**UNITED STATESSECURITIES 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, 2006**

**CommissionFile Number:  0-18832**

**FIRST FINANCIAL SERVICE CORPORATION**

(Exact name of registrantas specified in its charter)

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

 

Registrant’s telephonenumber, including area code: **(270) 765-2131**

Securities registeredpursuant to Section 12(b) of the 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  Nox

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 oNo 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 a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

| Large Accelerated Filer o | Accelerated Filer  x | Non-Accelerated  Filer 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. x

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

The aggregate market valueof the outstanding voting stock held by non-affiliates of the registrant basedon a June 30, 2006 closing price of $27.73 as quoted on the NASDAQ GlobalMarket was $88,909,279. Solelyfor purposes of this calculation, the shares held by directors and executiveofficers of the registrant and by any stockholder beneficially owning more than5% of the registrant’s outstanding common stock are deemed to be shares held byaffiliates.

As of February 28,2007****there were issued and outstanding****4,368,484****shares of the registrant’s common stock.

**DOCUMENTSINCORPORATED BY REFERENCE**

1.                 Portions of theRegistrant’s Definitive Proxy Statement for the 2007 Annual Meeting ofShareholders to be held May 9, 2007 are incorporated by reference into Part IIIof this Form 10-K.

 

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**FIRST FINANCIALSERVICE CORPORATION2006 ANNUAL REPORT AND FORM 10-K**

**TABLEOF CONTENTS**
|                    | ** **                                                                                                                                         | ** ** | **Page** |
|--------------------|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| **Part I.**   |                                                                                                                                               |       |     |
| Item 1.            | Business                                                                                                                                           |       | 2        |   |
| Item 1A.           | Risk Factors                                                                                                                                       |       | 13       |   |
| Item 1B.           | Unresolved  Staff Comments                                                                                                                         |       | 16       |   |
| Item 2.            | Properties                                                                                                                                         |       | 16       |   |
| Item 3.            | Legal  Proceedings                                                                                                                                 |       | 16       |   |
| Item 4.            | Submission  of Matters to a Vote of Security Holders                                                                                               |       | 16       |   |
| **Part II.**  |                                                                                                                                               |       |     |
| Item 5.            | Market  Price of and Dividends on the Registrant’s Common Equity, Related Stockholder Matters  and Issuer Purchases of Equity Securities |       | 17       |   |
| Item 6.            | Selected  Financial Data                                                                                                                           |       | 18       |   |
| Item 7.            | Management’s  Discussion and Analysis of Financial Condition and Results of  Operations                                                       |       | 19       |   |
| Item 7A.           | Quantitative  and Qualitative Disclosures about Market Risk                                                                                        |       | 37       |   |
| Item 8.            | Financial  Statements and Supplementary Data                                                                                                       |       | 39       |   |
| Item 9.            | Changes  in and Disagreements with Accountants on Accounting and Financial  Disclosure                                                             |       | 73       |   |
| Item 9A.           | Controls  and Procedures                                                                                                                           |       | 73       |   |
| Item 9B.           | Other  Information                                                                                                                                 |       | 73       |   |
| **Part III.** |                                                                                                                                               |       |     |
| Item 10.           | Directors  and Executive Officers of the Registrant                                                                                                |       | 73       |   |
| Item 11.           | Executive  Compensation                                                                                                                            |       | 73       |   |
| Item 12.           | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                                                   |       | 74       |   |
| Item 13.           | Certain  Relationships and Related Transactions                                                                                                    |       | 74       |   |
| Item 14.           | Principal  Accountant Fees and Services                                                                                                            |       | 74       |   |
| **Part IV.**  |                                                                                                                                               |       |     |
| Item 15.           | Exhibits  and Financial Statement Schedules                                                                                                        |       | 74       |   |
| Signatures         |                                                                                                                                               | 76         |     |

 

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**PRELIMINARY NOTEREGARDINGFORWARD-LOOKING STATEMENTS**

Statements in this report that are not statements ofhistorical fact are forward-looking statements. First Financial ServiceCorporation (the “Corporation”) may make forward-looking statements in futurefilings with the Securities and Exchange Commission (“SEC”), in press releases,and in oral and written statements made by or with the approval of theCorporation. Forward-looking statements include, but are not limited to: (1) projectionsof revenues, income or loss, earnings or loss per share, capital structure andother financial items; (2) plans and objectives of the Corporation or itsmanagement or Board of Directors; (3) statements regarding future events,actions or economic performance; and (4) statements of assumptionsunderlying such statements. Words such as “estimate,” “strategy,” “believes,” “anticipates,”“expects,” “intends,” “plans,” “targeted,” and similar expressions are intendedto identify forward-looking statements, but are not the exclusive means ofidentifying such statements.

Various risks and uncertainties may cause actualresults to differ materially from those indicated by our forward-lookingstatements. In addition to those risks described under “Item 1A Risk Factors,”of this report, the following factors could cause such differences: changes ingeneral economic conditions and economic conditions in Kentucky and the marketswe serve, any of which may affect, among other things, our level ofnon-performing assets, charge-offs, and provision for loan loss expense;changes in interest rates that may reduce interest margins and impact fundingsources; changes in market rates and prices which may adversely impact thevalue of financial products including securities, loans and deposits; changesin tax laws, rules and regulations; various monetary and fiscal policiesand regulations, including those determined by the Federal Reserve Board, theFederal Deposit Insurance Corporation (“FDIC”) and the Kentucky Office ofFinancial Institutions (“KOFI”); competition with other local and regionalcommercial banks, savings banks, credit unions and other non-bank financialinstitutions; our ability to grow core businesses; our ability to develop andintroduce new banking-related products, services and enhancements and gainmarket acceptance of such products; and management’s ability to manage theseand other 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 Kentucky law and became the holding company for FirstFederal Savings Bank of Elizabethtown (the “Bank’), effective on June 1,1990. Since that date, we have engaged in no significant activity other thanholding the stock of the Bank and directing, planning and coordinating its businessactivities. Unless the text clearly suggests otherwise, references to “us,” “we,”or “our” include First Financial Service Corporation and its wholly ownedsubsidiary. Accordingly, the information set forth in this report, includingfinancial statements and related data, relates primarily to the Bank and itssubsidiaries. In 2004 we amended our articles of incorporation to change ourname from First Federal Financial Corporation of Kentucky to First FinancialService Corporation.

We are headquartered inElizabethtown, Kentucky and were originally founded in 1923 as astate-chartered institution and became federally chartered in 1940. In 1987, weconverted to a federally chartered savings bank and converted from mutual tostock form. We are a member of the FHLB of Cincinnati and, since converting toa state charter in 2003, have been subject to regulation, examination andsupervision by the FDIC and the KOFI. Our deposits are insured by the SavingsAssociation Insurance Fund (“SAIF”) and administered by the FDIC.

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**General BusinessOverview**

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;

·       commercial real estateloans;

·       commercial loans tobusinesses, including revolving lines of credit and term loans;

·       real estate development;

·       construction lending; and

·       agricultural lending.

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:

·       actingas 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.

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 results 

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are alsoaffected by non-interest income, such as service charges, insurance agencyrevenue, loan fees, gains and losses from the sale of mortgage loans and gainsfrom the sale of real estate held for development. Our principal operatingexpenses, aside from interest expense, consist of compensation and employeebenefits, occupancy costs, data processing expense and provisions for loanlosses.

**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 and Jefferson Countycomprise the 16th largest city in the United States. Our coremarkets have experienced a compound annual growth rate of 5% in deposits forthe past five years. Management anticipates that our markets will continue togrow at a similar rate for the next few years and believes we are wellpositioned to benefit from this anticipated growth.

We operate in Hardin, Nelson, Hart, Bullitt, Meade andJefferson Counties in Kentucky. Excluding Jefferson County, we control in theaggregate over 21% of the deposit market share with the next largest competitorcontrolling just 8% of the market. Over the past five years, these countieshave demonstrated an average growth rate in deposits of 5%. According to themost recent census data, our core markets have experienced a population increaseof 2%,****a 6% increase in the median homeprice, and a growth in****median familyincome of 4% over the past threecensus reporting years.

We expanded our presence into the Louisville market,primarily through our commercial lending operations. At December 31, 2006,over 22% of our total loan portfolio resides in this market. In an effort tobetter serve these customers and to enhance our retail branch network in thismarket, we opened two new full-service state of the art retail facilities inthe second quarter of 2004. These facilities represent our state of the artprototype branch with a retail-focused design. This design features an internetcafé with access to online banking and bill payment services. Large plasmascreens in the lobby provide customers with current news and information aboutbank products and services as well as upcoming community events. The facilitiesare staffed to offer a full range of financial services to the growing retailand commercial customer base. We plan on expanding our retail branch network inthis market to ten branches over the next seven years. Our third LouisvilleBranch is expected to open in early 2007. We have a combined $39.1 million indeposits in these two facilities, representing a 30% increase in deposits inthis market during 2006. Our current deposit market share in Louisville remainsunder 1% of the current $14.8 billion deposit base. Based on ourservice-focused operating strategy, we believe we can increase our presence inLouisville, where six large out-of-state holding companies hold the largestdeposit market shares.

All of our market areaswill likely benefit from the Fort Knox Military Base Realignment passed intolaw during 2006. Fort Knox is located in Hardin County, where we have a 21%market share. With the base realignment, Fort Knox will receive severaladditional military units including the Light Infantry Brigade Combat Team, theCombat Service Support Units and the Human Resource Command. These militaryunits will bring an estimated 2,000 additional civilian positions and 3,000additional military positions with an estimated $250 million in annual payrollto this area beginning in late 2008 through 2010. Over $700 million inrenovations to Fort Knox are planned to accommodate these units, including theconstruction of approximately 800,000 square feet of office space to house theHuman Resource Command. We anticipate the base realignment will result insubstantial growth in the retail, housing, and service industries in our area. Weplan to begin construction on a new branch facility at the main entrance to theFort Knox Military Base during 2007 for completion in 2008. We have alreadyexperienced commercial loan growth 

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financingdevelopment and have active retail and commercial strategies prepared inanticipation of the new potential relationships arriving in our market area.

**General andOperating 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.

***Branch Expansion.****  *Management continues to considermarkets for branch expansion. Because of the economic growth in our marketsover the past several years, we may consider further branch expansion in ourcurrent or surrounding market areas. However, we do not rule out branchexpansion in other areas experiencing economic growth.

During 2006, we completed construction on a new fullservice-banking center in Elizabethtown and started construction on anotherfacility in Louisville with plans of opening in early 2007. We are alsoconsidering other possible locations within our core market area as we continueto identify future branch sites. Negotiations continue on several locations,contingent upon successful rezoning efforts. Our expectation is to completerezoning and begin construction on at least two facilities during 2007. Ourgoal is to protect and grow our 21% market share in Hardin County, where ourcore market is becoming increasingly competitive.

***Internal Growth.*****  **Management believes that its largestsource of internal growth is through our ongoing solicitation program conductedby branch managers and lending officers, followed by referrals from customers.The primary source for referrals is positive customer endorsements regardingour 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 has alwaysbeen to provide high quality community banking services to our customers andincrease market share through active solicitation of new business, repeatbusiness and referrals from customers, and continuation of selected promotionalstrategies.

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, plus 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, 

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recreational vehicle, andother secured and unsecured loans sourced directly by our branches. See “LendingActivities” below for a discussion of products we provide to commercialaccounts.

·       *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 involvement enhancesour reputation and contributes to our long-term success.

***Acquisitions.******  ***Managementbelieves that the consolidation in the banking industries, along with theeasing of restrictions on bank branching, as well as increased regulatoryburdens, concerns about technology and marketing, are likely to lead owners ofcommunity banks and agencies within the Bank’s market areas to explore thepossibility of sale or combination with a broader-based financial servicecompanies 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 believes that certainhuman resource and accounting functions can be consolidated immediately uponacquisition to achieve higher productivity levels without compromising customerservice. We emphasize revenue growth by offering customers a broader productline consistent with full service banking.

Management is veryselective when evaluating a potential acquisition based upon factors such asthe operating strategy, market, financial condition, and the culture of theacquisition candidate. The last acquisition we made was in July 1998 withthe acquisition of three bank branches.

**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. Wegenerate loans primarily in our market area. In recent years, we have putgreater emphasis on originating loans for small and medium-sized businessesfrom our various locations. We make commercial loans to a variety of industries.Substantially all of the commercial real estate loans we originate haveadjustable interest rates with maturities of 25 years or less or are loans withfixed interest rates and maturities of five years or less. At December 31,2006, we had $410.1 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.

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Loans secured by multi-family residential property,consisting of properties with more than four separate dwelling units, amountedto $20.1 million of the loan portfolio at December 31, 2006. These loansare included in the $410.1 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.

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 31,2006 we had $24.0 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. Commercialloans generally are made to small-to-medium size businesses located within ourdefined market area. Commercial loans generally carry a higher yield and aremade for a shorter term than real estate loans. Commercial loans, however, involvea higher degree of risk than residential real estate loans due to potentiallygreater volatility in the value of the assigned collateral, the need for moretechnical analysis of the borrower’s financial position, the potentiallygreater impact that changing economic conditions may have on the borrower’sability to retire debt, and the additional expertise required for commerciallending personnel. Commercial business loans outstanding at December 31,2006 totaled $40.9 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, 2006 wehad $137.3 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, 2006, approximately 43.3% 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 

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unsecured lines of credit.As of December 31, 2006, consumer loans outstanding were $93.7 million.These loans involve a higher risk of default than loans secured byone-to-four-family residential loans. We believe, however, that the shorterterm and the normally higher interest rates available on various types ofconsumer loans help maintain a profitable spread between the average loan yieldand cost of funds. Home equity lines of credit as of December 31, 2006,totaled $36.6 million.

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. OurConsumer 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: borrowersmay have no existing relationship with us; borrowers may not be residents ofthe lending area; less detailed financial statement information may becollected at application; collateral values can be more difficult to determine;and the condition of vehicles securing the loan can deteriorate rapidly. Toaddress the additional risks associated with indirect consumer lending, theExecutive Loan Committee continually evaluates data regarding the dealersenrolled in the program, including monitoring turn down and delinquency rates.All applications are approved by specific lending officers, selected based onexperience in this field, who obtain credit bureau reports on each applicationto assist in the decision. Aggressive collection procedures encourage moretimely recovery of late payments. At December 31, 2006, total loans underthe indirect consumer loan program totaled $30.9 million.

**SubsidiaryActivities**

First Service Corporation of Elizabethtown (“FirstService”), our licensed brokerage affiliate, provides investment services toour customers and offers tax-deferred annuities, government securities, mutualfunds, and stocks and bonds. First Service employs four full-time employees. Thenet income of First Service was $20,465 for the year ended December 31,2006.

First Federal Office Park, LLC, holds commercial lotsadjacent to our home office on Ring Road in Elizabethtown, that are availablefor sale. We did not record any lot sales during the year ended December 31,2006. Currently, we hold two of the original nine lots held for sale.

We provide title insurance coverage for mortgageborrowers through two subsidiaries: First Heartland Title, LLC, and FirstFederal Title Services, LLC. First Heartland Title is a joint venture with alocal title insurance company and First Federal Title Services is a jointventure with a title insurance company in Louisville. We hold a 48% interest inFirst Heartland Title and a 49% interest in First Federal Title Services. Thesubsidiaries generated $121,200 in net income for the year ended December 31,2006, of which our portion was $58,176.

In 2006, we dissolvedFirst Heartland Mortgage Company of Elizabethtown, through which our secondarymarket lending department originated and sold qualified VA, KHC, RHC andconventional 

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secondarymarket loans. The employees of the First Heartland have been rolled back intothe Bank. During 2006, our secondary market lending department originated $38.7million in loans on behalf of investors. We do not service these loans afterthe sale.

**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 establishmentseffectively compete for loans by offering credit cards and retail installmentcontracts for the purchase of goods, merchandise and services (i.e., HomeDepot, Lowe’s, etc). We believe that we have been able to compete effectivelyin 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 shows our market share and rank in terms of deposits in eachKentucky County where we have offices. We have two offices in Jefferson County,which is Louisville, Kentucky. The Louisville metropolitan area has a populationof 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          |                            |       |                                   | 26.0       |               |       |   | 1 |   |   |
| Meade      |       |       | 3          |                            |       |                                   | 55.0       |               |       |   | 1 |   |   |
| Jefferson  |       |       | 2          |                            |       |                                   | <1.0    |               |       |   | N/M |   |   |

 

**Employees**

As of December 31,2006, we had 277 employees, of which 262 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**

**General Regulatory Matters.****  **On January 8, 2003, weconverted from a federally chartered savings bank to a Kentucky charteredcommercial bank. Before the conversion, we were subject to the regulation ofthe Office of Thrift Supervision. As a Kentucky chartered commercial bank, weare now subject to supervision and regulation, which involves regular bankexaminations, by both the FDIC and the KOFI. Our deposits are insured by theFDIC. Kentucky’s banking statutes contain a “super-parity” provision thatpermits a well-rated Kentucky bank to engage in any banking activity in which anational bank operating in any state, a state bank, thrift or savings bankoperating in any other state, or a federally chartered thrift or 

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federal savingsassociation meeting the qualified thrift lender test and operating in any statecould engage, provided the Kentucky bank first obtains a legal opinionspecifying the statutory or regulatory provisions that permit the activity.

In connection with theconversion, we registered to become a bank holding company under the BankHolding Company Act of 1956, and are subject to supervision and regulation bythe Federal Reserve Board. As a bank holding company, we are required to filewith the Federal Reserve Board annual and quarterly reports and otherinformation regarding our business operations and the business operations ofour subsidiaries. We are also subject to examination by the Federal ReserveBoard and to its operational guidelines. We are subject to the Bank HoldingCompany Act and other federal laws on the types of activities in which we mayengage, and to other supervisory requirements, including regulatory enforcementactions for violations of laws and regulations.

**Acquisitions and Change inControl.****  **Asa bank holding company, we must obtain Federal Reserve Board approval beforeacquiring, directly or indirectly, ownership or control of more than 5% of thevoting stock of a bank, and before engaging, or acquiring a company that is nota bank but is engaged in certain non-banking activities. In approving theseacquisitions, the Federal Reserve Board considers a number of factors, andweighs the expected benefits to the public such as greater convenience,increased competition and gains in efficiency, against the risks of possibleadverse effects such as undue concentration of resources, decreased or unfaircompetition, conflicts of interest or unsound banking practices. The FederalReserve Board also considers the financial and managerial resources of the bankholding company, its subsidiaries and any company to be acquired, and theeffect of the proposed transaction on these resources. It also evaluatescompliance by the holding company’s financial institution subsidiaries and thetarget institution with the Community Reinvestment Act. The CommunityReinvestment Act generally requires each financial institution to takeaffirmative action to ascertain and meet the credit needs of its entirecommunity, including low and moderate income neighborhoods.

Federal law also prohibitsa person or group of persons from acquiring “control” of a bank holding companywithout notifying the Federal Reserve Board in advance, and then only if theFederal Reserve Board does not object to the proposed transaction. The FederalReserve Board has established a rebuttable presumptive standard that theacquisition of 10% or more of the voting stock of a bank holding company with aclass of securities registered under the Securities Exchange Act of 1934 (the “ExchangeAct”) would constitute an acquisition of control of the bank holding company. Inaddition, any company is required to obtain the approval of the Federal ReserveBoard before acquiring 25% (5% in the case of an acquirer that is a bankholding company) or more of any class of a bank holding company’s votingsecurities, or otherwise obtaining control or a “controlling influence” over abank holding company.

**Other Financial Activities.****  **The Gramm-Leach-Bliley Act of 1999permits a bank holding company to elect to become a financial holding company,which permits the holding company to conduct activities that are “financial innature.” 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 financialholding company.

**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-banksubsidiary), in investing in the stock or other securities of the bank holdingcompany or its non-bank subsidiaries, and/or in taking such stock or securitiesas collateral for loans to any borrower. Moreover, transactions between a bankand a bank holding company (or any non-bank subsidiary) must generally be onterms and under circumstances at least as favorable to the bank as thoseprevailing in comparable transactions with independent third parties or, in theabsence of comparable transactions, on terms and under circumstances that ingood faith would be available to nonaffiliated companies.

