralvalues. Fair values of advances from Federal Home Loan Bank are based oncurrent rates for similar financing. The principal amount of the subordinateddebentures is the estimated fair value. The fair value of off-balance-sheetitems is based on the current fees or cost that would be charged to enter intoor terminate such arrangements and is not material.

**15. FINANCIAL INSTRUMENTSWITH OFF-BALANCE-SHEET RISK**

We are a party to financial instruments withoff-balance-sheet risk in the normal course of business to meet the financingneeds of our customers. These financial instruments primarily includecommitments to extend credit and involve, to varying degrees, elements ofcredit and interest-rate risk in excess of the amount recognized in the balancesheet. The contract or notional amounts of these instruments reflect the extentof our involvement in particular classes of financial instruments.

73

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Our exposure to credit loss in the event ofnonperformance by the other party to the financial instrument for commitmentsto extend credit is represented by the contractual notional amount of thoseinstruments. Creditworthiness for all instruments is evaluated on acase-by-case basis in accordance with our credit policies. We use the samecredit policies in making commitments and conditional obligations as we do foron-balance-sheet instruments. Collateral from the customer may be requiredbased on management’s credit evaluation of the customer and may includebusiness assets of commercial customers as well as personal property and realestate of individual customers or guarantors.

Commitments to extend credit are agreements to lend toa customer as long as there is no violation of any condition established in thecontract. Commitments generally have fixed expiration dates or othertermination clauses and may require payment of a fee. Since many of thecommitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future cash requirements.

Thecontractual amounts of financial instruments with off-balance-sheet risk atyear end were as follows:

| ** **                 | ** ** | **December 31, 2005**      | ** ** | **December 31, 2004** | ** ** |
|----------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Fixed**                            | ** ** | **Variable**                    | ** ** | **Fixed** | ** ** | **Variable** | ** ** |
| ** **                 | ** ** | **Rate**                             | ** ** | **Rate**                        | ** ** | **Rate** | ** ** | **Rate** | ** ** |
| ** **                 | ** ** | **(Dollars in thousands)** | ** ** |
| Commitments to  make loans |       |                                 | $          | 38                              |       |   | $ | 882 |   |   | $ | — |   |   | $ | 470 |   |
| Unused lines of credit     | ** ** | ** **                           | **—** |                            |       | 118,598 |   |   | — |   |   | 89,109 |   |
| Standby letters  of credit | ** ** | ** **                           | **—** |                            |       | 12,536 |   |   | — |   |   | 11,180 |   |
|                       |       |                                 | $          | 38                              |       |   | $ | 132,016 |   |   | $ | — |   |   | $ | 100,759 |   |

 

Unused lines of credit at December 31, 2005 wereat current rates ranging****from 2.50% to17.00% and primarily at the national prime rate of interest plus****.5% to 5% for standby letters of credit.

At December 31, 2005and 2004, we had $54.7 million, and****$85.4 millionin letters of credit from the Federal Home Loan Bank issued to collateralizepublic deposits. These letters of credit are secured by a blanket pledge ofeligible one-to-four family residential mortgage loans. (For additionalinformation see Note 3 on Loans and Note 6 on Advances from the FederalHome Loan Bank.)

**16. RELATED PARTYTRANSACTIONS**

Certaindirectors, executive officers and principal shareholders of the Company,including associates of such persons, are our loan and deposit customers. Relatedparty deposits at December 31, 2005 and 2004 were $3.1 million and$2.8 million. A summary of the related party loan activity, for loansaggregating $60,000 or more to any one related party, is as follows:

| ** **        | ** ** | **Year Ended**              | ** ** |
|-------------------|------------|----------------------------------|------------|
| ** **        | ** ** | **December 31,**            | ** ** |
| ** **        | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| ** **        | ** ** | **(Dollars in  thousands)** | ** ** |
| Beginning of year |       | $                                | 315        |   | $ | 305 |   |
| New loans         |       | —                           |       | 34 |   |
| Repayments        |       | (24                              | )          | (24 | ) |
| End of year       |       | $                                | 291        |   | $ | 315 |   |

 