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Under Federal Reserve Board policy, a bank holdingcompany is 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 substantially similar risk-based andleverage 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, see“Item 7-Management’s Discussion and Analysis of Financial Condition andResults of Operations-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 the Bank are classified as “well-capitalized.”FDICIA also requires the bank regulatory agencies to implement systems for “promptcorrective action” for institutions that fail to meet minimum capitalrequirements within these five categories, with progressively more severerestrictions on operations, management and capital distributions according tothe category in which an institution is placed. Failure to meet capitalrequirements can also cause an institution to be directed to raise additionalcapital. FDICIA also mandates that the agencies adopt safety and soundnessstandards relating generally to operations and management, asset quality andexecutive compensation, and authorizes administrative action against aninstitution 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. In addition tothe “prompt corrective action” directives, failure to meet capital guidelinescan subject a banking organization to a variety of other enforcement remedies,including additional substantial restrictions on its operations and activities,termination of deposit insurance by the FDIC, and under some conditions theappointment of a conservator or receiver.

**DepositInsurance.****  **Ourdeposits are insured by the FDIC up to the statutory maximum limit of $100,000per depositor through SAIF. 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.

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**Dividends.****  **The Corporation is a legal entityseparate and distinct from the Bank. The majority of our revenue is fromdividends we receive from the Bank. The Bank is subject to laws and regulationsthat limit the amount of dividends it can pay. If, in the opinion of a federalregulatory agency, an institution under its jurisdiction is engaged in or isabout to engage in an unsafe or unsound practice, the agency may require, afternotice and hearing, that the institution cease and desist from such practice.The federal banking agencies have indicated that paying dividends that depletean institution’s capital base to an inadequate level would be an unsafe andunsound banking practice. Under FDICIA, an insured institution may not pay adividend if payment would cause it to become undercapitalized or if it alreadyis undercapitalized. Moreover, the Federal Reserve and the FDIC have issuedpolicy 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 dividendsto be declared by a bank for any calendar year would exceed the bank’s totalnet profits for such year combined with its retained net profits for thepreceding two years, less any required transfers to surplus or a fund for theretirement of preferred stock or debt. We are also subject to the KentuckyBusiness Corporation Act, which generally prohibits dividends to the extentthey result in the insolvency of the corporation from a balance sheetperspective or if becoming 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 of the Federal Reserve Board’s consideration of applications toacquire, merge or consolidate with another banking institution or its holdingcompany, to establish a new branch office or to relocate an office. The FederalReserve Board will also assess the CRA record of the subsidiary banks of a bankholding company in its consideration of any application to acquire a bank orother bank holding company, which 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, 

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ensuring effectivemanagement oversight, establishing sound policies and procedures, developingeffective monitoring and reporting capabilities, ensuring adequate training andestablishing a comprehensive internal 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. The Patriot Act also grants the Secretary of the Treasurybroad authority to establish regulations and to impose requirements andrestrictions on financial institutions’ operations. In addition, the PatriotAct requires the federal bank regulatory agencies to consider the effectivenessof a financial institution’s anti-money laundering activities when reviewingbank mergers and bank holding company acquisitions.

**AvailableInformation**

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 reportsare also available on our website at http://www.ffsbky.com. You may obtainelectronic or paper copies of our reports free of charge by contacting JanellePoppe, Corporate Secretary-Treasurer, FirstFederal Savings Bank, 2323 Ring Road, Elizabethtown, Kentucky 42701 (telephone)270-765-2131.

**Item 1A.**                RiskFactors

We, like other financial companies, are subject to anumber of risks, many of which are outside of our management’s control. Westrive to manage risks while optimizing returns. The principal risks thataffect our business are: (a) credit risk, which is the risk that loan andlease customers or other counterparties will be unable to perform theircontractual obligations, (b) market risk, which is the risk that changesin market rates and prices will adversely affect our financial condition orresults of operation, (c) liquidity risk, which is the risk that we willhave insufficient cash or access to cash to meet our operating needs, and (d) operationalrisk, which is the risk of loss resulting from inadequate or failed internalprocesses, people, and systems, or from external events.

The risks identifiedbelow, as well as in the other cautionary statements made throughout thisreport, identify factors that could materially and adversely affect ourbusiness, future results of operations, and future cash flows.

**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.

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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 legislativeor business developments or natural hazards that may affect Kentucky, mayreduce demand for credit or fee-based products and could negatively affect realestate and other collateral values, interest rate levels, and the availabilityof credit to refinance loans at or before maturity.

**Market Risk**

Changes in interest ratescould harm our financial condition or results of operations. Our results ofoperations depend substantially on net interest income, the difference betweeninterest earned on interest-earning assets (such as investments and loans) andinterest paid on interest-bearing liabilities (such as deposits and borrowings).Interest rates are highly sensitive to many factors, including governmentalmonetary policies and domestic and international economic and politicalconditions. Factors beyond our control, such as inflation, recession,unemployment, and money supply may also affect interest rates. If ourinterest-earning assets mature or reprice more quickly than ourinterest-bearing liabilities in a given period, as a result of decreasinginterest rates, our net interest income may decrease. Likewise, our netinterest income may decrease if interest-bearing liabilities mature or repricemore quickly than interest-earning assets in a given period as a result ofincreasing 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 interest 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.

**Liquidity Risk**

If we cannot borrow fundsthrough access to the capital markets, we may not be able to meet the cash flowrequirements of our depositors and borrowers, or meet the operating cash needsof the Corporation to fund corporate expansion or other activities. Ourliquidity policies and limits are established by the Board of Directors, withoperating limits set by the Asset Liability Committee (“ALCO”), based uponanalyses of the ratio of loans to deposits, the percentage of assets fundedwith non-core or wholesale funding. The ALCO regularly monitors the overallliquidity position of the Bank and the Corporation to ensure that variousalternative strategies exist to cover unanticipated events that could affectliquidity. Liquidity is the ability to meet cash flow needs on a timely basisat a reasonable cost. If our liquidity policies and strategies don’t work aswell as intended, then we may be unable to make loans and to repay depositliabilities as they become due or are demanded by customers. The ALCO followsestablished 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 are collateralizedwith 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, additionalcollateralized borrowings such as FHLB advances, the issuance of debtsecurities, and the issuance of preferred or common securities in public orprivate transactions. If we were unable to access any of these funding sourceswhen needed, we might not be able to meet the needs of our customers, whichcould adversely impact our financial condition, our results of 

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operations,cash flows, and our level of regulatory-qualifying capital. For furtherdiscussion, see the “Liquidity” section of Management’s Discussion and Analysisof Financial Condition and Results of Operations.

**Operational Risk**

We have significantcompetition in both attracting and retaining deposits and in originating loans.Competition is intense in most of the markets we serve. We compete on price andservice with other banks and financial companies such as commercial banks,savings institutions, credit unions, finance companies, insurance companies,mortgage banking companies, and brokerage firms. Competition could intensify inthe future as a result of industry consolidation, the increasing availabilityof products and services from non-banks, greater technological developments inthe industry, and banking reform. If our competition prices deposits or loansat rates significantly more favorable than ours, then we may have difficulty inboth attracting and retaining deposits and loans.

Management maintainsinternal operational controls and we have invested in technology to help usprocess large volumes of transactions. However, there can be no assurance thatwe will be able to continue processing at the same or higher levels oftransactions. If our systems of internal controls should fail to work asexpected, if our systems were to be used in an unauthorized manner, or ifemployees were to subvert the system of internal controls, significant lossescould occur.

We process large volumesof transactions on a daily basis and are exposed to numerous types of operationrisk, which could cause us to incur substantial losses. Operational riskresulting from inadequate or failed internal processes, people, and systemsincludes the risk of fraud by employees or persons outside of our company, theexecution of unauthorized transactions by employees, errors relating totransaction processing and systems, and breaches of the internal control systemand compliance requirements. This risk of loss also includes potential legalactions that could arise as a result of the operational deficiency or as aresult of noncompliance with applicable regulatory standards.

We establish and maintainsystems of internal operational controls that provide management with timelyand accurate information about our level of operational risk. While notfoolproof, these systems have been designed to manage operational risk atappropriate, cost effective levels. We have also established procedures thatare designed to ensure that policies relating to conduct, ethics, and businesspractices are followed. From time to time, we experience loss from operationalrisk, including the effects of operational errors, and these losses may besubstantial.

While managementcontinually monitors and improves our system of internal controls, dataprocessing systems, and corporate wide processes and procedures, there can beno assurance that we will not suffer such losses in the future. New, or changesin existing tax, accounting, are regulatory laws, regulations, rules,standards, policies, and interpretations could significantly impact strategicinitiatives, results of operations, cash flows, 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 govern financialreporting and disclosures. These laws, regulations, rules, standards, policies,and interpretations are constantly evolving and may change significantly overtime. Events that may not have a direct impact on us, such as the bankruptcy ofU.S. companies, can cause legislators, regulators, and authoritative bodies,such as the Financial Accounting Standards Board, the SEC, the Public CompanyAccounting Oversight Board, and other various taxing authorities to respond byadopting and or proposing substantive revisions to laws, 

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regulations,rules, standards, policies, and interpretations. The nature, extent, and timingof the adoption of significant new laws and regulations, or changes in orrepeal of existing laws and regulations may have a material impact on ourbusiness and results of operations. Changes in regulation may cause us todevote substantial additional financial resources and management time tocompliance, which may negatively affect our operating results.

**Item1B.**               Unresolved StaffComments

Not applicable

**Item2.**                        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      | ** **      |       |   | 57,295 | ** ** |   |
| 325 West Dixie  Avenue          |       |              | Owned      | ** **      |       |   | 5,880 | ** ** |   |
| 2101 North Dixie  Avenue        |       |              | Owned      | ** **      |       |   | 3,150 | ** ** |   |
| **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 2006.

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**PART II**

**Item5.**                        MarketPrice of and Dividends on the Registrant’s Common Equity, Related StockholderMatters and Issuer Purchases of Equity Securities

**(a)****          MarketInformation**

OurCommon Stock is traded on the NASDAQ Global Market (NASDAQ) under the symbol “FFKY”.The following table shows the high and low closing prices of our Common Stockand the dividends paid.

| ** **     | ** ** | **Quarter Ended** | ** ** |
|----------------|------------|------------------------|------------|
| **2006:(1)**   | ** ** | ** **             | ** ** | **3/31** | ** ** | **6/30** | ** ** | **9/30** | ** ** | **12/31** | ** ** |
| High           |       | $                      | 27.27      |   | $ | 28.12 |   | $ | 31.52 |   | $ | 31.89 |   |
| Low            |       | 25.03                  |       | 26.59 |   | 27.50 |   | 30.10 |   |
| Cash dividends |       | 0.173                  |       | 0.173 |   | 0.190 |   | 0.190 |   |
|                |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

| **2005:(1)**   | ** ** | ** ** | ** ** | **3/31** | ** ** | **6/30** | ** ** | **9/30** | ** ** | **12/31** | ** ** |
|----------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|-----------|------------|
| High           |       | $          | 20.32      |     | $          | 20.68    |       | $        | 22.26      |      | $          | 26.35 |   |
| Low            |       | 19.42      |       | 19.05    |       | 20.65    |       | 23.55    |       |
| Cash dividends |       | 0.157      |       | 0.157    |       | 0.157    |       | 0.173    |       |
|                |            |            |            |          |            |          |            |          |            |           |            |  |  |  |  |

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(1)           Adjusted to reflect the impact of stockdividends declared August 15, 2006 and September 20, 2005.

**(b)****          Holders**

At December 31,2006, the number of shareholders was approximately 1,128.

**(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     |       |                               | 169,160    |                              |       |                                    | $     | 20.35 |   |   |   | 562,500 |   |   |
| Equity compensation plans not approved by security  holders |       |                               | —     |                              |       |                                    | —     |   |   |   | — |   |   |
| Total                                                            |       |                               | 169,160    |                              |       |                                    | $          | 20.35 |   |   |   | 562,500 |   |   |
|                                                                  |            |                                    |            |                                   |            |                                         |            |  |  |  |  |  |  |  |  |  |

 

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

**(e)**           **Issuer Purchases of Equity Securities**

| ** **                       | ** ** | ** **         | ** ** | ** **    | ** ** | **Total Number of** | ** ** | **Maxium**                         | ** ** |
|----------------------------------|------------|--------------------|------------|---------------|------------|-------------------------------|------------|------------------------------------|------------|
| ** **                       | ** ** | **Total**          | ** ** | **Average**   | ** ** | **Shares Purchased**     | ** ** | **Number of Shares**     | ** ** |
| ** **                       | ** ** | **Number**         | ** ** | **Price**     | ** ** | **as Part of**      | ** ** | **that May Yet Be** | ** ** |
| ** **                       | ** ** | **of Shares** | ** ** | **Paid**      | ** ** | **Publicly Announced**   | ** ** | **Purchased Under**           | ** ** |
| **Period**                       | ** ** | ** **         | ** ** | **Purchased** | ** ** | **per Share**            | ** ** | **Plans**                          | ** ** | **the Plan** | ** ** |
| October 1-October 31   |       |               | —     |          |       |                          | —     |                               |       |   | — |   |   |   | 398,601 |   |   |
| November 1-November 30 |       |               | 500        |          |       |                          | $          | 31.00                              |       |   |   | 500 |   |   |   | 398,101 |   |   |
| December 1-December 31 |       |               | —     |          |       |                          | —     |                               |       |   | — |   |   |   | 398,101 |   |   |
| Total                  |       |               | 500        |          |       |                          | $          | 31.00                              |       |   |   | 500 |   |   |   |   |   |   |
|                                  |            |                    |            |               |            |                               |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

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**Item6.**                        SelectedConsolidated Financial and Other Data

| ** **                              | ** ** | **At December 31,** | ** ** | **At June 30,** | ** ** |
|-----------------------------------------|------------|-------------------------------|------------|---------------------------|------------|
| **Financial Condition Data:** | ** ** | ** **                    | ** ** | **2006**                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2002** | ** ** |
| Total assets                            |       | $                             | 822,826    |                      | $          | 766,513 |   | $ | 737,646 |   | $ | 676,335 |   | $ | 670,728 |   |   | $ | 679,395 |   |   |
| Net loans  outstanding(1)               |       | 698,026                       |       | 635,740                   |       | 599,428 |   | 550,153 |   | 528,535 |   |   | 520,261 |   |   |
| Interest bearing  deposits              |       | —                        |       | —                    |       | — |   | — |   | — |   |   | 64,000 |   |   |
| Investments                             |       | 52,447                        |       | 61,555                    |       | 56,843 |   | 34,938 |   | 18,575 |   |   | 23,693 |   |   |
| Deposits                                |       | 641,037                       |       | 591,106                   |       | 586,386 |   | 529,162 |   | 521,121 |   |   | 529,882 |   |   |
| Borrowings                              |       | 106,724                       |       | 107,875                   |       | 88,904 |   | 88,283 |   | 87,683 |   |   | 87,778 |   |   |
| Stockholders’ equity               |       | 72,098                        |       | 64,741                    |       | 59,801 |   | 56,321 |   | 59,647 |   |   | 58,615 |   |   |
| Number of:                              |       |                          |       |                      |       |   |   |   |   |   |   |   |   |   |   |
| Real estate loans  outstanding          |       | 11,015                        |       | 10,130                    |       | 9,358 |   | 8,028 |   | 7,156 |   |   | 7,577 |   |   |
| Deposit accounts                        |       | 53,165                        |       | 50,790                    |       | 48,637 |   | 48,443 |   | 49,210 |   |   | 49,726 |   |   |
| Offices                                 |       | 14                            |       | 14                        |       | 14 |   | 13 |   | 13 |   |   | 13 |   |   |
| Full time equivalent  employees         |       | 270                           |       | 254                       |       | 246 |   | 237 |   | 219 |   |   | 209 |   |   |
|                                         |            |                               |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                        | ** ** | ** **                                 | ** ** | ** **            | ** ** | ** **        | ** ** | ** ** | ** ** | **Six Months** | ** ** | ** **          | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|-----------------------|------------|-------------------|------------|------------|------------|---------------------|------------|---------------------|------------|
| ** **                        | ** ** | ** **                                 | ** ** | ** **            | ** ** | ** **        | ** ** | ** ** | ** ** | **Ended**           | ** ** | **Year Ended** | ** ** |
| ** **                        | ** ** | **Year Ended December 31,** | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
| **Operations Data:**         | ** ** | ** **                                 | ** ** | **2006**              | ** ** | **2005**          | ** ** | **2004**   | ** ** | **2003**            | ** ** | **2002**            | ** ** | **2002** | ** ** |
| Interest income                   |       | $                                          | 53,832     |                  | $          | 45,368            |       | $          | 39,143     |                | $          | 39,339              |       |   | $ | 21,556 |   |   |   | $ | 44,100 |   |   |
| Interest expense                  |       | 24,108                                     |       | 17,862                |       | 14,792            |       | 16,365     |       |                | 9,394      |                |       |   | 21,426 |   |   |
| Net interest  income              |       | 29,724                                     |       | 27,506                |       | 24,351            |       | 22,974     |       |                | 12,162     |                |       |   | 22,674 |   |   |
| Provision for  loan losses        |       | 540                                        |       | 1,258                 |       | 1,656             |       | 1,656      |       |                | 1,161      |                |       |   | 1,604 |   |   |
| Non-interest  income              |       | 7,739                                      |       | 8,067                 |       | 8,104             |       | 7,981      |       |                | 3,177      |                |       |   | 5,398 |   |   |
| Non-interest  expense             |       | 21,952                                     |       | 20,759                |       | 19,274            |       | 17,292     |       |                | 7,597      |                |       |   | 15,281 |   |   |
| Income tax  expense               |       | 4,634                                      |       | 4,412                 |       | 3,735             |       | 4,004      |       |                | 2,199      |                |       |   | 3,729 |   |   |
| Net income                        |       | 10,337                                     |       | 9,144                 |       | 7,790             |       | 8,003      |       |                | 4,382      |                |       |   | 7,458 |   |   |
| Earnings per share:(2)            |       |                                       |       |                  |       |              |       |       |       |                |       |                |       |   |   |   |   |
| Basic                             |       | $                                          | 2.36       |                  | $          | 2.08              |       | $          | 1.76       |                | $          | 1.75                |       |   | $ | 0.90 |   |   |   | $ | 1.50 |   |   |
| Diluted                           |       | 2.34                                       |       | 2.07                  |       | 1.75              |       | 1.73       |       |                | 0.89       |                |       |   | 1.49 |   |   |
| Book value per  share(2)          |       | 16.45                                      |       | 14.77                 |       | 13.55             |       | 12.56      |       |                | 12.30      |                |       |   | 11.81 |   |   |
| Dividends paid  per share(2)      |       | 0.73                                       |       | 0.64                  |       | 0.61              |       | 0.58       |       |                | 0.27       |                |       |   | 0.54 |   |   |
| Dividend payout ratio             |       | 31                                         | %          | 31                    | %          | 35                | %          | 33         | %          |                | 30         | %                   |       |   | 36 | % |   |
| Return on average  assets         |       | 1.31                                       | %          | 1.22                  | %          | 1.12              | %          | 1.18       | %          |                | 1.31       | %                   |       |   | 1.19 | % |   |
| Average equity to  average assets |       | 8.71                                       | %          | 8.33                  | %          | 8.28              | %          | 8.26       | %          |                | 8.77       | %                   |       |   | 9.10 | % |   |
| Return on average  equity         |       | 15.03                                      | %          | 14.60                 | %          | 13.47             | %          | 14.32      | %          |                | 14.89      | %                   |       |   | 13.08 | % |   |
| Efficiency ratio                  |       | 59                                         | %          | 58                    | %          | 59                | %          | 56         | %          |                | 50         | %                   |       |   | 54 | % |   |
|                                   |            |                                            |            |                       |            |                   |            |            |            |                     |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Includes loans held forsale.

(2)          Amounts adjusted toreflect 10% stock dividends declared April 16, 2003, September 20,2005, and August 15, 2006.

18

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

Management’s Discussionand Analysis of Financial Condition and Results of Operations analyzes themajor elements of our balance sheets and statements of income. This sectionshould be read in conjunction with our Consolidated Financial Statements andaccompanying Notes and other detailed information.

**OVERVIEW**

We conduct operations in14 full-service banking centers in six contiguous counties in Central Kentuckyalong the Interstate 65 corridor. Our markets range from the major metropolitanarea of Louisville in Jefferson County, Kentucky approximately 40 miles northof our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky,approximately 30 miles south of Elizabethtown. Our core markets haveexperienced a compound annual growth rate of 5% in deposits for the past fiveyears. We anticipate that our markets will continue to grow at a similar ratefor the next few years and believe we are well positioned to benefit from thisanticipated growth.

Over the past severalyears we have focused on enhancing and expanding our retail and commercialbanking network in our core markets as well as establishing our presence in theLouisville market. Our core markets, where we have a combined 21% market share,have become increasingly competitive as several new banks have entered the fivecounties other than Louisville/Jefferson County in the past few years. In orderto protect and grow our market share, we replaced existing branches with newer,enhanced facilities and anticipate constructing several new facilities over thenext few years. In addition to the enhancement and expansion in our coremarkets, we have been increasing our presence in the Louisville market. Approximately75% of the deposit base in the Louisville market is controlled by sixout-of-state banks. While the market is very competitive, we believe thiscreates an opportunity for smaller community banks with more power to makedecisions locally. We believe our investment in these initiatives along withour continued commitment to a high level of customer service will enhance ourmarket share in our core markets and our development in the Louisville market.

Our retail branch networkcontinues to generate encouraging results. Total deposits have grown at a 5%compound annual growth rate over the past five years. Total deposits were $641million at December 31, 2006, an increase of $50 million, or 8% for theyear. The continued development of the retail branch network into theLouisville market also yielded positive results. We have a combined $39.1 millionin deposits in our two full-service facilities in the Louisville marketrepresenting a 30% increase in deposits for the year. We opened thesefacilities in the second quarter of 2004 to support our growing customer basein this market and have started construction on a new full service-bankingcenter in the Louisville market with plans of opening in early 2007.

We have developed a strongcommercial real estate niche in our markets. We have an experienced team ofbankers who are focused on providing service and convenience to our customers. Itis quite common for our bankers to close loans at a customer’s place ofbusiness or even the customer’s personal residence. This high level of servicehas been especially well received in our Louisville market, which is dominatedby regional banks. Currently, twenty-two percent of our loan portfolio residesin the Louisville market. To further develop our commercial bankingrelationships in Louisville, we anticipate opening a private banking office inearly 2007. This office will be an upscale facility complementing our retailbranch network in Louisville allowing us to further attract commercial depositrelationships in conjunction with our commercial lending relationships.

This emphasis on commercial lending generated an 8%compound annual growth rate in the total loan portfolio and a 20% compoundannual growth rate in commercial loans over the past three years. Commercialloans were $475 million at December 31, 2006, an increase of $71.8million, or 18%, from December 31, 2005. Commercial checking balances were$36.7 million at December 31, 2006. We have experienced a 14% compoundannual growth rate in commercial checking accounts over the past three years.

19

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The growth in ourcommercial and commercial real estate loan portfolio, coupled with our effortsto fund these loans with lower cost customer deposits is our primary businessmodel and has substantially contributed to the growth in earnings over the pastseveral years.

**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. The Allowance for Loan Loss Review Committee evaluates theallowance for loan losses on a quarterly basis. We estimate the allowance usingpast loan loss experience, known and inherent risks in the portfolio, adversesituations that may affect the borrower’s ability to repay, estimated value ofthe underlying collateral, and current economic conditions. While we estimatethe allowance for loan losses based in part on historical losses within eachloan category, estimates for losses within the commercial and commercial realestate portfolio are more dependent upon credit analysis and recent paymentperformance. Allocations of the allowance may be made for specific loans orloan categories, 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. The methodology for allocatingthe allowance for loan and lease losses takes into account our strategic planto increase our emphasis on commercial and consumer lending. We increase the amountof the allowance allocated to commercial loans and consumer loans in responseto the growth of the commercial and consumer loan portfolios and management’srecognition of the higher risks and loan losses in these lending areas.Allowance estimates are developed with actual loss experience adjusted forcurrent economic conditions. Allowance estimates are considered a prudentmeasurement of the risk in the loan portfolio and are applied to individualloans based on loan type.

Based on our calculation,an allowance of $7.7 million****or1.09% of total loans was our estimate of probable losses within the loanportfolio as of****December 31,2006. This estimate resulted in a provision for loan losses on the incomestatement of****$540,000 for 2006. Ifthe mix and amount of future charge off percentages differ significantly fromthose assumptions used by management in making its determination, the allowancefor loan losses and provision for loan losses on the income statement could bematerially affected.

**RESULTS OF OPERATION**

Net income for the period ended December 31, 2006was $10.3 million or $2.34 per share diluted compared to $9.1 million or $2.07per share diluted for the same period in 2005. The increase was primarily theresult of an increase in net interest income of $2.2 million and a decrease inprovision for loan loss expense of $718,000. Our book value per common shareincreased from $14.77 at December 31, 2005 to $16.45 at December 31,2006. Net income for 2006 generated a return on average assets of 1.31% and areturn on average equity of 15.03%. These compare with a return on averageassets of 1.22% and a return on average equity of 14.60% for the 2005 period.

Net income for the period ended December 31, 2005was $9.1 million or $2.07 per share diluted compared to $7.8 million or $1.75per share diluted for the same period in 2004. The increase was 

20

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primarily the result of anincrease in net interest income of $3.2 million and a decrease in provision forloan loss expense of $398,000. Our book value per common share increased from$13.55 at December 31, 2004 to $14.77 at December 31, 2005. Netincome for 2005 generated a return on average assets of 1.22% and a return onaverage equity of 14.60%. These compare with a return on average assets of1.12% and a return on average equity of 13.47% for the 2004 period.

***Net Interest Income******—******The***principalsource of our revenue is net interest income. Net interest income is thedifference between interest income on interest-earning assets, such as loansand securities and the interest expense on liabilities used to fund thoseassets, such as interest-bearing deposits and borrowings. Net interest incomeis impacted by both changes in the amount and composition of interest-earningassets and interest-bearing liabilities as well as changes in market interestrates.

Net interest margin as a percent of average earningassets increased 11 basis points to 4.04% for the year ended December 31,2006 compared to 3.93% for the 2005 period. An increase in short-term interestrates and an increase in average earning assets improved net interest incomefor the periods presented. Average interest earning assets increased $38.4million for the 2006 period compared to 2005.****The yield on earning assets averaged 7.30% for the 2006 period comparedto an average yield on earning assets of 6.48% for the same period in 2005. Theprime-lending rate increased 75 basis points during 2006 and the increase hasfavorably impacted the yield on earning assets for the year.

Our cost of funds averaged 3.58% for the 2006 periodcompared to an average cost of funds of 2.77% for the same period in 2005. Depositcosts have accelerated due to the re-pricing of maturing certificates ofdeposit that roll off into certificates of deposit at currently higher interestrates as well as to our paying higher rates on our money market products. Goingforward, our cost of funds is expected to increase as interest rates paid ondeposit products have become increasingly competitive with the recent upwardtrend in interest rates.

Net interest margin was also impacted during 2006 bythe conversion of a fixed rate FHLB advance. During January 2001, weentered into a $50.0 million convertible fixed rate advance with a maturity often years. This advance was fixed for a period of two years. At the end ofthe fixed rate term and quarterly thereafter, the FHLB had the right to convertthis advance to a variable rate advance tied to the three-month LIBORindex. Upon conversion, we could prepay the advance at no penalty. Thisadvance, fixed at a rate of 4.86%, was converted and paid off in July 2006,at a rate of 5.25% without penalty. We replaced the borrowing with overnightshort-term borrowings, which averaged a rate of 5.31% during the year. Theseborrowings will continue to float at an overnight rate until we replace theborrowings with deposits or other fixed rate and term borrowings. For the nextseveral quarters, we anticipate maintaining the borrowings at a floating rate. Thisfloating rate will better match the variable rate commercial and commercialreal estate loans in our loan portfolio and therefore reduce the volatility ofnet interest margin with future interest rate movements.

The net result of the above factors was an increase innet interest income of $2.2 million for the year ended December 31, 2006compared to 2005. The net interest margin is likely to compress in futurequarters as short term interest rates peak and the cost of deposits continue torise. The cost of deposits typically lags behind the increase in adjustablerate loans because certificates of deposit generally mature over longer periodsthan immediately adjustable rate loans.

21

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Comparativeinformation regarding net interest income follows:

| ** **                                      | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | **2006/2005** | ** ** | **2005/2004** | ** ** |
|-------------------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|---------------|------------|---------------|------------|
| ** **                                      | ** ** | **2006**                             | ** ** | **2005**   | ** ** | **2004**   | ** ** | **Change**    | ** ** | **Change**    | ** ** |
| ** **                                      | ** ** | **(Dollars in thousands)** | ** ** |
| Net interest  income, tax equivalent basis |       | $                                    | 53,987     |       | $          | 45,431     |       | $             | 39,165     |          |       | 18.8 | % |   |   | 16.0 | % |   |
| Net interest  spread                            |       | 3.72                                 | %          | 3.71       | %          | 3.58       | %          |          | 1          | bp            |       |   | 13 | bp |   |
| Net interest  margin                            |       | 4.04                                 | %          | 3.93       | %          | 3.76       | %          |          | 11         | bp            |       |   | 17 | bp |   |
| Average earnings  assets                        |       | $                                    | 739,215    |       | $          | 700,849    |       | $             | 648,703    |          |       | 5.5 | % |   |   | 8.0 | % |   |
| Prime rate at  year end                         |       | 8.25                                 | %          | 7.25       | %          | 5.25       | %          |          | 100        | bp            |       |   | 200 | bp |   |
| Average prime rate                              |       | 7.98                                 | %          | 6.19       | %          | 4.34       | %          |          | 179        | bp            |       |   | 185 | bp |   |

----

bp = basis point = 1/100thof a percent

Prime rate is includedabove to provide a general indication of the interest rate environment in whichwe operate. A large portion of our variable rate loans were indexed to theprime rate and re-price as the prime rate changes, unless they reach acontractual floor or ceiling.

22

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**AVERAGE BALANCE SHEETS**

Thefollowing table provides information relating to our average balance sheet andreflects the average yield on assets and average cost of liabilities for theindicated periods. Yields and costs for the periods presented are derived bydividing income or expense by the average monthly balance of assets orliabilities, respectively.

| ** **                                                                             | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                             | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                             | ** ** | **Average**                                | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                                             | ** ** | **Balance**                                | ** ** | **Interest** | ** ** | **Yield/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost** | ** ** |
| ** **                                                                             | ** ** | **(Dollars in thousands)**       | ** ** |
| **ASSETS**                                                                             | ** ** | ** **                                 | ** ** | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |   | ** ** | ** ** |   |
| Interest  earning assets:                                                              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies                                                             |       | $                                          | 27,823     |   | $ | 891 |   |   | 3.20 | % |   | $ | 48,063 |   | $ | 1,319 |   |   | 2.74 | % |   | $ | 26,761 |   | $ | 728 |   |   | 2.72 | % |   |
| Mortgage-backed securities                                                             |       | 14,832                                     |       | 631 |   |   | 4.25 | % |   | 12,714 |   | 516 |   |   | 4.06 | % |   | 9,343 |   | 352 |   |   | 3.77 | % |   |
| Equity securities                                                                      |       | 1,974                                      |       | 73 |   |   | 3.70 | % |   | 2,063 |   | 93 |   |   | 4.51 | % |   | 3,215 |   | 124 |   |   | 3.86 | % |   |
| State and political subdivision securities(1)                                     |       | 7,134                                      |       | 459 |   |   | 6.43 | % |   | 2,971 |   | 186 |   |   | 6.26 | % |   | 1,058 |   | 67 |   |   | 6.33 | % |   |
| Corporate bonds                                                                        |       | 6,047                                      |       | 413 |   |   | 6.83 | % |   | 3,547 |   | 181 |   |   | 5.10 | % |   | 2,000 |   | 66 |   |   | 3.30 | % |   |
| Loans(2)(3)(4)                                                                         |       | 667,793                                    |       | 50,803 |   |   | 7.61 | % |   | 613,185 |   | 42,481 |   |   | 6.93 | % |   | 583,020 |   | 37,364 |   |   | 6.41 | % |   |
| FHLB stock                                                                             |       | 7,351                                      |       | 427 |   |   | 5.81 | % |   | 6,967 |   | 349 |   |   | 5.01 | % |   | 6,671 |   | 275 |   |   | 4.12 | % |   |
| Interest bearing deposits                                                              |       | 6,261                                      |       | 290 |   |   | 4.63 | % |   | 11,339 |   | 306 |   |   | 2.70 | % |   | 16,635 |   | 189 |   |   | 1.14 | % |   |
| **Total interest earning  assets**                                                     |       | 739,215                                    |       | 53,987 |   |   | 7.30 | % |   | 700,849 |   | 45,431 |   |   | 6.48 | % |   | 648,703 |   | 39,165 |   |   | 6.04 | % |   |
| Less: Allowance for loan  losses                                                       |       | (7,456                                     | )          |   |   |   |   |   |   | (6,794 | ) |   |   |   |   |   |   | (5,890 | ) |   |   |   |   |   |   |
| Non-interest earning assets                                                            |       | 57,227                                     |       |   |   |   |   |   |   | 57,632 |   |   |   |   |   |   |   | 55,760 |   |   |   |   |   |   |   |
| **Total assets**                                                                       |       | $                                          | 788,986    |   |   |   |   |   |   |   | $ | 751,687 |   |   |   |   |   |   |   | $ | 698,573 |   |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                          |       | ** **                                 |       | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |   | ** ** | ** ** |   |
| Interest  bearing liabilities:                                                         |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                                                       |       | $                                          | 91,418     |   | $ | 2,542 |   |   | 2.78 | % |   | $ | 90,941 |   | $ | 1,678 |   |   | 1.85 | % |   | $ | 84,089 |   | $ | 783 |   |   | 0.93 | % |   |
| NOW and money market accounts                                                          |       | 129,063                                    |       | 2,061 |   |   | 1.60 | % |   | 147,731 |   | 2,093 |   |   | 1.42 | % |   | 135,265 |   | 1,156 |   |   | 0.85 | % |   |
| Certificates of deposit and other time deposits                                        |       | 352,364                                    |       | 14,085 |   |   | 4.00 | % |   | 312,807 |   | 9,428 |   |   | 3.01 | % |   | 291,486 |   | 8,539 |   |   | 2.93 | % |   |
| Short-term borrowings                                                                  |       | 35,826                                     |       | 1,904 |   |   | 5.31 | % |   | 3,655 |   | 148 |   |   | 4.05 | % |   | 3,424 |   | 47 |   |   | 1.37 | % |   |
| FHLB advances                                                                          |       | 54,503                                     |       | 2,621 |   |   | 4.81 | % |   | 78,629 |   | 3,803 |   |   | 4.84 | % |   | 78,543 |   | 3,738 |   |   | 4.76 | % |   |
| Subordinated debentures                                                                |       | 10,000                                     |       | 895 |   |   | 8.95 | % |   | 10,000 |   | 712 |   |   | 7.12 | % |   | 10,000 |   | 529 |   |   | 5.29 | % |   |
| **Total interest bearing liabilities**                                                 |       | 673,174                                    |       | 24,108 |   |   | 3.58 | % |   | 643,763 |   | 17,862 |   |   | 2.77 | % |   | 602,807 |   | 14,792 |   |   | 2.45 | % |   |
| Non-interest  bearing liabilities:                                                     |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest bearing  deposits                                                         |       | 42,289                                     |       |   |   |   |   |   |   | 41,505 |   |   |   |   |   |   |   | 34,925 |   |   |   |   |   |   |   |
| Other liabilities                                                                      |       | 4,768                                      |       |   |   |   |   |   |   | 3,780 |   |   |   |   |   |   |   | 3,014 |   |   |   |   |   |   |   |
| **Total liabilities**                                                                  |       | 720,231                                    |       |   |   |   |   |   |   | 689,048 |   |   |   |   |   |   |   | 640,746 |   |   |   |   |   |   |   |
| Stockholders’ equity                                                              |       | 68,755                                     |       |   |   |   |   |   |   | 62,639 |   |   |   |   |   |   |   | 57,827 |   |   |   |   |   |   |   |
| **Total liabilities and stockholders’ equity**                                    |       | $                                          | 788,986    |   |   |   |   |   | ** ** |   | $ | 751,687 | ** ** | ** ** | ** ** |   | ** ** | ** ** |   | $ | 698,573 | ** ** | ** ** | ** ** |   | ** ** | ** ** |   |
| **Net interest income**                                                                |       |                                       |       | $ | 29,879 |   |   |   |   |   |   |   | $ | 27,569 |   |   |   |   |   |   |   | $ | 24,373 |   |   |   |   |   |
| **Net interest spread**                                                                |       |                                       |       |   |   |   | 3.72 | % |   |   |   |   |   |   | 3.71 | % |   |   |   |   |   |   | 3.58 | % |   |
| **Net interest margin**                                                                |       |                                       |       |   |   |   | 4.04 | % |   |   |   |   |   |   | 3.93 | % |   |   |   |   |   |   | 3.76 | % |   |
| Ratio of average  interest earning assets to average interest bearing liabilities |       |                                       |       |   |   |   | 109.81 | % |   |   |   |   |   |   | 108.87 | % |   |   |   |   |   |   | 107.61 | % |   |

----

(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.