74

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**FIRST FINANCIAL SERVICE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**17.SUMMARY OF QUARTERLY FINANCIAL DATA—(Unaudited)**

| **Year Ended December 31, 2005:** | ** ** | ** **                                                                     | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                            | ** ** | **(Dollars in thousands except per share data)** | ** ** |
| Total interest  income                                |       |                                                                           | $          | 10,630             |       |              | $          | 11,027                 |       |                  | $          | 11,593 |   |   |   | $ | 12,118 |   |   |
| Total interest  expense                               |       |                                                                           | 3,994      |               |       | 4,272             |       |                   | 4,634      |                  |       |   | 4,963 |   |   |
| Net interest  income                                  |       |                                                                           | 6,636      |               |       | 6,755             |       |                   | 6,959      |                  |       |   | 7,155 |   |   |
| Provision for  loan losses                            |       |                                                                           | 275        |               |       | 41                |       |                   | 440        |                  |       |   | 502 |   |   |
| Non-interest  income                                  |       |                                                                           | 2,021      |               |       | 1,976             |       |                   | 2,061      |                  |       |   | 2,008 |   |   |
| Non-interest  expense                                 |       |                                                                           | 5,144      |               |       | 5,276             |       |                   | 5,156      |                  |       |   | 5,181 |   |   |
| Net income                                            |       |                                                                           | 2,186      |               |       | 2,294             |       |                   | 2,311      |                  |       |   | 2,353 |   |   |
| Earnings per share:                                   |       |                                                                           |       |               |       |              |       |                   |       |                  |       |   |   |   |   |
| Basic                                                 |       |                                                                           | 0.55       |               |       | 0.57              |       |                   | 0.58       |                  |       |   | 0.59 |   |   |
| Diluted                                               |       |                                                                           | 0.55       |               |       | 0.57              |       |                   | 0.57       |                  |       |   | 0.58 |   |   |
|                                                       |            |                                                                                |            |                    |            |                   |            |                        |            |                       |            |  |  |  |  |  |  |  |  |  |  |

 

| **Year Ended December 31, 2004:** | ** ** | ** **                                                                     | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                            | ** ** | **(Dollars in thousands except per share data)** | ** ** |
| Total interest  income                                |       |                                                                           | $          | 9,550              |       |              |       | $                      | 9,440      |                  |       |   | $ | 9,784 |   |   |   | $ | 10,369 |   |   |
| Total interest  expense                               |       |                                                                           | 3,777      |               |       |              | 3,575      |                   |       |                  | 3,590      |   |   |   | 3,850 |   |   |
| Net interest  income                                  |       |                                                                           | 5,773      |               |       |              | 5,865      |                   |       |                  | 6,194      |   |   |   | 6,519 |   |   |
| Provision for  loan losses                            |       |                                                                           | 389        |               |       |              | 259        |                   |       |                  | 824        |   |   |   | 184 |   |   |
| Non-interest  income                                  |       |                                                                           | 1,771      |               |       |              | 2,261      |                   |       |                  | 2,122      |   |   |   | 1,950 |   |   |
| Non-interest  expense                                 |       |                                                                           | 4,439      |               |       |              | 5,016      |                   |       |                  | 4,970      |   |   |   | 4,849 |   |   |
| Net income                                            |       |                                                                           | 1,838      |               |       |              | 1,926      |                   |       |                  | 1,714      |   |   |   | 2,312 |   |   |
| Earnings per share:                                   |       |                                                                           |       |               |       |              |       |                   |       |                  |       |   |   |   |   |   |   |
| Basic                                                 |       |                                                                           | 0.45       |               |       |              | 0.48       |                   |       |                  | 0.43       |   |   |   | 0.57 |   |   |
| Diluted                                               |       |                                                                           | 0.45       |               |       |              | 0.48       |                   |       |                  | 0.43       |   |   |   | 0.56 |   |   |

 

75

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**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure

None

**Item 9A.**                Controlsand Procedures

Management is responsible for establishing andmaintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934. As of December 31,2005, an evaluation was performed under the supervision and with theparticipation of management, including the Chief Executive Officer and ChiefFinancial Officer, of the effectiveness of the design and operation of ourdisclosure controls and procedures. Based on that evaluation, managementconcluded that disclosure controls and procedures as of December 31, 2005were effective in ensuring material information required to be disclosed inthis Annual Report on Form 10-K was recorded, processed, summarized,and reported on a timely basis. Additionally, there were no changes in ourinternal control over financial reporting that occurred during the quarterended December 31, 2005 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

Management’s responsibilities related to establishingand maintaining effective disclosure controls and procedures include maintainingeffective internal controls over financial reporting that are designed toproduce reliable financial statements in accordance with accounting principlesgenerally accepted in the United States. As disclosed in the Report onManagement’s Assessment of Internal Control Over Financial Reporting of thisAnnual Report, we assessed our system of internal control over financialreporting as of December 31, 2005, in relation to criteria for effectiveinternal control over financial reporting as described in “Internal Control -Integrated Framework,” issued by the Committee of Sponsoring Organizations ofthe Treadway Commission. Based on this assessment, we believe that, as of December 31,2005, our system of internal control over financial reporting met thosecriteria and is effective.