23

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**RATE/VOLUMEANALYSIS**

Thetable below provides information regarding changes in interest income andinterest expense 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,**               | ** ** |
| ** **                                      | ** ** | **2006 vs. 2005**          | ** ** | **2005 vs. 2004**         | ** ** |
| ** **                                      | ** ** | **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                      |       | $                                    | 194        |                                | $          | (622 | ) | $ | (428 | ) | $ | 6 |   | $ | 585 |   | $ | 591 |   |
| Mortgage-backed securities                      |       | 26                                   |       | 89                                  |       | 115 |   | 29 |   | 135 |   | 164 |   |
| Equity securities                               |       | (16                                  | )          | (4                                  | )          | (20 | ) | 19 |   | (50 | ) | (31 | ) |
| State and  political subdivision                |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |
| securities                                      |       | 5                                    |       | 268                                 |       | 273 |   | (1 | ) | 120 |   | 119 |   |
| Corporate bonds                                 |       | 232                                  |       | —                              |       | 232 |   | 115 |   | — |   | 115 |   |
| Loans                                           |       | 4,362                                |       | 3,960                               |       | 8,322 |   | 3,123 |   | 1,994 |   | 5,117 |   |
| FHLB stock                                      |       | 58                                   |       | 20                                  |       | 78 |   | 61 |   | 13 |   | 74 |   |
| Interest bearing deposits                       |       | 159                                  |       | (175                                | )          | (16 | ) | 193 |   | (76 | ) | 117 |   |
| **Total interest earning assets**               |       | 5,020                                |       | 3,536                               |       | 8,556 |   | 3,545 |   | 2,721 |   | 6,266 |   |
| **Interest  expense:**                          | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Savings accounts                                |       | 855                                  |       | 9                                   |       | 864 |   | 826 |   | 69 |   | 895 |   |
| NOW and money market accounts                   |       | 249                                  |       | (281                                | )          | (32 | ) | 822 |   | 115 |   | 937 |   |
| Certificates of deposit and other time deposits |       | 3,356                                |       | 1,301                               |       | 4,657 |   | 251 |   | 638 |   | 889 |   |
| Short-term borrowings                           |       | 1,756                                |       | —                              |       | 1,756 |   | 101 |   | — |   | 101 |   |
| FHLB advances                                   |       | (22                                  | )          | (1,160                              | )          | (1,182 | ) | 61 |   | 4 |   | 65 |   |
| Subordinated debentures                         |       | 183                                  |       | —                              |       | 183 |   | 183 |   | — |   | 183 |   |
| **Total interest bearing liabilities**          |       | 6,377                                |       | (131                                | )          | 6,246 |   | 2,244 |   | 826 |   | 3,070 |   |
| **Net  change in net interest income**          |       | $                                    | (1,357     | )                                   | $          | 3,667 |   | $ | 2,310 |   | $ | 1,301 |   | $ | 1,895 |   | $ | 3,196 |   |

 

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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, 2006, 2005 and 2004. Thetables show the dollar and percentage change from 2005 to 2006 and from 2004 to2005. Below each table is a discussion of significant changes and trends.

| ** **                                        | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | **2006/2005** | ** ** | **2005/2004** | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|---------------|------------|---------------|------------|
| ** **                                        | ** ** | **2006**                             | ** ** | **2005**   | ** ** | **2004**   | ** ** | **Change**    | ** ** | **%**         | ** ** | **Change** | ** ** | **%** | ** ** |
| ** **                                        | ** ** | **(Dollars in thousands)** | ** ** |
| **Non-interest income**                           | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |          | ** ** | ** **    |       | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |
| Customer sevice fees on  deposit accounts         |       | $                                    | 5,460      |       | $          | 5,167      |       | $             | 4,913      |          |       | $ | 293 |   |   | 5.7 | % |   | $ | 254 |   |   | 5.2 | % |
| Gain on sale of mortgage  loans                   |       | 783                                  |       | 868        |       | 862        |       |          | (85        | )             |       | -9.8 | % |   | 6 |   |   | 0.7 | % |
| Gain on sale of  investments                      |       | —                               |       | 381        |       | 202        |       |          | (381       | )             |       | -100.0 | % |   | 179 |   |   | 88.6 | % |
| Gain on sale of real  estate held for development |       | —                               |       | 143        |       | 526        |       |          | (143       | )             |       | -100.0 | % |   | (383 | ) |   | -72.8 | % |
| Brokerage commissions                             |       | 346                                  |       | 313        |       | 404        |       |          | 33         |          |       | 10.5 | % |   | (91 | ) |   | -22.5 | % |
| Other income                                      |       | 1,150                                |       | 1,195      |       | 1,197      |       |          | (45        | )             |       | -3.8 | % |   | (2 | ) |   | -0.2 | % |
|                                              |       | $                                    | 7,739      |       | $          | 8,067      |       | $             | 8,104      |          |       | $ | (328 | ) |   | -4.1 | % |   | $ | (37 | ) |   | -0.5 | % |

 

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 thesale of fee based products for 2006, 2005 and 2004. We continue to increase ourcustomer base through cross-selling opportunities and marketing initiatives andpromotions. In addition, we continue to emphasize growing our checking accountbase to better enhance our profitability and franchise value.

We originate qualified VA, KHC, RHC and conventionalsecondary market loans and sell them into the secondary market with servicingrights released. Gain on sale of mortgage loans decreased for 2006 compared to2005 due to a decrease in the volume of loans closed. For 2005, gain on sale ofmortgage loans remained steady compared to 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 2006 we did not record any gains on the saleof investments compared to $381,000 and $202,000 in recorded gains for the 2005and 2004 periods. Gains on investment securities are infrequent in nature andare not a consistent recurring source of 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. Currently, two of the original nine lots held forsale remain unsold.

Other income decreased for2006 due to decreases in trust income, write downs on real estate acquiredthrough foreclosure and refunded loan fees. During the fourth quarter of 2004we made the decision to outsource our trust operations and implemented thisplan during 2005. However, we still held some of these trust assets until June 2006.As of December 2006, all trust operations have been outsourced. Includedin other income for the year ended December 31, 2006 is income from trustoperations of $63,000 as compared to $93,000 for 2005. We also recorded a$73,000 gain recorded on the sale of our credit card portfolio during the thirdquarter of 2006, in which a total of $610,000 in retail credit card balanceswere sold at a 12% premium.

25

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| ** **                             | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | **2006/2005** | ** ** | **2005/2004** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|---------------|------------|---------------|------------|
| ** **                             | ** ** | **2006**                             | ** ** | **2005**   | ** ** | **2004**   | ** ** | **Change**    | ** ** | **%**         | ** ** | **Change** | ** ** | **%** | ** ** |
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** |
| **Non-interest  expenses**             | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |          | ** ** | ** **    |       | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |
| Employee compensation and benefits     |       | $                                    | 11,903     |       | $          | 11,126     |       | $             | 10,295     |          |       | $ | 777 | ** ** |   | 7.0 | % |   | $ | 831 |   |   | 8.1 | % |
| Office occupancy expense and equipment |       | 2,106                                |       | 2,065      |       | 1,833      |       |          | 41         | ** **    |       | 2.0 | % |   | 232 |   |   | 12.7 | % |
| Marketing and advertising              |       | 859                                  |       | 778        |       | 726        |       |          | 81         | ** **    |       | 10.4 | % |   | 52 |   |   | 7.2 | % |
| Outside services and data processing   |       | 2,567                                |       | 2,393      |       | 2,134      |       |          | 174        | ** **    |       | 7.3 | % |   | 259 |   |   | 12.1 | % |
| Bank franchise tax                     |       | 871                                  |       | 788        |       | 822        |       |          | 83         | ** **    |       | 10.5 | % |   | (34 | ) |   | -4.1 | % |
| Other expense                          |       | 3,646                                |       | 3,609      |       | 3,464      |       |          | 37         | ** **    |       | 1.0 | % |   | 145 |   |   | 4.2 | % |
|                                   |       | $                                    | 21,952     |       | $          | 20,759     |       | $             | 19,274     |          |       | $ | 1,193 | ** ** |   | 5.7 | % |   | $ | 1,485 |   |   | 7.7 | % |

 

Employee compensation and benefits is the largestcomponent of non-interest expense. Compensation expense increased for 2006 dueto an increase in staff needed for our continued growth and expansion as wellas annual raises. We have increased our staff in each of the last three yearsas we expand the products and services we offer our retail and commercialcustomers and increase the number and size of our branch offices. Employeecompensation and benefits expense for the 2006 period also increased by$129,000, due to a change in accounting rules in which compensationexpense related to stock options is recorded. We expect a continued increase inemployee compensation and benefits expense in line with recent years, as weprogress with our retail expansion and market protection efforts.

Office occupancy expense and equipment, marketing andadvertising, and outside services and data processing increased due toadditional operating expenses related to our expansion efforts during 2006,2005 and 2004. The two full service branch openings in 2004 contributed tohigher operating costs including additional postage for promotions and directmailings for marketing, along with increased communications and suppliesexpense.

We anticipate ournon-interest expense to continue to increase in 2007 as our retail expansionand market share efforts continue. During the second quarter of 2006 we openeda new full service-banking center in Elizabethtown****and began construction on a third facility in JeffersonCounty, which we expect to open in early 2007. We are also considering otherpossible locations within our core market area to maintain or grow our 21%market share. Our efficiency ratio was 59% for 2006 compared to 58% for the 2005period.

**ANALYSIS OFFINANCIAL CONDITION**

Total assets at December 31,2006 increased to $822.8 million compared to $766.5 million at December 31,2005, an increase of $56.3 million. The increase was primarily driven by anincrease in loans of $62.3 million. The growth in loans was funded withdeposits, which increased $49.9 million for the period, and $9.1 million inproceeds from investment securities.

***Loans***

Net loans increased $62.3 million or 10% to $698million at December 31, 2006 compared to $635.7 million at December 31,2005. Our commercial, commercial real estate and real estate constructionportfolios increased $71.8 million, an 18% increase in these loans to****$475 million at December 31, 2006. Forthe 2006 period, these loans comprised 67% of the total loan portfolio comparedto****63% of the loan portfolio at December 31,2005. Offsetting this growth was a $5.4 million, or 4% decrease in theresidential mortgage loan portfolio to $137.3 million at December 31,2006, compared to $142.7 million****atDecember 31, 2005. Consumer and home equity loans also decreased for the2006 period by $3.4 million to $62.8 million at December 31, 2006. For2007, the growth in commercial, commercial real estate and real estateconstruction loans is expected to continue in line with recent years as wecontinue to emphasize commercial lending.

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***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 totalloans.

| ** **               | ** ** | **December 31,**                | ** ** |
|--------------------------|------------|--------------------------------------|------------|
| ** **               | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **               | ** ** | **Amount**                           | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **               | ** ** | **(Dollars in thousands)** | ** ** |
| Type of Loan:            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Real Estate:             |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential              |       | $                                    | 137,155    |   | 19.44 | % | $ | 142,358 |   | 22.14 | % | $ | 158,966 |   | 26.23 | % | $ | 190,088 |   | 34.21 | % | $ | 262,990 |   | 49.34 | % |
| Construction             |       | 23,953                               |       | 3.39 |   | 13,579 |   | 2.11 |   | 10,850 |   | 1.79 |   | 9,952 |   | 1.79 |   | 12,857 |   | 2.41 |   |
| Commercial               |       | 410,146                              |       | 58.12 |   | 353,637 |   | 54.99 |   | 302,567 |   | 49.94 |   | 230,964 |   | 41.56 |   | 133,328 |   | 25.01 |   |
| Consumer and home equity |       | 62,805                               |       | 8.90 |   | 66,208 |   | 10.29 |   | 70,141 |   | 11.58 |   | 64,759 |   | 11.65 |   | 67,398 |   | 12.64 |   |
| Indirect consumer        |       | 30,857                               |       | 4.37 |   | 31,577 |   | 4.91 |   | 30,798 |   | 5.08 |   | 28,279 |   | 5.09 |   | 20,594 |   | 3.86 |   |
| Commercial, other        |       | 40,121                               |       | 5.68 |   | 35,161 |   | 5.47 |   | 31,376 |   | 5.18 |   | 30,658 |   | 5.52 |   | 32,268 |   | 6.05 |   |
| Loans held for sale      |       | 673                                  |       | 0.10 |   | 597 |   | 0.09 |   | 1,219 |   | 0.20 |   | 1,021 |   | 0.18 |   | 3,676 |   | 0.69 |   |
| Total loans              |       | $                                    | 705,710    |   | 100.00 | % | $ | 643,117 |   | 100.00 | % | $ | 605,917 |   | 100.00 | % | $ | 555,721 |   | 100.00 | % | $ | 533,111 |   | 100.00 | % |

 

***Loan Maturity Schedule.******  ***The following tableprovides information at December 31, 2006, regarding the dollar amount ofloans, net of deferred loan fees, maturing in the loan portfolio based on theircontractual 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**  | ** ** |
| ** **                                   | ** ** | **2007**                             | ** ** | **2006**                    | ** ** | **2006**                  | ** ** | **Loans**  | ** ** |
| ** **                                   | ** ** | **(Dollars in thousands)** | ** ** |
| Residential  mortgage                        |       |                                 | $          | 8,002                       |       |                      |       | $          | 23,555     |   |   |   | $ | 105,598 |   |   | $ | 137,155 |   |
| Real estate  construction                    |       |                                 | 23,953     |                        |       |                      | —     |       |       |   | — |   |   | 23,953 |   |
| Real estate  commercial                      |       |                                 | 127,537    |                        |       |                      | 250,764    |       |       |   | 31,845 |   |   | 410,146 |   |
| Consumer, home  equity and indirect consumer |       |                                 | 11,374     |                        |       |                      | 45,879     |       |       |   | 36,409 |   |   | 93,662 |   |
| Commercial, other                            |       |                                 | 16,942     |                        |       |                      | 21,499     |       |       |   | 1,680 |   |   | 40,121 |   |
| Loans held for  sale                         |       |                                 | 673        |                        |       |                      | —     |       |       |   | — |   |   | 673 |   |
| Total                                        |       |                                 | $          | 188,481                     |       |                      |       | $          | 341,697    |   |   |   | $ | 175,532 |   |   | $ | 705,710 |   |

 

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                        |       |                                 | $          | 73,290                    |       |       |       | $ | 55,863 |   |   | $ | 129,153 |   |
| Real estate  commercial                      |       |                                 | 122,026    |                      |       |       | 160,583    |   |   | 282,609 |   |
| Consumer, home  equity and indirect consumer |       |                                 | 50,415     |                      |       |       | 31,873     |   |   | 82,288 |   |
| Commercial, other                            |       |                                 | 17,035     |                      |       |       | 6,144      |   |   | 23,179 |   |
| Total                                        |       |                                 | $          | 262,766                   |       |       |       | $ | 254,463 |   |   | $ | 517,229 |   |

 

***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.

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The Allowance for Loan Loss Review Committee evaluatesthe allowance for loan losses quarterly to maintain a level sufficient toabsorb probable 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.

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

| ** **                                                                | ** ** | ** **                                 | ** ** | ** **            | ** ** | ** **        | ** ** | ** ** | ** ** | **Six Months Ended** | ** ** | **Year Ended** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------|------------|-------------------|------------|------------|------------|--------------------------------|------------|---------------------|------------|
| ** **                                                                | ** ** | **Year Ended December 31,** | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
| ** **                                                                | ** ** | **2006**                                   | ** ** | **2005**              | ** ** | **2004**          | ** ** | **2003**   | ** ** | **2002**                       | ** ** | **2002**            | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)**       | ** ** |
| Balance at beginning of period                                            |       | $                                          | 7,377      |                  | $          | 6,489             |       | $          | 5,568      |                           | $          | 4,576               |       |   | $ | 3,735 |   |   |   | $ | 2,906 |   |   |
| Loans charged-off:                                                        |       |                                       |       |                  |       |              |       |       |       |                           |       |                |       |   |   |   |   |
| Real estate mortgage                                                      |       | 3                                          |       | 15                    |       | 41                |       | 60         |       |                           | 5          |                |       |   | 25 |   |   |
| Consumer                                                                  |       | 446                                        |       | 584                   |       | 702               |       | 721        |       |                           | 419        |                |       |   | 635 |   |   |
| Commercial                                                                |       | 165                                        |       | 67                    |       | 206               |       | 76         |       |                           | —     |                |       |   | 256 |   |   |
| Total charge-offs                                                         |       | 614                                        |       | 666                   |       | 949               |       | 857        |       |                           | 424        |                |       |   | 916 |   |   |
| Recoveries:                                                               |       |                                       |       |                  |       |              |       |       |       |                           |       |                |       |   |   |   |   |
| Real estate mortgage                                                      |       | 7                                          |       | 4                     |       | —            |       | —     |       |                           | —     |                |       |   | 6 |   |   |
| Consumer                                                                  |       | 287                                        |       | 290                   |       | 214               |       | 190        |       |                           | 74         |                |       |   | 97 |   |   |
| Commercial                                                                |       | 87                                         |       | 2                     |       | —            |       | 3          |       |                           | 30         |                |       |   | 38 |   |   |
| Total recoveries                                                          |       | 381                                        |       | 296                   |       | 214               |       | 193        |       |                           | 104        |                |       |   | 141 |   |   |
| Net loans charged-off                                                     |       | 233                                        |       | 370                   |       | 735               |       | 664        |       |                           | 320        |                |       |   | 775 |   |   |
| Provision for loan losses                                                 |       | 540                                        |       | 1,258                 |       | 1,656             |       | 1,656      |       |                           | 1,161      |                |       |   | 1,604 |   |   |
| Balance at end of period                                                  |       | $                                          | 7,684      |                  | $          | 7,377             |       | $          | 6,489      |                           | $          | 5,568               |       |   | $ | 4,576 |   |   |   | $ | 3,735 |   |   |
| Allowance for loan losses to total loans (excluding  loans held for sale) |       | 1.09                                       | %          | 1.15                  | %          | 1.07              | %          | 1.00       | %          |                           | 0.86       | %                   |       |   | 0.71 | % |   |
| Net charge-offs to average loans outstanding                              |       | 0.03                                       | %          | 0.06                  | %          | 0.13              | %          | 0.12       | %          |                           | 0.12       | %                   |       |   | 0.15 | % |   |
| Allowance for loan  losses to total non-performing loans                  |       | 159                                        | %          | 118                   | %          | 124               | %          | 105        | %          |                           | 100        | %                   |       |   | 100 | % |   |

 

The provision for loan losses decreased $718,000 to$540,000 for 2006, compared to 2005.****Werecorded a smaller provision for 2006 due to****animprovement in our security and position of certain classified loans during theperiod, resulting in a reduction in the allowance allocated to the loans. Inaddition, our provision for loan loss was higher in 2005, resulting from twoclassified loans downgraded to substandard. The allowance for loan lossesincreased $307,000 to $7.7 million from December 31, 2005 to December 31,2006. The increase in the allowance in 2006 reflected a $62.5 million increasein net loans for the year, as well as a $1.6 million increase in classifiedloans.

The provision for loan lossesdecreased $398,000, or 24% to $1.3 million for 2005, compared to 2004. Thedecrease in the provision reflected a decrease in net charge offs of $365,000to $370,000 during 2005 compared to $735,000 the prior year, due to lowercommercial and indirect consumer loan charge-offs. The total allowance for loan losses increased $888,000 to $7.4 millionfrom December 31, 2004 to December 31, 2005. The increase in theallowance reflected a $37.8 million increase in net loans during 2005 comparedto 2004, and a $2.8 million increase in classified loans for 2005.

28

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Thefollowing table depicts management’s allocation of the allowance for loanlosses by loan type. Allowance and allocation is based on management’s currentevaluation of risk in each category, economic conditions, past loss experience,loan volume, past due history and other factors. Since these factors andmanagement’s assumptions are subject to change, the allocation is not aprediction of future portfolio performance.

| ** ** | ** ** | **December 31,**             | ** ** |
|------------|------------|------------------------------|------------|
| ** ** | ** ** | **2006**                     | ** ** | **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** | ** ** | **Amount of**

**Allowance** | ** ** | **Percent of**

**Total loans** | ** ** |
| ** ** | ** ** | **(Dollars in thousands)**   | ** ** |
|            |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

| Residential mortgage |   |   | $     | 340    |   |   |   | 20     | %      |   |   | $      | 373    |   |   |   | 22     | %      |   |   | $      | 413    |   |   |   | 26     | %     |   |   | $      | 456   |   |   |   | 34    | %      |   |   | $  | 608    |   |   |   | 49  | % |   |
|----------------------|--------|--------|-------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|-------|--------|--------|--------|-------|--------|--------|--------|-------|--------|--------|--------|----|--------|--------|--------|--------|-----|---|--------|
| Consumer             |   |   | 1,298 |   |   |   | 13     |   |   |   | 1,372  |   |   |   | 15     |   |   |   | 1,345  |   |   |   | 17     |   |   |   | 1,235 |   |   |   | 17    |   |   |   | 1,096 |   |   |   | 17 |   |   |
| Commercial           |   |   | 6,046 |   |   |   | 67     |   |   |   | 5,632  |   |   |   | 63     |   |   |   | 4,731  |   |   |   | 57     |   |   |   | 3,877 |   |   |   | 49    |   |   |   | 2,872 |   |   |   | 34 |   |   |
| Total                |   |   | $     | 7,684  |   |   |   | 100    | %      |   |   | $      | 7,377  |   |   |   | 100    | %      |   |   | $      | 6,489  |   |   |   | 100    | %     |   |   | $      | 5,568 |   |   |   | 100   | %      |   |   | $  | 4,576  |   |   |   | 100 | % |   |

 

Federal regulations require banks to classify theirown assets on a regular basis. The regulations provide for three categories ofclassified loans—substandard, doubtful and loss. A bank must establish generalallowances for loan losses for any assets classified as substandard ordoubtful. If an asset or portion thereof is classified as loss, the bank musteither establish specified allowances for loan losses in the amount of 100% ofthe portion of the asset classified loss, or charge off the amount of the loss.

Thefollowing table provides information with respect to classified loans for theperiods indicated:

| ** **           | ** ** | **December 31,**                | ** ** |
|----------------------|------------|--------------------------------------|------------|
| ** **           | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **           | ** ** | **(Dollars in thousands)** | ** ** |
| **Classified Loans** | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Substandard          |       | $                                    | 11,520     |   | $ | 9,826 |   |
| Doubtful             |       | 858                                  |       | 933 |   |
| Loss                 |       | 31                                   |       | 21 |   |
| Total Classified     |       | $                                    | 12,409     |   | $ | 10,780 |   |

 

The $1.7 million increase in substandard assets for2006 was primarily the result****ofthe downgrading of loans with two borrowers in the amount of a $2.9 million and****$1.1 million,****respectively. Offsetting this increase were pay offs of twoclassified loans having balances of $763,000 and $239,000. We remain wellsecured and adequately collateralized with these credits.

Although we may allocate aportion of the allowance to specific loans or loan categories, the entireallowance is available for active charge-offs. We develop our allowanceestimates based on actual loss experience adjusted for current economicconditions. Allowance estimates represent a prudent measurement of the risk inthe loan portfolio, which we apply 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 have any loans greater than 90 days past duestill on accrual. Loans, including impaired loans, are placed on non-accrualstatus when they become past due 90 days or more as to principal orinterest, unless they are adequately secured and in the process of collection. Loansare considered impaired when we no longer anticipate full principal or interestpayments in accordance with the contractual loan terms. We carry impaired loansat the present value of expected future cash flows discounted at the loan’seffective interest rate or at the fair value of the collateral if the loan issecured by collateral.

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We review our loans on a regular basis and implementnormal collection procedures when a borrower fails to make a required paymenton a loan. If the delinquency on a mortgage loan exceeds 90 days and is notcured through normal collection procedures or an acceptable arrangement is notworked out with the borrower, we institute measures to remedy the default,including commencing a foreclosure action. We generally charge off consumerloans when management deems a loan uncollectible and any available collateralhas been liquidated. We handle commercial business and real estate loandelinquencies on an individual basis with the advice of legal counsel.

We recognize interest income on loans on the accrualbasis except for those loans in a non-accrual of income status. We discontinueaccruing interest on impaired loans 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 wediscontinue interest accrual, we reverse existing accrued interest andsubsequently recognize interest income only to the extent we receive cashpayments.

We classify real estate acquired as a result offoreclosure or by deed in lieu of foreclosure as real estate owned until suchtime as it is sold. We classify new and used automobile, motorcycle and allterrain vehicles acquired as a result of foreclosure as repossessed assetsuntil they are sold. When such property is acquired we record it at the lowerof the unpaid principal balance of the related loan or its fair market value. Wecharge any write-down of the property at the time of acquisition to theallowance for loan losses. Subsequent gains and losses are included innon-interest income and non-interest expense.

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

| ** **                                                           | ** **                                                                | **December 31,**               | ** ** |
|----------------------------------------------------------------------|---------------------------------------------------------------------------|-------------------------------------|------------|
| ** **                                                           | ** **                                                                | **2006**                            | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                           | ** **                                                                | **(Dollar in thousands)** | ** ** |
| Restructured                                                         |                                                                      | $                                   | 2,470      |   | $ | 3,104 |   | $ | 3,218 |   | $ | 3,037 |   | $ | 3,325 |   |
| Past due 90 days  still on accrual                                   |                                                                      | —                              | ** ** | **—** |   | — |   | — |   | — |   |
| Loans on  non-accrual status                                         |                                                                      | 2,368                               |       | 3,128 |   | 2,022 |   | 2,281 |   | 1,259 |   |
| Total non-performing loans                                           |                                                                      | 4,838                               |       | 6,232 |   | 5,240 |   | 5,318 |   | 4,584 |   |
| Real estate acquired  through foreclosure                            |                                                                      | 918                                 |       | 1,022 |   | 681 |   | 387 |   | 510 |   |
| Other repossessed  assets                                            |                                                                      | 82                                  |       | 119 |   | 40 |   | 62 |   | 119 |   |
| Total non-performing assets                                          |                                                                      | $                                   | 5,838      |   | $ | 7,373 |   | $ | 5,961 |   | $ | 5,767 |   | $ | 5,213 |   |
| Interest income that would have been earned on non-performing  loans |                                                                      | $                                   | 368        |   | $ | 432 |   | $ | 336 |   | $ | 374 |   | $ | 177 |   |
| Interest income  recognized on non-performing loans                  |                                                                      | 227                                 |       | 219 |   | 197 |   | 227 |   | 126 |   |
| Ratios:                                                              | Non-performing  loans to total loans (excluding loans held for sale) |                                | 0.69       | % | 0.97 | % | 0.87 | % | 0.96 | % | 0.87 | % |
|                                                                 | Non-performing assets to  total loans (excluding loans held for sale)     |                                | 0.83       | % | 1.15 | % | 0.99 | % | 1.04 | % | 0.98 | % |

 

Non-performing assets for the 2006 period include $2.5million in restructured commercial, residential mortgage and consumer loans. Therestructured loans primarily consist of two credit relationships with balancesof $2.1 million and $204,000. The terms of these loans have been renegotiatedto reduce the rate of interest and extend the term, thus reducing the amount ofcash flow required from the borrower to service the loans. The borrowers arecurrently meeting the terms of the restructured loans.

Non-performing assets for2005 includes $3.1 million in restructured commercial and residential mortgageloans. The restructured loans primarily consist of two commercial relationshipswith balances of $2.2 million and $210,000 and a $452,000 residential mortgagerelationship.

30

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***Investment Securities***

Interest on securities provides us our largest sourceof interest income after interest on loans, constituting 5.6% of the totalinterest income for the year ended December 31, 2006. 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 decreased by $9.1 million during the2006 period as securities were called for redemption in accordance with theirterms due to increasing rates. During the year we made purchases of****investments in state and municipalobligations and corporate bonds. The corporate bonds re-price quarterly withthree-month LIBOR. The state and municipal obligations have an average life of10 years. We purchased these securities to enhance earnings and manage interestrate risk by placing assets with longer terms on the balance sheet. See Note 2of the Notes to Consolidated Financial Statements for further informationconcerning the investment portfolio.

We review unrealized losses at least on a quarterlybasis to determine whether the losses are other than temporary and morefrequently when economic or market concerns warrant such evaluation. Weconsider the length of time and the extent to which the fair value has beenless than cost, the financial condition and near-term prospects of the issuer,and our intent and ability to retain the investment in the issuer for a periodof time sufficient to allow for any anticipated recovery in fair value. Inanalyzing an issuer’s financial condition, we may consider whether thesecurities are issued by the federal government or its agencies, whetherdowngrades by bond rating agencies have occurred, and the results of reviews ofthe issuer’s financial condition. The unrealized losses on our investments inU.S. Treasury and agencies, mortgage-backed securities and obligations of stateand political subdivisions are due to interest rate increases. Because thedecline in market value is attributable to changes in interest rates and notcredit quality, and because we have the ability and intent to hold theseinvestments until recovery of fair value, which may be maturity, we do notconsider these investments to be other-than-temporarily impaired at December 31,2006.

Thefollowing table provides the carrying value of our securities portfolio at thedates indicated.

| ** **                         | ** ** | **December 31,**                | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities available-for-sale:** | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| U.S. Treasury and agencies         |       | $                                    | 3,484      |   | $ | 6,437 |   | $ | 15,929 |   |
| Mortgage-backed                    |       | 9,244                                |       | 11,302 |   | 1,879 |   |
| Equity                             |       | 2,146                                |       | 1,991 |   | 3,079 |   |
| State and municipal                |       | 10,029                               |       | 5,558 |   | 1,041 |   |
| Corporate                          |       | 3,320                                |       | 3,036 |   | — |   |
| Total                              |       | $                                    | 28,223     |   | $ | 28,324 |   | $ | 21,928 |   |
| **Securities  held-to-maturity:**  | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| U.S. Treasury and agencies         |       | $                                    | 18,097     |   | $ | 26,095 |   | $ | 26,095 |   |
| Mortgage-backed                    |       | 4,127                                |       | 5,136 |   | 6,820 |   |
| Corporate                          |       | 2,000                                |       | 2,000 |   | 2,000 |   |
| Total                              |       | $                                    | 24,224     |   | $ | 33,231 |   | $ | 34,915 |   |

 

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Thefollowing table provides the scheduled maturities, amortized cost, fair valueand weighted average yields for our securities at December 31, 2006.

| ** **                             | ** ** | ** **                           | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|------------|------------|--------------|------------|
| ** **                             | ** ** | **Amortized**                        | ** ** | **Fair**   | ** ** | **Average**  | ** ** |
| ** **                             | ** ** | **Cost**                             | ** ** | **Value**  | ** ** | **Yield***   | ** ** |
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities  available-for-sale:**    | ** ** |                                 | ** ** | ** ** |       | ** **   | ** ** |   | ** ** | ** ** |   |
| Due in one year or less                |       |                                 | $          | 1,375      | ** ** |         | $          | 1,374 |   |   | 4.38 | % |   |
| Due after one year through five years  |       |                                 | 3,955      | ** ** |       | 3,922        |       |   | 4.74 |   |   |
| Due after five years through ten years |       |                                 | 3,459      | ** ** |       | 3,387        |       |   | 4.21 |   |   |
| Due after ten years                    |       |                                 | 17,752     | ** ** |       | 17,394       |       |   | 4.61 |   |   |
| Equity                                 |       |                                 | 1,553      | ** ** |       | 2,146        |       |   | 3.70 |   |   |
| Total                                  |       |                                 | $          | 28,094     | ** ** |         | $          | 28,223 |   |   | 4.52 |   |   |

 

| ** **                             | ** ** | ** **                           | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|------------|------------|--------------|------------|
| ** **                             | ** ** | **Amortized**                        | ** ** | **Fair**   | ** ** | **Average**  | ** ** |
| ** **                             | ** ** | **Cost**                             | ** ** | **Value**  | ** ** | **Yield***   | ** ** |
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities held-to-maturity:**       | ** ** |                                 | ** ** | ** ** |       | ** **   | ** ** |   | ** ** | ** ** |   |
| Due in one year or less                |       |                                 | $          | 4,000      | ** ** |         | $          | 3,948 |   |   | 3.16 | % |   |
| Due after one year through five years  |       |                                 | 17,984     | ** ** |       | 17,611       |       |   | 3.74 |   |   |
| Due after five years through ten years |       |                                 | 28         | ** ** |       | 29           |       |   | 7.31 |   |   |
| Due after ten years                    |       |                                 | 2,212      | ** ** |       | 2,229        |       |   | 7.08 |   |   |
| Total                                  |       |                                 | $          | 24,224     | ** ** |         | $          | 23,817 |   |   | 3.95 |   |   |

----

* The weighted averageyields are calculated on amortized cost on a non tax-equivalent basis.

***Deposits***

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. We attract both short-term and long-term deposits from thegeneral public by offering a wide range of deposit accounts and interest rates.In recent years market conditions have caused us to rely increasingly onshort-term certificate accounts and other deposit alternatives that are moreresponsive to market interest rates. We use forecasts based on interest raterisk simulations to assist management in monitoring our use of certificates ofdeposit and other deposit products as funding sources and the impact of the useof those products on interest income and net interest margin in various rateenvironments.

In conjunction with our initiatives to expand andenhance our retail branch network, we emphasize growing our customer checkingaccount base to better enhance profitability and franchise value. Retail andcommercial deposits increased $35.1 million and we added $35.0 million inbrokered certificates of deposit for the year. These increases were offset by a$20.2 million decrease in public fund deposits, resulting in an increase intotal deposits of $49.9 million for the period. The increase in retail depositswas primarily in certificate of deposit balances due to a promotion andcustomers moving from money market and savings products into more attractivecertificate of deposit products.

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.

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We offer a broad selection of deposit instruments,including non-interest bearing checking, statement and passbook savingsaccounts, health savings accounts, NOW accounts, money market accounts andfixed and variable rate certificates with varying maturities. We also offertax-deferred individual retirement accounts. The flow of deposits is influencedsignificantly by general economic conditions, changes in interest rates andcompetition. As of December 31, 2006, approximately 39% of our depositsconsisted of various savings and demand deposit accounts from which customerscan withdraw funds at any time without penalty. Management periodically adjustsinterest rates paid on our deposit products, maturity terms, service fees andwithdrawal penalties.

We also offer certificates of deposit with a varietyof terms, interest rates and minimum deposit requirements. The variety ofdeposit accounts allows us to compete more effectively for funds and to respondwith more flexibility to the flow of funds away from depository institutionsinto direct investment vehicles such as government and corporate securities. However,market conditions continue to significantly affect our ability to attract andmaintain deposits and our cost of funds.

Thefollowing table breaks down our deposits.

| ** **               | ** ** | **December 31,**                | ** ** |
|--------------------------|------------|--------------------------------------|------------|
| ** **               | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **               | ** ** | **(Dollars in thousands)** | ** ** |
| Non-interest  bearing    |       | $                                    | 40,349     |   | $ | 39,145 |   |
| NOW demand               |       | 73,552                               |       | 76,848 |   |
| Savings                  |       | 84,994                               |       | 99,879 |   |
| Money market             |       | 53,917                               |       | 66,175 |   |
| Certificates of  deposit |       | 388,225                              |       | 309,059 |   |
| Total                    |       | $                                    | 641,037    |   | $ | 591,106 |   |

 

As of December 31, 2006, certificates of depositsin amounts of $100,000 or more totaled $122.8 million, most of which were heldby persons residing within our service areas. An additional $35.5 million ofcertificates of deposits in amounts of $100,000 or more were obtained fromdeposit brokers at December 31, 2006. Brokered deposits consist ofcertificates of deposit placed by deposit brokers for a fee and can be utilizedto support our asset growth.

Thefollowing table shows at December 31, 2006 the amount of our certificatesof deposit of $100,000 or more by time remaining until maturity.

| ** **                 | ** ** | **Certificates**        | ** ** |
|----------------------------|------------|-------------------------|------------|
| **Maturity Period**   | ** ** | ** **              | ** ** | **of Deposit** | ** ** |
| ** **                 | ** ** | **(In Thousands)** | ** ** |
| Three months or  less      |       |                    | $          | 25,465 |   |   |
| Three through six  months  |       |                    | 22,172     |   |   |
| Six through  twelve months |       |                    | 66,261     |   |   |
| Over twelve  months        |       |                    | 44,372     |   |   |
| Total                      |       |                    | $          | 158,270 |   |   |
|                            |            |                         |            |  |  |  |  |  |

 

***Short-term Borrowings***

We have the ability toobtain short-term borrowings, consisting of federal funds purchased andsecurities sold under agreements to repurchase at year end 2006 and 2005. Wehad short-term borrowings of $68.5 million for 2006 and $19.5 millionfor 2005 from the FHLB of Cincinnati. These borrowings averaged a rate of 5.31%for 2006 and 4.05% for 2005.

33

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***Advances from Federal Home Loan Bank***

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 compensate forreductions in deposits or deposit inflows at less than projected levels.Advances from the FHLB are secured by our stock in the FHLB, certainsecurities, certain commercial real estate loans and substantially all of ourfirst mortgage loans. At December 31, 2006 we had $28.2 million inadvances outstanding from the FHLB and the capacity to increase our borrowingsan additional $41.6 million.

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 creditworthiness standards. For further information, see Note 7 of theNotes to Consolidated Financial Statements in this Annual Report.

Thefollowing table provides information about our FHLB advances and short-termborrowings as of and for the periods ended.

| ** **                                                     | ** ** | **December 31,**                | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Average balance  outstanding                                   |       | $                                    | 90,329     |   | $ | 82,284 |   | $ | 78,543 |   |
| Maximum amount  outstanding at any month-end during the period |       | 121,836                              |       | 97,875 |   | 78,974 |   |
| Year end balance                                               |       | 96,724                               |       | 97,875 |   | 78,904 |   |
| Weighted average  interest rate:                               |       |                                 |       |   |   |   |   |
| At end of year                                                 |       | 5.00                                 | %          | 4.76 | % | 4.87 | % |
| During the year                                                |       | 5.01                                 | %          | 4.80 | % | 4.76 | % |
|                                                                |            |                                      |            |  |  |  |  |  |  |  |

 

**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 we can meet the cash flow requirements ofdepositors and borrowers, as well as our operating cash needs, at a reasonablecost, taking into account all on- and off-balance sheet funding demands. Wemaintain an investment and funds management policy, which identifies theprimary sources of liquidity, establishes procedures for monitoring and measuringliquidity, and establishes minimum liquidity requirements in compliance withregulatory guidance. The Asset Liability Committee continually monitors ourliquidity position.

Our sources of funds include the sale of securities inthe available-for-sale portion of the investment portfolio, principal pay-downson loans and mortgage-backed securities, proceeds realized from loans held forsale, brokered deposits and other wholesale funding. We also secured federalfunds borrowing lines from two of our correspondent banks of $15 million each. Ourbanking centers also provide access to retail deposit markets. If largecertificate depositors shift to our competitors or other markets in response tointerest rate changes, we have the ability to replenish those deposits throughalternative funding sources. Traditionally, we have also borrowed from the FHLBto supplement our funding requirements. At December 31, 2006, we had anunused approved line of credit in the amount of $96.5 million and sufficient collateral available toborrow, approximately, an additional $41.6 million in advances from the FHLB. Webelieve our sources of liquidity are adequate to meet expected cash needs forthe foreseeable future.

34

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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 Corporation include dividends from the Bank, borrowings and access to thecapital markets.

The primary source offunding for the Corporation has been dividends and returns of investment fromthe Bank. Kentucky banking laws limit the amount of dividends that may be paidto the Corporation by the Bank without prior approval of the KOFI. Under theselaws, the amount of dividends that may be paid in any calendar year is limitedto current year’s net income, as defined in the laws, combined with theretained net income of the preceding two years, less any dividends declaredduring those periods. At December 31, 2006, the Bank had approximately$12.3 million of retained earnings that could be used to pay dividends withoutprior regulatory approval. Because of these limitations, consolidated cashflows as presented in the consolidated statements of cash flows may notrepresent cash immediately available to the Corporation. During 2006, the Bankdeclared and paid dividends of $4.2 million to the Corporation.

**CAPITAL**

Stockholders’ equity increased by $7.4 million during2006, primarily due to net income earned during the year. This increase wasoffset by cash dividends declared.****Averagestockholders’ equity to average assets ratio increased to 8.71% at December 31,2006 from 8.33% at the end of 2005.

During 2006, we purchased 500 shares of our own commonstock for $15,500. During the third quarter, our Board of Directors authorizedthe repurchase of 398,601 shares from time-to-time if market conditions aredeemed favorable. The repurchase program will remain effective until the numberof shares authorized is repurchased or until the program expires September 19,2008. As of December 31, 2006, 398,101 shares could be repurchased underthe current stock repurchase program.

Eachof the federal bank regulatory agencies has established minimum leveragecapital requirements for banks. Banks must maintain a minimum ratio of Tier 1capital to adjusted average quarterly assets ranging from 3% to 5%, subject tofederal bank regulatory evaluation of an organization’s overall safety andsoundness. We intend to maintain a capital position that meets or exceeds the “wellcapitalized” requirements established for banks by the FDIC. The followingtable shows the ratios of Tier 1 capital and total capital to risk-adjustedassets and the leverage ratios for the Corporation and the Bank as of December 31,2006.

| ** **                              | ** ** | **Capital Adequacy Ratios as of** | ** ** |                 |
|-----------------------------------------|------------|-------------------------------------------------------|------------|----------------------|
| ** **                              | ** ** | **December 31, 2006**                       | ** ** |                 |
| ** **                              | ** ** | **Regulatory**                                        | ** ** | **Well-Capitalized** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| **Risk-Based Capital Ratios** | ** ** | ** **                                            | ** ** | **Minimums**         | ** ** | **Minimums** | ** ** | **The Bank** | ** ** | **The Corporation** | ** ** |
| Tier 1 capital(1)                       |       |                                                  | 4.0        | %                    |   |   | 6.0 | % |   |   | 10.0 | % |   |   | 10.4 | % |   |   |
| Total risk-based  capital(2)            |       |                                                  | 8.0        | %                    |   |   | 10.0 | % |   |   | 11.2 | % |   |   | 11.6 | % |   |   |
| Tier 1 leverage ratio(3)                |       |                                                  | 4.0        | %                    |   |   | 5.0 | % |   |   | 8.9 | % |   |   | 9.2 | % |   |   |
|                                         |            |                                                       |            |                      |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(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.