There have been nosignificant changes in our internal controls or in other factors that couldsignificantly affect internal controls after December 31, 2005.

**Item 9B.**               OtherInformation

Effective January 1,2006, the annual salary for B. Keith Johnson, President and Chief ExecutiveOfficer, is $240,000.

76

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**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant

The informationcontained under the sections captioned “Proposal I—Election of Directors” and “Section 16(a) BeneficialOwnership Reporting Compliance” in the Company’s definitive proxy statement forthe 2006 Annual Meeting of Shareholders (the “Proxy Statement”) is incorporatedherein by reference.

(a)          Codeof Ethics

Youmay obtain copies of First Financial Service Corporation’s code of ethics freeof charge by contacting Rebecca Bowling, Corporate Secretary-Treasurer, First Federal Savings Bank, 2323 Ring Road,Elizabethtown, Kentucky 42701 (telephone) 270-765-2131.

**Item 11.**                 ExecutiveCompensation

The information containedunder the sections captioned “Summary Compensation Table,” “Option Exercisesand Year-end Value Table,” “Directors Compensation,” and “Retirement Plan” inthe Proxy Statement is incorporated herein by reference.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management

(a)          Security Ownership ofCertain Beneficial Owners

Information required by this item is incorporatedherein by reference to the section captioned “Voting Securities and PrincipalHolders Thereof” in the Proxy Statement

(b)         Security Ownership ofManagement

Information required by this item is incorporatedherein by reference to the sections captioned “Proposal I—Election of Directors”and “Voting Securities and Principal Holders Thereof” in the Proxy Statement.

(c)          Changes in Control

Management of the Companyknows of no arrangements, including any pledge by any person of securities ofthe Company, the operation of which may at a subsequent date result in a changeof control of the Company.

**Item 13.**                 CertainRelationships and Related Transactions

The information requiredby this item is incorporated herein by reference to the section captioned “Transactionswith the Corporation and the Bank” in the Proxy Statement.

**Item 14.**                 PrincipalAccountant Fees and Services

The information required by this item is incorporatedby reference to the section captioned “Independent Public Accountants” in theProxy Statement.

77

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**PART IV**

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

**1.****                FinancialStatements Filed**

| (a)(1) |   | Report of  Independent Registered Public Accounting Firm on Consolidated Financial  Statements-Crowe Chizek and Company LLC  |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------|
| (b)    |   | Consolidated Balance  Sheets at December 31, 2005 and 2004.                                                             |
| (c)    |   | Consolidated  Statements of Income for the years ended December 31, 2005, 2004 and  2003.                               |
| (d)    |   | Consolidated  Statements of Comprehensive Income for the years ended December 31,  2005, 2004 and 2003.                 |
| (e)    |   | Consolidated  Statements of Changes in Stockholders’ Equity for the years ended  December 31, 2005, 2004 and 2003. |
| (f)    |   | Consolidated  Statements of Cash Flows for the years ended December 31, 2005, 2004 and  2003.                           |
| (g)    |   | Notes to  Consolidated Financial Statements                                                                                  |

 

**2.****                FinancialStatements Schedules**

Allfinancial statement schedules have been omitted, as the required information iseither inapplicable or included in the financial statements or related notes.

**3.****                Exhibits**

| 3  | (a), 4(a) | Articles of  Incorporation *                                                                                                                                                                |
|----|-----------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3  | (b), 4(b) | Amended and  Restated Bylaws**                                                                                                                                                              |
| 4  | (c)       | Rights Agreement  between First Financial Service Corporation and Illinois Stock Tranfser  Company dated April 15, 2003***                                                             |
| 10 | (a)       | 1998 Stock Option  and Incentive Compensation Plan **                                                                                                                                       |
| 10 | (b)       | Form of  Stock Option Agreement**                                                                                                                                                      |
| 10 | (c)       | Executive  Compensation **                                                                                                                                                                  |
| 21 |      | Subsidiaries of  the Registrant                                                                                                                                                             |
| 23 | (a)       | Consent of Crowe  Chizek and Company LLC, Independent Registered Public Accounting Firm                                                                                                |
| 31 | .1        | Certification of  Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act                                                                                                |
| 31 | .2        | Certification of  Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act                                                                                                |
| 32 |      | Certification of  Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.  Section 1350 (As Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002) |

----

*                    Incorporatedby reference to Exhibit 3 of the Company’s Form 10-Q filed August 9,2004.