35

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**OFF BALANCE SHEETARRANGEMENTS**

Our off balance sheetarrangements consist of commitments to make loans, unused borrower lines ofcredit, and stand by letters of credit, which are disclosed in Note 16 to theconsolidated financial statements.

**AGGREGATE CONTRACTUAL OBLIGATIONS**

| ** **                              | ** ** | ** **                           | ** ** | ** **         | ** ** | **Greater than**     | ** ** | **Greater than**    | ** ** | ** **                                                       | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|--------------------|------------|---------------------------|------------|--------------------------|------------|------------------------------------------------------------------|------------|
| ** **                              | ** ** | ** **                           | ** ** | **Less than** | ** ** | **one year to** | ** ** | **3 years to** | ** ** | **More than**                                               | ** ** |
| **December 31, 2006**         | ** ** | ** **                           | ** ** | **Total**          | ** ** | **one year**         | ** ** | **3 years**         | ** ** | **    5 years    ** | ** ** | **5 years** | ** ** |
| ** **                              | ** ** | **(Dollars in thousands)** | ** ** |
| **Aggregate  Contractual Obligations:** | ** ** | ** **                           | ** ** | ** **         | ** ** |                      | ** ** | ** **               |       |                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Time deposits                           |       | $                                    | 388,225    |               | $          | 269,033                   | ** ** |                     | $          | 102,039                                                          | ** ** |   |   | $ | 16,683 | ** ** |   |   | $ | 470 | ** ** |   |
| FHLB borrowings                         |       | 28,224                               |       | 139                | ** ** |                      | 268        | ** **               |       |                                                             | 25,262     | ** ** |   |   | 2,555 | ** ** |   |
| Short-term borrowings                   |       | 68,500                               |       | 68,500             | ** ** |                      | —     | ** **               |       |                                                             | —     | ** ** |   |   | — | ** ** |   |
| Subordinated debentures                 |       | 10,000                               |       | —             | ** ** |                      | —     | ** **               |       |                                                             | —     | ** ** |   |   | 10,000 | ** ** |   |
| Lease commitments                       |       | 1,792                                |       | 330                | ** ** |                      | 632        | ** **               |       |                                                             | 601        | ** ** |   |   | 229 | ** ** |   |
|                                         |            |                                      |            |                    |            |                           |            |                          |            |                                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

FHLB borrowings represent the amounts that are due tothe FHLB of Cincinnati. These amounts have fixed maturity dates. One of theseborrowings, although fixed, is subject to conversion provisions at the optionof the FHLB. The FHLB has the right to convert this advance to a variable rateor 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 believethis advance will be converted in the near term.

The subordinated debentures, which mature March 26,2032, are redeemable before 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%. Similar debt instruments are currently being issued with spreads to three-monthLIBOR that are more favorable than our 3.60% spread. If this pricing continuesthrough March 26, 2007, we will likely exercise our option to redeem ouroutstanding subordinated debentures on or after March 26, 2007. We havethe option to defer distributions on the subordinated debentures from time totime for a period not to exceed 20 consecutive quarters.

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

**IMPACT OFINFLATION & CHANGING PRICES**

The financial statements and related data presentedherein have 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 the effectsof general levels of inflation. Periods of high inflation are often accompaniedby relatively higher interest rates, and periods of low inflation areaccompanied by relatively lower interest rates. As market interest rates riseor fall in relation to the rates earned on our loans and investments, the valueof these assets decreases or increases respectively.

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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. We then evaluate potential changes in marketinterest rates and their subsequent effects on net interest income. The modelprojects the effect of instantaneous movements in interest rates of both 100and 200 basis points. We also incorporate assumptions based on the historicalbehavior of our deposit rates and balances in relation to changes in interestrates into the model. These assumptions are inherently uncertain and, as aresult, the model cannot precisely measure future net interest income or preciselypredict the impact of fluctuations in market interest rates on net interestincome. Actual results will differ from the model’s simulated results due totiming, magnitude and frequency of interest rate changes as well as changes inmarket conditions and the application and timing of various managementstrategies.

Our interest sensitivity profile was liabilitysensitive at December 31, 2006, compared to an asset sensitive position atDecember 31, 2005. Given a sustained 100 basis point decrease in rates,our base net interest income would increase by an estimated****.55% at December 31, 2006 compared toa decrease of 2.03% at December 31, 2005. Given a 100 basis point increasein interest rates our base net interest income would decrease by an****estimated .48% at December 31, 2006compared to an increase of 1.92% at December 31, 2005.

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, their relative pricing schedules, marketinterest rates, deposit growth, loan growth, decay rates and prepayment speedassumptions.

We have been restructuring our assets in theexpectation that interest rates will be stable or decrease in the futures. Asdemonstrated by the December 31, 2006 and December 31, 2005sensitivity tables, we transitioned from an asset sensitive to a liabilitysensitive position as compared to prior periods. This means that our earningassets, which consist of loans and investment securities, will change in priceat a slower rate than our deposits and borrowings. Therefore, if short terminterest rates increase, our net interest income will decrease. Likewise, ifshort term interest rates decrease, our net interest income will increase. Alsochanging from 2005 is the anticipated degree of change. As of December 31,2006, an increase or decrease in interest rates of 200 basis points isprojected to result in less than a 1% change in net interest income. Interestrate changes under our current balance sheet position will not have as large ofimpact on earnings as the balance sheet position at December 31, 2005,when a 200 basis point increase or decrease in interest rates was projected toresult in over a 4.00% change in net interest income.

Our efforts to structure funding and future liquidityneeds have decreased our asset sensitivity. From June 2004 until June 2006,the Federal Open Market Committee increased short-term interest rates. Webelieve the Federal Open Market Committee may decrease short term interestrates at some point in 2007. Our net interest margin and the level of netinterest income would increase with a decrease in short term interest rates. Wecontinually monitor the effects rate changes will have on our level of netinterest income, and management works to structure the maturity and pricing ofloans and deposits to mitigate large swings in net interest income. During2006, we made efforts to increase the level of short-term deposits offering 

37

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more attractive rates onshort-term certificates of deposits. Also, during the third quarter of 2006, wepaid off a fixed rate FHLB advance that had converted to a variable rateadvance. We replaced this borrowing with overnight short-term borrowings. Inaddition, the majority of the newly originated or renewed loans during 2005 and2006 were fixed rates loans with the interest rate fixed from three to fiveyears.

Oursensitivity to interest rate changes is presented based on data as of December 31,2006 and December 31, 2005.

| ** **                      | ** ** | **December 31, 2006**      | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **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                           |       |                                 | $          | 58,262 |   |   |   | $ | 59,517 |   |   | $ | 60,592 |   |   | $ | 61,623 |   |   |   | $ | 62,759 |   |   |
| Investments                     |       |                                 | 2,342      |   |   |   | 2,482 |   |   | 2,535 |   |   | 2,625 |   |   |   | 2,653 |   |   |
| **Total  interest income**      |       |                                 | 60,604     |   |   |   | 61,999 |   |   | 63,127 |   |   | 64,248 |   |   |   | 65,412 |   |   |
| **Projected  interest expense** | ** ** |                                 | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Deposits                        |       |                                 | 20,643     |   |   |   | 21,500 |   |   | 22,356 |   |   | 23,124 |   |   |   | 23,891 |   |   |
| Borrowed funds                  |       |                                 | 5,071      |   |   |   | 5,628 |   |   | 6,090 |   |   | 6,608 |   |   |   | 7,040 |   |   |
| **Total  interest expense**     |       |                                 | 25,714     |   |   |   | 27,128 |   |   | 28,446 |   |   | 29,732 |   |   |   | 30,931 |   |   |
| **Net interest income**         |       |                                 | $          | 34,890 |   |   |   | $ | 34,871 |   |   | $ | 34,681 |   |   | $ | 34,516 |   |   |   | $ | 34,481 |   |   |
| Change from base                |       |                                 | $          | 209 |   |   |   | $ | 190 |   |   |   |   |   | $ | (165 | ) |   |   | $ | (200 | ) |   |
| % Change from base              |       |                                 | .60        | % |   |   | .55 | % |   |   |   |   | (.48 | )% |   |   | (.58 | )% |   |

 

| ** **                      | ** ** | **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 | % |   |

 

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**Item 8.**                        FinancialStatements and Supplementary Data

**FIRST FINANCIALSERVICE CORPORATIONTable of Contents**
| Audited Consolidated Financial Statements: |   |                                                                                                   |
|--------------------------------------------|--------|--------------------------------------------------------------------------------------------------------|
|                                       | · | Report  on Management’s Assessment of Internal Control Over Financial Reporting                   |   | 40 |
|                                       | · | Report  of Independent Registered Public Accounting Firm on Internal Control Over  Financial Reporting |   | 41 |
|                                       | · | Report  of Independent Registered Public Accounting Firm on Financial Statements                       |   | 43 |
|                                       | · | Consolidated  Balance Sheets                                                                           |   | 44 |
|                                       | · | Consolidated  Statements of Income                                                                     |   | 45 |
|                                       | · | Consolidated  Statements of Comprehensive Income                                                       |   | 46 |
|                                       | · | Consolidated  Statements of Changes in Stockholders’ Equity                                       |   | 47 |
|                                       | · | Consolidated  Statements of Cash Flows                                                                 |   | 48 |
|                                       | · | Notes  to Consolidated Financial Statements                                                            |   | 49-72 |

 

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**Report onManagement’s Assessment of Internal Control Over 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 any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or that thedegree of compliance with the policies or procedures may deteriorate.

Managementassessed the system of internal control over financial reporting as of December 31,2006, 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, 2006, 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 an attestationreport on management’s assessment of the Corporation’s internal control overfinancial reporting dated March 13, 2007.
| Date: March 16, 2007  |     | By:      | /s/ B. KEITH  JOHNSON                   |
|----------------------------|----------|----------|-----------------------------------------|
|                       |     |     | B. Keith Johnson                        |
| * *                   | * * | * * | *President and Chief Executive Officer* |
| Date:  March 16, 2007 |     | By:      | /s/ GREGORY SCHREACKE                   |
|                       |     |     | Gregory Schreacke                       |
| * *                   | * * | * * | *Chief Financial Officer*               |
| * *                   | * * | * * | *Principal Accounting Officer*          |

 

40

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****

**Report ofIndependent Registered Public Accounting Firm On Internal Control OverFinancial Reporting**

Board of Directors and StockholdersFirst Financial Service CorporationElizabethtown, Kentucky

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 31,2006, 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 operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis 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, 2006 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, 2006 based on criteria established inInternal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

41

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Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the accompanying consolidated balancesheets of First Financial Service Corporation as of December 31, 2006 and2005 and the related statements of income, comprehensive income, changes instockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2006 and our report dated March 13, 2007 expressedan unqualified opinion thereon.

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

 

Louisville, KentuckyMarch 13, 2007

42

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****

**Report ofIndependent Registered Public Accounting Firm 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, 2006 and2005, 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, 2006. 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). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of First Financial Service Corporation as of December 31, 2006and 2005, and the results of its operations and its cash flows for each of thethree years in the period ended December 31, 2006 in conformity with U.S.generally accepted accounting principles.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of FirstFinancial Service Corporation’s internal control over financial reporting as ofDecember 31, 2006, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission and our report dated March 13, 2007 expressed an unqualifiedopinion thereon.

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

 

Louisville, KentuckyMarch 13, 2007

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**FIRST FINANCIAL SERVICE CORPORATIONConsolidated Balance Sheets**

| ** **                                                                                                                                         | ** ** | **December 31,**                                              | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                                                         | ** ** | **2006**                                                           | ** ** | **2005** | ** ** |
| ** **                                                                                                                                         | ** ** | **(Dollars in thousands,  except share data)** | ** ** |
| **ASSETS**                                                                                                                                         | ** ** | ** **                                                         | ** ** | ** ** | ** ** |
| Cash and due from banks                                                                                                                            |       | $                                                                  | 19,082     |   | $ | 20,451 |   |
| Securities available-for-sale                                                                                                                      |       | 28,223                                                             |       | 28,324 |   |
| Securities held-to-maturity, fair value of $23,817  (2006) and $32,434 (2005)                                                                      |       | 24,224                                                             |       | 33,231 |   |
| Total securities                                                                                                                                   |       | 52,447                                                             |       | 61,555 |   |
| Loans held for sale                                                                                                                                |       | 673                                                                |       | 597 |   |
| Loans, net of unearned fees                                                                                                                        |       | 705,037                                                            |       | 642,520 |   |
| Allowance for loan losses                                                                                                                          |       | (7,684                                                             | )          | (7,377 | ) |
| Net loans receivable                                                                                                                               |       | 698,026                                                            |       | 635,740 |   |
| Federal Home Loan Bank stock                                                                                                                       |       | 7,621                                                              |       | 7,194 |   |
| Cash surrender value of life insurance                                                                                                             |       | 7,947                                                              |       | 7,637 |   |
| Premises and equipment, net                                                                                                                        |       | 22,500                                                             |       | 19,134 |   |
| Real  estate owned:                                                                                                                                |       |                                                               |       |   |   |
| Acquired through foreclosure                                                                                                                       |       | 918                                                                |       | 1,022 |   |
| Held for development                                                                                                                               |       | 337                                                                |       | 337 |   |
| Other repossessed assets                                                                                                                           |       | 82                                                                 |       | 119 |   |
| Goodwill                                                                                                                                           |       | 8,384                                                              |       | 8,384 |   |
| Accrued interest receivable                                                                                                                        |       | 4,094                                                              |       | 3,051 |   |
| Other assets                                                                                                                                       |       | 1,388                                                              |       | 1,889 |   |
| **TOTAL ASSETS**                                                                                                                                   | ** ** | $                                                                  | 822,826    |   | $ | 766,513 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                      | ** ** | ** **                                                         | ** ** | ** ** | ** ** |
| **LIABILITIES:**                                                                                                                                   | ** ** | ** **                                                         | ** ** | ** ** | ** ** |
| Deposits:                                                                                                                                          |       |                                                               |       |   |   |
| Non-interest bearing                                                                                                                               |       | $                                                                  | 40,349     |   | $ | 39,145 |   |
| Interest bearing                                                                                                                                   |       | 600,688                                                            |       | 551,961 |   |
| Total deposits                                                                                                                                     |       | 641,037                                                            |       | 591,106 |   |
| Short-term borrowings                                                                                                                              |       | 68,500                                                             |       | 19,500 |   |
| Advances from Federal Home Loan Bank                                                                                                               |       | 28,224                                                             |       | 78,375 |   |
| Subordinated debentures                                                                                                                            |       | 10,000                                                             |       | 10,000 |   |
| Accrued interest payable                                                                                                                           |       | 273                                                                |       | 389 |   |
| Accounts payable and other liabilities                                                                                                             |       | 1,321                                                              |       | 1,023 |   |
| Deferred income taxes                                                                                                                              |       | 1,373                                                              |       | 1,379 |   |
| **TOTAL LIABILITIES**                                                                                                                              | ** ** | 750,728                                                            |       | 701,772 |   |
| Commitments and contingent liabilities (See Note 16)                                                                                               |       | —                                                             |       | — |   |
| **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, 4,384,088 shares (2006), and  3,983,530 shares (2005) |       | 4,384                                                              |       | 3,984 |   |
| Additional paid-in capital                                                                                                                         |       | 27,419                                                             |       | 16,409 |   |
| Retained earnings                                                                                                                                  |       | 40,210                                                             |       | 44,291 |   |
| Accumulated other comprehensive income                                                                                                             |       | 85                                                                 |       | 57 |   |
| **TOTAL STOCKHOLDERS’ EQUITY**                                                                                                                | ** ** | 72,098                                                             |       | 64,741 |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                               | ** ** | $                                                                  | 822,826    |   | $ | 766,513 |   |

 

See notes to consolidated financial statements.

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**FIRST FINANCIAL SERVICE CORPORATIONConsolidated Statements of Income**

| ** **                                          | ** ** | **Year Ended December 31,**                                  | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                          | ** ** | **(Dollars in thousands,  except per share data)** | ** ** |
| **Interest and Dividend Income:**                   | ** ** | ** **                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans, including fees                               |       | $                                                                           | 50,803     |   | $ | 42,481 |   | $ | 37,364 |   |
| Taxable securities                                  |       | 2,726                                                                       |       | 2,764 |   | 1,734 |   |
| Tax exempt securities                               |       | 303                                                                         |       | 123 |   | 45 |   |
| Total interest income                               |       | 53,832                                                                      |       | 45,368 |   | 39,143 |   |
| **Interest Expense:**                               | ** ** | ** **                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                                            |       | 18,688                                                                      |       | 13,199 |   | 10,478 |   |
| Short-term borrowings                               |       | 1,904                                                                       |       | 148 |   | 47 |   |
| Federal Home Loan Bank advances                     |       | 2,621                                                                       |       | 3,803 |   | 3,738 |   |
| Subordinated debentures                             |       | 895                                                                         |       | 712 |   | 529 |   |
| Total interest expense                              |       | 24,108                                                                      |       | 17,862 |   | 14,792 |   |
| Net interest income                                 |       | 29,724                                                                      |       | 27,506 |   | 24,351 |   |
| Provision for loan losses                           |       | 540                                                                         |       | 1,258 |   | 1,656 |   |
| Net interest income after provision for loan losses |       | 29,184                                                                      |       | 26,248 |   | 22,695 |   |
| **Non-interest Income:**                            | ** ** | ** **                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer service fees on deposit accounts           |       | 5,460                                                                       |       | 5,167 |   | 4,913 |   |
| Gain on sale of mortgage loans                      |       | 783                                                                         |       | 868 |   | 862 |   |
| Gain on sale of investments                         |       | —                                                                      |       | 381 |   | 202 |   |
| Gain on sale of real estate held for development    |       | —                                                                      |       | 143 |   | 526 |   |
| Brokerage commissions                               |       | 346                                                                         |       | 313 |   | 404 |   |
| Other income                                        |       | 1,150                                                                       |       | 1,195 |   | 1,197 |   |
| Total non-interest income                           |       | 7,739                                                                       |       | 8,067 |   | 8,104 |   |
| **Non-interest Expense:**                           | ** ** | ** **                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Employee compensation and benefits                  |       | 11,903                                                                      |       | 11,126 |   | 10,295 |   |
| Office occupancy expense and equipment              |       | 2,106                                                                       |       | 2,065 |   | 1,833 |   |
| Marketing and advertising                           |       | 859                                                                         |       | 778 |   | 726 |   |
| Outside services and data processing                |       | 2,567                                                                       |       | 2,393 |   | 2,134 |   |
| Bank franchise tax                                  |       | 871                                                                         |       | 788 |   | 822 |   |
| Other expense                                       |       | 3,646                                                                       |       | 3,609 |   | 3,464 |   |
| Total non-interest expense                          |       | 21,952                                                                      |       | 20,759 |   | 19,274 |   |
| Income before income taxes                          |       | 14,971                                                                      |       | 13,556 |   | 11,525 |   |
| Income taxes                                        |       | 4,634                                                                       |       | 4,412 |   | 3,735 |   |
| **Net Income**                                      |       | $                                                                           | 10,337     |   | $ | 9,144 |   | $ | 7,790 |   |
| Shares applicable to basic income per share         |       | 4,383                                                                       |       | 4,398 |   | 4,428 |   |
| **Basic income per share**                          |       | $                                                                           | 2.36       |   | $ | 2.08 |   | $ | 1.76 |   |
| Shares applicable to diluted income per share       |       | 4,427                                                                       |       | 4,428 |   | 4,447 |   |
| **Diluted  income per share**                       |       | $                                                                           | 2.34       |   | $ | 2.07 |   | $ | 1.75 |   |

 

See notes to consolidated financial statements.

45

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**FIRST FINANCIAL SERVICE CORPORATIONConsolidated Statements of Comprehensive Income**

| ** **                                                     | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                     | ** ** | **(Dollars in thousands)**       | ** ** |
| **Net  Income**                                                |       | $                                          | 10,337     |   | $ | 9,144 |   | $ | 7,790 |   |
| Other comprehensive  income (loss):                            |       |                                       |       |   |   |   |   |
| Change in unrealized gain (loss) on securities                 |       | 41                                         |       | (678 | ) | 138 |   |
| Reclassification of realized amount                            |       | —                                     |       | (381 | ) | (202 | ) |
| Net unrealized gain (loss) recognized in comprehensive  income |       | 41                                         |       | (1,059 | ) | (64 | ) |
| Tax effect                                                     |       | (13                                        | )          | 360 |   | 22 |   |
| Total other comphrehensive income (loss)                       |       | 28                                         |       | (699 | ) | (42 | ) |
| **Comphrehensive  Income**                                     |       | $                                          | 10,365     |   | $ | 8,445 |   | $ | 7,748 |   |

 

See notes to consolidated financial statements.

46

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**FIRST FINANCIAL SERVICE CORPORATIONConsolidated Statements of Changes in Stockholders’ EquityYears Ending December 31, 2006, 2005 and 2004(Dollars In Thousands, Except Per Share Amounts)**

| ** **                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** | ** **   | ** ** | **Accumulated**              | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|----------------|------------|--------------|------------|------------------------------|------------|------------|------------|
| ** **                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** | ** **   | ** ** | **Other**                    | ** ** | ** ** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **   | ** ** | **Comprehensive**            | ** ** | ** ** | ** ** |
| ** **                                                                            | ** ** | **Common** | ** ** | **Stock**  | ** ** | **Paid-in**    | ** ** | **Retained** | ** ** | **Income, Net of** | ** ** | ** ** | ** ** |
| ** **                                                                            | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Capital**    | ** ** | **Earnings** | ** ** | **Tax**                      | ** ** | **Total**  | ** ** |
| **Balance,  January 1, 2004**                                                    |       |       | 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 ($.61 per share)                                             |       |       |       |       |       |           |       |         |       |                         |       |       |       | (2,708 | ) |   |   |   |   | (2,708 | ) |
| Stock repurchased                                                                     |       |       | (60        | )          |       |           | (60        | )            |       |                         | (1,500     | )          |       | — |   |   | — |   |   | (1,560 | ) |
| **Balance,  December 31, 2004**                                                  |       |       | 3,645      |       |       |           | 3,645      |         |       |                         | 8,226      |       |       | 47,174 |   |   | 756 |   |   | 59,801 |   |
| Net income                                                                            |       |       |       |       |       |           |       |         |       |                         |       |       |       | 9,144 |   |   |   |   |   | 9,144 |   |
| Stock  dividend-10%                                                                   |       |       | 363        |       |       |           | 363        |         |       |                         | 8,834      |       |       | (9,197 | ) |   |   |   | ** ** | **—** | ** ** |
| Exercise of stock  options                                                            |       |       | 5          |       |       |           | 5          |         |       |                         | 80         |       |       |   |   |   |   |   |   | 85 |   |
| Net change in  unrealized gains (losses) on securities available-for-sale, net of tax |       |       |       |       |       |           |       |         |       |                         |       |       |       |   |   |   | (699 | ) |   | (699 | ) |
| Cash dividends  declared ($.64 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 |   |
| Net income                                                                            |       |       |       |       |       |           |       |         |       |                         |       |       |       | 10,337 |   |   |   |   |   | 10,337 |   |
| Stock  dividend-10%                                                                   |       |       | 398        |       |       |           | 398        |         |       |                         | 10,835     |       |       | (11,233 | ) |   |   |   |   | — |   |
| Stock issued for  stock options exercised and employee benefit plans                  |       |       | 3          |       |       |           | 3          |         |       |                         | 61         |       |       |   |   |   |   |   |   | 64 |   |
| Compensation  expense for stock options                                               |       |       |       |       |       |           |       |         |       |                         | 129        |       |       |   |   |   |   |   |   | 129 |   |
| Net change in  unrealized gains (losses) on securities available-for-sale, net of tax |       |       |       |       |       |           |       |         |       |                         |       |       |       |   |   |   | 28 |   |   | 28 |   |
| Cash dividends  declared ($.73 per share)                                             |       |       |       |       |       |           |       |         |       |                         |       |       |       | (3,185 | ) |   |   |   |   | (3,185 | ) |
| Stock repurchased                                                                     |       |       | (1         | )          |       |           | (1         | )            |       |                         | (15        | )          |       | — |   |   | — |   |   | (16 | ) |
| **Balance, December 31, 2006**                                                   |       |       | 4,384      |       |       |           | $          | 4,384        |       |                         |       | $          | 27,419     |   |   | $ | 40,210 |   |   | $ | 85 |   |   | $ | 72,098 |   |

 

See notes to consolidated financial statements.

47

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**FIRST FINANCIAL SERVICE CORPORATIONConsolidated Statements of Cash Flows**

| ** **                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                         | ** ** | **(Dollars in thousands)**       | ** ** |
| **Operating Activities:**                                                          | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                          | 10,337     |   | $ | 9,144 |   | $ | 7,790 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Provision for loan losses                                                          |       | 540                                        |       | 1,258 |   | 1,656 |   |
| Depreciation on premises and equipment                                             |       | 1,378                                      |       | 1,298 |   | 1,119 |   |
| Federal Home Loan Bank stock dividends                                             |       | (427                                       | )          | (349 | ) | (275 | ) |
| Net amortization (accretion) available-for-sale                                    |       | 17                                         |       | 8 |   | 16 |   |
| Net amortization (accretion) held-to-maturity                                      |       | 31                                         |       | 55 |   | 71 |   |
| Gain on sale of investments available-for-sale                                     |       | —                                     |       | (381 | ) | (202 | ) |
| Gain on sale of real estate held for development                                   |       | —                                     |       | (143 | ) | (526 | ) |
| Gain on sale of mortgage loans                                                     |       | (783                                       | )          | (868 | ) | (862 | ) |
| Origination of loans held for sale                                                 |       | (38,708                                    | )          | (45,446 | ) | (52,368 | ) |
| Proceeds on sale of loans held for sale                                            |       | 39,415                                     |       | 46,936 |   | 53,032 |   |
| Deferred taxes                                                                     |       | (20                                        | )          | 234 |   | 401 |   |
| Compensation expense for stock options                                             |       | 129                                        |       | — |   | — |   |
| Changes  in:                                                                       |       |                                       |       |   |   |   |   |
| Cash surrender value of life insurance                                             |       | (310                                       | )          | (284 | ) | (286 | ) |
| Interest receivable                                                                |       | (1,043                                     | )          | (564 | ) | (556 | ) |
| Other assets                                                                       |       | 499                                        |       | (72 | ) | 1,084 |   |
| Interest payable                                                                   |       | (116                                       | )          | (24 | ) | (3 | ) |
| Accounts payable and other liabilities                                             |       | 298                                        |       | 386 |   | (150 | ) |
| Net cash from operating activities                                                 |       | 11,237                                     |       | 11,188 |   | 9,941 |   |
| **Investing  Activities:**                                                         | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Sales of securities available-for-sale                                             |       | —                                     |       | 1,431 |   | 745 |   |
| Purchases of securities available-for-sale                                         |       | (6,641                                     | )          | (37,393 | ) | (18,640 | ) |
| Maturities of securities available-for-sale                                        |       | 6,767                                      |       | 28,880 |   | — |   |
| Purchases of securities held-to-maturity                                           |       | —                                     |       | — |   | (24,100 | ) |
| Maturities of securities held-to-maturity                                          |       | 8,976                                      |       | 1,629 |   | 20,141 |   |
| Net change in loans                                                                |       | (62,607                                    | )          | (38,612 | ) | (51,005 | ) |
| Net purchases of premises and equipment                                            |       | (4,744                                     | )          | (2,963 | ) | (3,288 | ) |
| Sales of real estate held for development                                          |       | —                                     |       | 195 |   | 509 |   |
| Net cash from investing activities                                                 |       | (58,249                                    | )          | (46,833 | ) | (75,638 | ) |
| **Financing  Activities**                                                          | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net change in deposits                                                             |       | 49,931                                     |       | 4,720 |   | 57,224 |   |
| Change in short-term borrowings                                                    |       | 49,000                                     |       | 19,500 |   | — |   |
| Advances from Federal Home Loan Bank                                               |       | —                                     |       | 450 |   | 821 |   |
| Repayments to Federal Home Loan Bank                                               |       | (50,151                                    | )          | (979 | ) | (200 | ) |
| Issuance of common stock for options and employee  benefit plans                   |       | 64                                         |       | 85 | ** ** | **—** | ** ** |
| Dividends paid                                                                     |       | (3,185                                     | )          | (2,830 | ) | (2,708 | ) |
| Common stock repurchased                                                           |       | (16                                        | )          | (760 | ) | (1,560 | ) |
| Net cash from financing activities                                                 |       | 45,643                                     |       | 20,186 |   | 53,577 |   |
| **(Decrease) in cash and cash equivalents**                                        |       | (1,369                                     | )          | (15,459 | ) | (12,120 | ) |
| **Cash and cash equivalents, beginning of year**                                   |       | 20,451                                     |       | 35,910 |   | 48,030 |   |
| **Cash and  cash equivalents, end of year**                                        |       | $                                          | 19,082     |   | $ | 20,451 |   | $ | 35,910 |   |

 

See notes to consolidated financial statements.

48

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.**                 SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES

The following is a description of the significantaccounting policies First Financial Service Corporation follows in preparingand presenting its consolidated financial statements:

**Principlesof Consolidation and Business—****The**consolidatedfinancial statements include the accounts of First Financial ServiceCorporation and its wholly owned subsidiary, First Federal Savings Bank. FirstFederal Savings Bank has two wholly owned subsidiaries, First Service Corporationof Elizabethtown and First Federal Office Park, LLC. Unless the text clearlysuggests otherwise, references to “us,” “we,” or “our” include First FinancialService Corporation and its wholly-owned subsidiary. All significantintercompany transactions and balances have been eliminated in consolidation.

On January 8, 2003, the First Federal SavingsBank converted from a federal savings bank, regulated by the Office of ThriftSupervision (OTS), to a commercial bank chartered under Kentucky banking lawsregulated by the Federal Deposit Insurance Corporation (FDIC) and the KentuckyOffice of Financial Institutions (KOFI). At the same time, the First FinancialService Corporation became a bank holding company regulated by the FederalReserve and changed its fiscal year from June 30 to December 31.

Our business consists primarily of attracting depositsfrom the general public and origination of mortgage loans on commercialproperty, single-family residences and multi-family housing. We also make homeimprovement loans, consumer loans and commercial business loans. Our primarylending area is a region within North Central Kentucky. The economy within thisregion is diversified with a variety of medical service, manufacturing, andagricultural industries, and Fort Knox, a military installation.

The principal sources of funds for our lending andinvestment activities are deposits, repayment of loans, Federal Home Loan Bankadvances and other borrowings. Our principal source of income is interest onloans. In addition, other income is derived from loan origination fees, servicecharges, returns on investment securities, gain on sale of mortgage loans, andbrokerage and insurance commissions.

Our subsidiary First Service Corporation is a licensedbroker providing investment services and offering tax-deferred annuities,government securities and stocks and bonds to our customers. First FederalOffice Park, LLC, another subsidiary, holds commercial lots adjacent to ourhome office on Ring Road in Elizabethtown, which are available for sale.

**Estimatesand Assumptions—****The**preparation of consolidatedfinancial statements in conformity with U.S. generally accepted accountingprinciples requires us to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of the amount ofrevenues and expenses during the reporting period. Actual results could differfrom those estimates. The allowance for loan losses and the fair value offinancial instruments are particularly subject to change.

**CashFlows—****For**purposes of the statement ofcash flows, we consider all highly liquid debt instruments purchased with anoriginal maturity of three months or less to be cash equivalents. Cash and cashequivalents include cash on hand, amounts due from banks, federal funds soldand certain interest bearing deposits. Net cash flows are reported forinterest-bearing deposits, loans, short-term borrowings and deposits.

**Securities—****We**classifyinvestments into held-to-maturity and available-for-sale. Debt securities inwhich management has a positive intent and ability to hold are classified asheld-to-maturity and are carried at cost adjusted for the amortization ofpremiums and discounts using the interest method over the terms of thesecurities. Debt and equity securities, which do not fall into this category,are classified as 

49

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

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

available-for-sale. Unrealizedholding gains and losses, net of tax, on available-for-sale securities arereported as a component of other comprehensive income.

Interest income includes amortization of purchasepremium or discount. Premiums and discounts on securities are amortized on thelevel-yield method without anticipating prepayments, except for mortgage backedsecurities where prepayments are anticipated. Gains and losses on sales arerecorded on the trade date and determined using the specific identificationmethod.

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 atunpaid principal balances, less undistributed construction loans, and netdeferred loan origination fees. We defer loan origination fees and discountsnet of certain direct origination costs. These net deferred fees are amortizedusing the level yield method on a loan-by-loan basis over the lives of theunderlying loans.

Interest income on loans is accrued on the unpaidprincipal balance except for those loans in nonaccrual status. The accrual ofinterest is discontinued when a loan becomes 90 or more days delinquent. Wheninterest accrual is discontinued, interest income is subsequently recognizedonly to the extent cash payments are received. Interest accruals resume whenthe loan becomes less than 90 days delinquent.

**Allowancefor Loan Losses—****The**allowance for loan losses is avaluation allowance for probable incurred credit losses. Loan losses arecharged against the allowance when we believe the uncollectibility of a loanbalance is confirmed. Subsequent recoveries, if any, are credited to theallowance. Our periodic evaluation of the allowance is based on our past loanloss experience, known and inherent risks in the portfolio, adverse situationsthat may affect the borrower’s ability to repay, estimated value of anyunderlying collateral, and current economic conditions. Allocations of theallowance may be made for specific loans, but the entire allowance is availablefor 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.

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 andinterest payments when due. Loans that experience insignificant payment delaysand payment shortfalls generally are not classified as impaired. Impaired loansare carried at the present value of expected future cash flows discounted atthe loan’s effective interest rate or at the fair value of the collateral ifthe loan is collateral dependent. Commercial and commercial real estate loansare individually evaluated for impairment. Large groups of smaller balancehomogeneous loans, such as consumer and residential real estate loans, arecollectively evaluated for impairment and are not separately identified forimpairment disclosures. A portion of the allowance for 

50

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

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

loan losses is allocatedto impaired loans if the value of such loans is less than the unpaid balance.If these allocations cause the allowance for loan losses to require anincrease, such increase is reported in the provision for loan losses.

**MortgageBanking Activities—****Mortgage**loans originated andintended for sale in the secondary market are carried at the lower of aggregatecost or market value. To deliver closed loans to the secondary market and tocontrol its interest rate risk prior to sale, we enter into “best efforts”agreements to sell loans. The aggregate market value of mortgage loans held forsale considers the price of the sales contracts. The loans are sold withservicing 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 $1.6 million****and$1.2 million in loans at December 31, 2006 and 2005, which we intend tosell after the loans are closed.

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

**FederalHome Loan Bank Stock—****The**Bank is a member of the FHLBsystem. Members are required to own a certain amount of stock based on thelevel of borrowings and other factors, and may invest in additional amounts.Investment in stock of Federal Home Loan Bank is carried at cost, and periodicallyevaluated for impairment. Both cash and stock dividends are reported as income.

**CashSurrender Value of Life Insurance—****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.

**Premisesand Equipment—****Land**is carried cost. Premises andequipment are stated at cost less accumulated depreciation. Buildings andrelated components are depreciated using the straight-line method with usefullives ranging from 5 to 40 years. Furniture, fixtures and equipment aredepreciated using the straight-line method with useful lives ranging from 3 to15 years.

**RealEstate Owned—****Real**estate properties acquiredthrough foreclosure and in settlement of loans are stated at lower of cost orfair value less estimated selling costs at the date of foreclosure. The excessof cost over fair value less the estimated costs to sell at the time offoreclosure is charged to the allowance for loan losses. Costs relating to developmentand improvement of property are capitalized, whereas costs relating to holdingproperty are not capitalized and are charged against operations in the currentperiod.

**RealEstate Held for Development—****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.

**OtherRepossessed Assets—****Consumer**assets acquired throughrepossession and in settlement of loans, typically automobiles, are carried atlower of cost or fair value at the date of repossession. The excess cost overfair value at time of repossession is charged to the allowance for loan losses.

**Goodwilland Other Intangible Assets—****Goodwill**resultsfrom business acquisitions and represents the excess of the purchase price overthe fair value of acquired tangible assets and liabilities and 

51

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

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

identifiable intangibleassets. Goodwill is assessed at least annually for impairment and any suchimpairment will be recognized in the period identified.

**StockDividends—****We**declared a 10% stock dividendon August 15, 2006 to our shareholders of record as of August 29,2006, payable on September 14, 2006. 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 payments of these dividends were inaddition to the regular quarterly cash dividends. Per share amounts have beenrestated for the impact of the stock dividends.

**Brokerageand Insurance Commissions—****Brokerage**commissionsare recognized as income on settlement date. Insurance commissions on loanproducts (credit life, mortgage life, accidental death, and guaranteed autoprotection) are recognized as income over the life of the loan.

**StockBased Compensation—****Effective**January 1, 2006, weadopted Statement of Financial Accounting Standards (“SFAS No. 123R”), “Share-BasedPayment”. Accordingly, we have recorded stock-based employee compensation costusing the fair value method in 2006. The cost is measured at the fair value ofthe options when granted, and this cost is expensed over the employee serviceperiod, which is normally the vesting period of the options. Compensation costis recorded for prior option grants that vest after the date of adoption. For2006, adopting this standard resulted in a reduction of income before incometaxes of $129,212, a reduction in net income of $85,280, a decrease in basicand diluted earnings per share of $.01 and $.01, an increase in cash flow fromoperations of $129,212 and an increase in cash flows from financing of $0.

Prior to January 1, 2006, employee compensationexpense under stock options was reported using the intrinsic value method;therefore, no stock-based compensation cost is reflected in net income for theyears ending December 31, 2005 and 2004, as all options granted had anexercise price equal to the market price of the underlying common stock at dateof 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      ** | ** ** |
| ** **                                                                         | ** **  | **(Dollars in thousands  except per share data)**       | ** ** |
| Net income:                                                                        |        |                                                                             |       |   |   |   |   |   |   |
| As reported                                                                        |        |                                                                             | $          | 9,144 |   |   |   | $ | 7,790 |   |   |
| Deduct: Stock-based compensation expense determined  under fair value based method |        |                                                                             | (89        | ) |   |   | (190 | ) |   |
| Pro-forma                                                                          |        |                                                                             | $          | 9,055 |   |   |   | $ | 7,600 |   |   |
| Earnings per  share:                                                               |        |                                                                             |       |   |   |   |   |   |   |
| Basic                                                                              | As Reported |                                                                             |       | $ | 2.08 |   |   |   | $ | 1.76 |   |   |
|                                                                               | Pro-forma   |                                                                             |       | 2.05 |   |   |   | 1.72 |   |   |
| Diluted                                                                            | As Reported |                                                                             |       | $ | 2.07 |   |   |   | $ | 1.75 |   |   |
|                                                                               | Pro-forma   |                                                                             |       | 2.04 |   |   |   | 1.71 |   |   |

 

**IncomeTaxes—****Income**tax expense is the total ofthe current year income tax due or refundable and the change in deferred taxassets and liabilities. Deferred tax assets and liabilities are the expectedfuture 

52

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

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

tax amounts for thetemporary differences between carrying amounts and tax bases of assets andliabilities, computed using enacted tax rates. A valuation allowance, ifneeded, reduces deferred tax assets to the amount expected to be realized.

**EmployeeStock Ownership Plan—****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.

**EarningsPer Common Share—****Basic**earnings per common share isnet income divided by the weighted average number of common shares outstandingduring the period. Diluted earnings per common share include the dilutiveeffect of additional potential common shares issuable under stock options.