**             Incorporated byreference to Form 10-K dated March 15, 2005.

***      Incorporated by reference toForm 8-K dated April 15, 2003.

78

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

|               | FIRST FINANCIAL SERVICE CORPORATION |
|---------------|-------------------------------------|
| Date: 3/15/06 | By:                                 | /s/ B. KEITH JOHNSON |
|          |                                | B. Keith Johnson |
|          |                                | *President and Chief Executive Officer* |
|          |                                | *Duly Authorized Representative* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

| By:      |     | /s/ B. KEITH  JOHNSON                            |     | By:      |     | /s/ BOB BROWN                                           |
|----------|----------|--------------------------------------------------|----------|----------|----------|---------------------------------------------------------|
|     |     | B. Keith Johnson                                 |     |     |     | Bob Brown                                               |
|     |     | *Principal Executive Office & Director* |     |     |     | *Director*                                              |
| Date:    |     | 3/15/06                                          |     | Date:    |     | 3/15/06                                                 |
| By:      |     | /s/ WRENO M. HALL                                |     | By:      |     | /s/ DIANE E. LOGSDON                                    |
|     |     | Wreno M. Hall                                    |     |     |     | Diane E. Logsdon                                        |
|     |     | *Director*                                       |     |     |     | *Director*                                              |
| Date:    |     | 3/15/06                                          |     | Date:    |     | 3/15/06                                                 |
| By:      |     | /s/ J. ALTON RIDER                               |     | By:      |     | /s/ JOHN L. NEWCOMB, JR.                           |
|     |     | J. Alton Rider                                   |     |     |     | John L. Newcomb, Jr.                               |
| * * | * * | *Director*                                       | * * | * * | * * | *Director*                                              |
| Date:    |     | 3/15/06                                          |     | Date:    |     | 3/15/06                                                 |
| By:      |     | /s/ WALTER D. HUDDLESTON                         |     | By:      |     | /s/ MICHAEL THOMAS, DVM                                 |
|     |     | Walter D. Huddleston                             |     |     |     | Michael Thomas, DVM                                     |
| * * | * * | *Director*                                       | * * | * * | * * | *Director*                                              |
| Date:    |     | 3/15/06                                          |     | Date:    |     | 3/15/06                                                 |
| By:      |     | /s/ STEPHEN MOUSER                               |     | By:      |     | /s/ DONALD SCHEER                                       |
|     |     | Stephen Mouser                                   |     |     |     | Donald Scheer                                           |
| * * | * * | *Director*                                       | * * | * * | * * | *Director*                                              |
| Date:    |     | 3/15/06                                          |     | Date:    |     | 3/15/06                                                 |
| By:      |     | /s/ GAIL SCHOMP                                  |     | By:      |     | /s/ GREGORY SCHREACKE                                   |
|     |     | Gail Schomp                                      |     |     |     | Gregory Schreacke                                       |
| * * | * * | *Director*                                       | * * | * * | * * | *Chief Financial Officer  Principal Accounting Officer* |
| Date:    |     | 3/15/06                                          |     | Date:    |     | 3/15/06                                                 |

 

79

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**INDEX TO EXHIBITS**

| Exhibit No. | ** ** | ** ** | ** **                                                                                                                                                                                  | **Description** |
|------------------|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------|
| 3                | (a), 4(a)  |       | Articles of Incorporation *                                                                                                                                                                 |
| 3                | (b), 4(b)  |       | Amended and Restated Bylaws**                                                                                                                                                               |
| 4                | (c)        |       | Rights Agreement between First Financial Service  Corporation and Illinois Stock Tranfser Company dated April 15, 2003***                                                              |
| 10               | (a)        |       | 1998 Stock Option and Incentive Compensation Plan**                                                                                                                                         |
| 10               | (b)        |       | Form of Stock Option Agreement**                                                                                                                                                       |
| 10               | (c)        |       | Executive Compensation**                                                                                                                                                                    |
| 21               |       |       | Subsidiaries of the Registrant                                                                                                                                                              |
| 23               | (a)        |       | Consent of Crowe Chizek and Company LLC, Independent  Registered Public Accounting Firm                                                                                                |
| 31               | .1         |       | Certification of Chief Executive Officer Pursuant to  Section 302 of Sarbanes-Oxley Act                                                                                                |
| 31               | .2         |       | Certification of Chief Financial Officer Pursuant to  Section 302 of Sarbanes-Oxley Act                                                                                                |
| 32               |       |       | Certification of Chief  Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.  Section 1350 (As Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002) |
|                  |            |            |                                                                                                                                                                                             |                 |  |

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*                    Incorporatedby reference to Exhibit 3 of the Company’s Form 10-Q filed August 9,2004.

**             Incorporated byreference to Form 10-K dated March 15, 2005.

***      Incorporated by reference toForm 8-K dated April 15, 2003.

80

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