**LossContingencies—****In**the normal course of business,there are various outstanding legal proceedings and claims. In the opinion ofmanagement the disposition of such legal proceedings and claims will notmaterially affect our consolidated financial position, results of operations orliquidity.

**ComprehensiveIncome—****Comprehensive**income consists ofnet income and other comprehensive income. Other comprehensive income includesunrealized gains and losses on securities available-for-sale, which are alsorecognized as a separate component of equity, net of tax.

**Derivatives—****The**Corporation onlyuses derivative instruments as described in “Mortgage Banking Activities.”

**LoanCommitments and Related Financial Instruments—****Financial**instrumentsinclude off-balance sheet credit instruments, such as commitments to make loansand commercial letters of credit, issued to meet customer financing needs. Theface amount for these items represents the exposure to loss, before consideringcustomer collateral or ability to repay. Such financial instruments arerecorded when they are funded.

**FairValue of Financial Instruments—****Fair**values of financialinstruments are estimated using relevant market information and otherassumptions, as more fully disclosed in a separate note. Fair value estimatesinvolve uncertainties and matters of significant judgment regarding interestrates, credit risk, prepayments, and other factors, especially in the absenceof broad markets for particular items. Changes in assumptions or in marketconditions could significantly affect the estimates.

**OperatingSegments—****Segments**are parts of a companyevaluated by management with separate financial information. Our internalfinancial information is primarily reported and evaluated in three lines ofbusiness, banking, mortgage banking, and brokerage. These segments aredominated by banking at a magnitude for which separate individual segmentdisclosures are not required.

**Reclassifications—****Some**items in theprior year financial statements were reclassified to conform to the currentpresentation.

**Adoptionof New Accounting Standards—****Effective**January 1,2006, we adopted Statement of Financial Accounting Standards (“SFAS No. 123R”),“Share-Based Payment”. See “Stock Based Compensation” for further discussion ofthe effect of adopting this standard.

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 108 Topic 1N, “Consideringthe Effects of Prior Year Misstatements When Quantifying Misstatements inCurrent Year Financial Statements” (“SAB 108”). SAB 108 requires that a 

53

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

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

dual approach be used tocompute the amount of a financial statement misstatement. More specifically,the amount should be computed using both the “rollover” (current year incomestatement perspective) and “iron curtain” (year-end balance sheet perspective)methods. A registrant’s financial statements require adjustment when eitherapproach results in quantifying a misstatement that is material, afterconsidering all relevant quantitative and qualitative factors. Registrants willnot be required to restate prior period financial statements when initiallyapplying SAB 108 if management properly applied its previous approach (i.e.rollover or iron curtain) given that all relevant qualitative factors wereconsidered. SAB 108 states that, upon initial application, registrants mayelect to (a) restate prior periods, or (b) record the cumulativeeffect of the initial application of SAB 108 in the carrying amounts of assetsand liabilities, with the offsetting adjustment made to retained earnings. Tothe extent that registrants elect to record the cumulative effect of initiallyapplying SAB 108, they will disclose the nature and amount of each individualerror being corrected in the cumulative adjustment. The disclosure will alsoinclude when and how each error being corrected arose and the fact that theerrors had previously been considered immaterial. The adoption of SAB 108 hadno effect on our financial statements for the year ending December 31,2006.

**Effectof Newly Issued But Not Yet Effective Accounting Standards—****In**March 2006,the FASB issued Statement No. 156, “Accounting for Servicing of FinancialAssets, an amendment of FASB Statement No. 140”, which changes theaccounting for all servicing rights recorded as the result of purchasing ororiginating a loan servicing right. SFAS No. 156 amends the currentaccounting guidance for servicing rights in that it allows companies to carry theirservicing rights at fair value, where presently servicing rights are recorded atcost allocated on a fair value basis at inception and assessed for impairment basedon their fair value at each reporting date, using lower of cost or market value.This pronouncement is effective beginning January 1, 2007. Since we sellloans with servicing released, this standard will have no impact on ourfinancial statements.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements” (“SFAS No. 157”), which defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles (GAAP), and expands disclosures about fair valuemeasurements. More specifically, this statement clarifies the definition offair value, establishes a fair valuation hierarchy based upon observable (e.g.quoted prices, interest rates, yield curves) and unobservable market inputs,and expands disclosure requirements to include the inputs used to developestimates of fair value and the effects of the estimates on income for theperiod. This statement does not require any new fair value measurements. Thispronouncement is effective for fiscal years beginning after November 15,2007, and interim periods within those fiscal years. We are in the process ofevaluating the impact, if any; the adoption of SFAS No. 157 will have onour financial statements.

In July 2006, the FASB issued Interpretation No. 48,“Accounting for Uncertainty in Income Taxes, an interpretation of FASBStatement No. 109” (FIN 48), which prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. FIN 48 alsoprovides guidance on derecognition, classification, interest and penalties,accounting in interim periods, disclosure and transition. FIN 48 is effectivebeginning in 2007. We do not believe that adoption of this standard will have amaterial impact on our financial statements.

In September 2006, the FASB Emerging Issues TaskForce finalized Issue No. 06-4, “Accounting for DeferredCompensation and Postretirement Benefit Aspects of Endorsement Split-DollarLife Insurance Arrangements.” This issue requires that a liability be recordedduring the service period when a split-dollar 

54

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

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

life insurance agreementcontinues after participants’ employment or retirement. The required accruedliability will be based on either the post-employment benefit cost for thecontinuing life insurance or based on the future death benefit depending on thecontractual terms of the underlying agreement. This issue is effective forfiscal years beginning after December 15, 2007. We are in the process ofevaluating the impact, if any; the adoption of Issue 06-4 will have onour financial statements.

In September 2006, the FASB ratified the EmergingIssues Task Force’s (EITF) consensus on Issue 06-5, “Accounting forPurchases of Life Insurance” Determining the Amount That Could Be Realized inAccordance with FASB Technical Bulletin No. 85-4, “Accounting forPurchases of Life Insurance”. FASB Technical Bulletin No. 85-4requires that assets such as bank owned life insurance be carried at their cashsurrender value (CSV) or the amount that could be realized, with changes in CSVreported in earnings. Issue 06-5 requires that a policyholder considerany additional amounts (e.g. claims stabilization reserves and deferredacquisition costs) included in the contractual terms of the policy indetermining the amount that could be realized under the insurance contract. Certainlife insurance contracts provide the policyholder with an amount that, uponsurrender, is greater if all individual policies are surrendered at the sametime rather than if the policies were surrendered over a period of time. Issue 06-5requires that policyholders determine the amount that could be realized underthe life insurance contract assuming the surrender of an individual-life byindividual-life policy.

Issue 06-5 iseffective for us beginning January 1, 2007. Issue 06-5 can beapplied as either (a) a change in accounting principle through acumulative-effect adjustment to retained earnings as of the beginning of theyear of adoption, or (b) a change in accounting principle throughretrospective application to all periods. We are in the process of evaluatingthe impact, if any; the adoption of Issue 06-5 will have on our financialstatements.

55

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**2.**                 SECURITIES

Theamortized cost basis and fair values of securities are as follows:

| ** **                          | ** ** | ** **                           | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** **          | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|----------------|------------|----------------|------------|---------------------|------------|
| ** **                          | ** ** | **Amortized**                        | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | ** **          | ** ** |
| ** **                          | ** ** | **Cost**                             | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** |
| ** **                          | ** ** | **(Dollars in thousands)** | ** ** |
| **Securities  available-for-sale:** | ** ** |                                 | ** ** | ** **     |       |           | ** ** | ** **          |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| **December 31, 2006:**         | ** ** |                                 | ** ** | ** **     |       |           | ** ** | ** **          |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| U.S. Treasury and agencies          |       |                                 | $          | 3,497          | ** ** |           |       | $                   | —     | ** ** |   |   | $ | (13 | ) |   |   | $ | 3,484 | ** ** |   |
| Mortgage-backed                     |       |                                 | 9,425      | ** **     |       |           | 8          | ** **          |       |   | (189 | ) |   |   | 9,244 | ** ** |   |
| Equity                              |       |                                 | 1,553      | ** **     |       |           | 629        | ** **          |       |   | (36 | ) |   |   | 2,146 | ** ** |   |
| State and municipal                 |       |                                 | 10,299     | ** **     |       |           | 7          | ** **          |       |   | (277 | ) |   |   | 10,029 | ** ** |   |
| Corporate                           |       |                                 | 3,320      | ** **     |       |           | —     | ** **          |       |   | — |   |   |   | 3,320 | ** ** |   |
| Total                               |       |                                 | $          | 28,094         | ** ** |           |       | $                   | 644        | ** ** |   |   | $ | (515 | ) |   |   | $ | 28,223 | ** ** |   |
| **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 | ** ** |   |

 

| ** **                       | ** ** | ** **    | ** ** | **Gross**        | ** ** | **Gross**        | ** ** | ** **          | ** ** |
|----------------------------------|------------|---------------|------------|------------------|------------|------------------|------------|---------------------|------------|
| ** **                       | ** ** | **Amortized** | ** ** | **Unrecognized** | ** ** | **Unrecognized** | ** ** | ** **          | ** ** |
| ** **                       | ** ** | **Cost**      | ** ** | **Gains**        | ** ** | **Losses**       | ** ** | **Fair Value** | ** ** |
| **Securities held-to-maturity:** | ** ** |          | ** ** | ** **       |       |             | ** ** | ** **          |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| **December 31,  2006:**     | ** ** |          | ** ** | ** **       |       |             | ** ** | ** **          |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| U.S. Treasury and agencies       |       |          | $          | 18,097           | ** ** |             |       | $                   | 4          | ** ** |   |   | $ | (318 | ) |   |   | $ | 17,783 | ** ** |   |
| Mortgage-backed                  |       |          | 4,127      | ** **       |       |             | 3          | ** **          |       |   | (111 | ) |   |   | 4,019 | ** ** |   |
| Corporate                        |       |          | 2,000      | ** **       |       |             | 15         | ** **          |       |   | — |   |   |   | 2,015 | ** ** |   |
| Total                            |       |          | $          | 24,224           | ** ** |             |       | $                   | 22         | ** ** |   |   | $ | (429 | ) |   |   | $ | 23,817 | ** ** |   |
| **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 | ** ** |   |

 

56

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**2.**                 SECURITIES—(Continued)

Theamortized cost and fair value of securities at December 31, 2006, bycontractual maturity, are shown below. Securities not due at a single maturitydate, primarily mortgage-backed and 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                |       |                                 | $          | 1,375                |       |   | $ | 1,374 |   |   | $ | 4,000 |   |   | $ | 3,948 |   |
| Due after one  year through five years  |       |                                 | 2,324      |                 |       | 2,326 |   |   | 14,097 |   |   | 13,835 |   |
| Due after five  years through ten years |       |                                 | 497        |                 |       | 488 |   |   |   |   |   |   |   |
| Due after ten  years                    |       |                                 | 12,920     |                 |       | 12,645 |   |   | 2,000 |   |   | 2,015 |   |
| Mortgage-backed                         |       |                                 | 9,425      |                 |       | 9,244 |   |   | 4,127 |   |   | 4,019 |   |
| Equity                                  |       |                                 | 1,553      |                 |       | 2,146 |   |   | — |   |   | — |   |
|                                    |       |                                 | $          | 28,094               |       |   | $ | 28,223 |   |   | $ | 24,224 |   |   | $ | 23,817 |   |

 

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

| ** **           | ** ** | **Year Ended December 31,** | ** ** |
|----------------------|------------|--------------------------------------------|------------|
| ** **           | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **           | ** ** | **(Dollars in thousands)**       | ** ** |
| Proceeds from  sales |       |                                       | $          | — |   |   | $ | 1,431 |   | $ | 745 |   |
| Gross realized gains |       |                                       | $          | — |   |   | $ | 381 |   | $ | 202 |   |

 

The tax expense related to these realized gains was$0, $130,000, and $69,000, respectively.

Investment securities pledged to secure publicdeposits and FHLB advances had an amortized cost of $31.9 million and fairvalue of $31.3 million at December 31, 2006 and a $36.7 million amortizedcost and a $35.8 fair value at December 31, 2005.

Securitieswith unrealized losses at year-end 2006 and 2005 aggregated by investmentcategory and length of time that individual securities have been in acontinuous unrealized loss position are as follows:

| ** **                              | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| **December 31, 2006**         | ** ** | **Fair**                               | ** ** | **Unrealized**                       | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **Description of Securities** | ** ** | ** **                             | ** ** | **Value**                            | ** ** | **Loss**  | ** ** | **Value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
| U. S. Treasury  and agencies            |       | $                                      | —     |                                 |       | $         | —     |   |   | $ | 19,263 |   |   | $ | (331 | ) |   | $ | 19,263 |   |   | $ | (331 | ) |   |
| Mortgage-backed                         |       | —                                 |       |                                 | —     |      |       | 12,340 |   |   | (300 | ) |   | 12,340 |   |   | (300 | ) |   |
| Equity                                  |       | 591                                    |       |                                 | (36        | )         |       | — |   |   | — |   |   | 591 |   |   | (36 | ) |   |
| State and  municipal                    |       | 4,139                                  |       |                                 | (117       | )         |       | 4,836 |   |   | (160 | ) |   | 8,975 |   |   | (277 | ) |   |
| Total temporarily  impaired             |       | $                                      | 4,730      |                                 |       | $         | (153       | ) |   | $ | 36,439 |   |   | $ | (791 | ) |   | $ | 41,169 |   |   | $ | (944 | ) |   |
|                                         |            |                                        |            |                                      |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

57

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**2.**                 SECURITIES—(Continued)

| ** **                              | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| **December 31, 2005**         | ** ** | **Fair**                               | ** ** | **Unrealized**                       | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **Description of Securities** | ** ** | ** **                             | ** ** | **Value**                            | ** ** | **Loss**  | ** ** | **Value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **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 | ) |   |
|                                         |            |                                        |            |                                      |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

All unrealized losses arereviewed at least on a quarterly basis to determine whether the losses are otherthan temporary and more frequently when economic or market concerns warrantsuch evaluation. Consideration is given to the length of time and the extent towhich the fair value has been less than cost, the financial condition andnear-term prospects of the issuer, and our intent and ability to retain theinvestment in the issuer for a period of time sufficient to allow for anyanticipated recovery in fair value. In analyzing an issuer’s financialcondition, we may consider whether the securities are issued by the federalgovernment or its agencies, whether downgrades by bond rating agencies haveoccurred, and the results of reviews of the issuer’s financial condition. Theunrealized losses on our investments in U.S. Treasury and agencies,mortgage-backed securities and obligations of state and political subdivisionswere caused by interest rate increases. Because the decline in market value isattributable to changes in interest rates and not credit quality, and becausewe have the ability and intent to hold these investments until recovery of fairvalue, which may be maturity, we do not consider these investments to beother-than-temporarily impaired at December 31, 2006 and 2005.

**3.**                 LOANS

Loansare summarized as follows:

| ** **                         | ** ** | **December 31,**                | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial                         |       | $                                    | 40,902     |   | $ | 36,004 |   |
| Real estate  commercial            |       | 410,146                              |       | 353,637 |   |
| Real estate  construction          |       | 23,953                               |       | 13,579 |   |
| Residential  mortgage              |       | 137,334                              |       | 142,727 |   |
| Consumer and home  equity          |       | 62,805                               |       | 66,208 |   |
| Indirect consumer                  |       | 30,857                               |       | 31,577 |   |
| Loans held for  sale               |       | 673                                  |       | 597 |   |
|                               |       | 706,670                              |       | 644,329 |   |
| Less:                              |       |                                 |       |   |   |
| Net deferred loan origination fees |       | (960                                 | )          | (1,212 | ) |
| Allowance for loan losses          |       | (7,684                               | )          | (7,377 | ) |
|                               |       | (8,644                               | )          | (8,589 | ) |
| Loans Receivable                   |       | $                                    | 698,026    |   | $ | 635,740 |   |

 

We utilize eligible real estate loans to collateralizeadvances and letters of credit from the Federal Home Loan Bank.****We had $373 and****$369million in residential mortgage loans and commercial real estate loans pledgedunder this arrangement at December 31, 2006 and 2005.

58

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**3.**                 LOANS—(Continued)

The allowance for loanloss is summarized as follows:

| ** **                  | ** ** | **As of and For the**   | ** ** |
|-----------------------------|------------|---------------------------------------------|------------|
| ** **                  | ** ** | **Years Ended December 31,** | ** ** |
| ** **                  | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                  | ** ** | **(Dollars in thousands)**        | ** ** |
| Balance,  beginning of year |       | $                                           | 7,377      |   | $ | 6,489 |   | $ | 5,568 |   |
| Provision for  loan losses  |       | 540                                         |       | 1,258 |   | 1,656 |   |
| Charge-offs                 |       | (614                                        | )          | (666 | ) | (949 | ) |
| Recoveries                  |       | 381                                         |       | 296 |   | 214 |   |
| Balance, end of year        |       | $                                           | 7,684      |   | $ | 7,377 |   | $ | 6,489 |   |

 

Impaired loans aresummarized below. There were no impaired loans for the periods presentedwithout an allowance allocation.

| ** **                                   | ** ** | **As of and For the**   | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                   | ** ** | **Years Ended December 31,** | ** ** |
| ** **                                   | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | **(Dollars in thousands)**        | ** ** |
| Year-end impaired  loans                     |       | $                                           | 4,838      |   | $ | 6,232 |   | $ | 5,240 |   |
| Amount of  allowance for loan loss allocated |       | 128                                         |       | 350 |   | 168 |   |
| Average impaired  loans outstanding          |       | 5,808                                       |       | 5,647 |   | 4,783 |   |
| Interest income  recognized                  |       | 227                                         |       | 219 |   | 197 |   |
| Interest income received                     |       | 227                                         |       | 219 |   | 197 |   |
|                                              |            |                                             |            |  |  |  |  |  |  |  |

 

Wereport non-performing loans as impaired. Our non-performing loans at year-endwere as follows:

| ** **                                    | ** ** | **December 31,**                | ** ** |
|-----------------------------------------------|------------|--------------------------------------|------------|
| ** **                                    | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **                                    | ** ** | **(Dollars in thousands)** | ** ** |
| Restructured                                  |       |                                 | $          | 2,470 |   |   |   | $ | 3,104 |   |   |
| Loans past due  over 90 days still on accrual | ** ** | ** **                           | —     |   |   |   | — |   |   |
| Non accrual loans                             |       |                                 | 2,368      |   |   |   | 3,128 |   |   |
| Total                                         |       |                                 | $          | 4,838 |   |   |   | $ | 6,232 |   |   |

 

**4.**                 PREMISES ANDEQUIPMENT

Premisesand equipment consist of the following:

| ** **                         | ** ** | **December 31,**                | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)** | ** ** |
| Land                               |       | $                                    | 5,527      |   | $ | 3,675 |   |
| Buildings                          |       | 17,736                               |       | 15,826 |   |
| Furniture,  fixtures and equipment |       | 8,516                                |       | 8,649 |   |
|                               |       | 31,779                               |       | 28,150 |   |
| Less accumulated  depreciation     |       | (9,279                               | )          | (9,016 | ) |
|                               |       | $                                    | 22,500     |   | $ | 19,134 |   |

 

59

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**4.**                 PREMISESAND EQUIPMENT—(Continued)

Certain premises areleased under various operating leases. Rental expense was $281,000, $274,000and $259,000, for the years ended December 31, 2006, 2005 and 2004,respectively. Future minimum commitments under these leases are:

| ** ** | ** ** | **Year Ended**                  | ** ** |
|------------|------------|--------------------------------------|------------|
| ** ** | ** ** | **December 31,**                | ** ** |
| ** ** | ** ** | **(Dollars in thousands)** | ** ** |
| 2007       |       |                                 | $          | 330 |   |   |
| 2008       |       |                                 | 315        |   |   |
| 2009       |       |                                 | 317        |   |   |
| 2010       |       |                                 | 317        |   |   |
| 2011       |       |                                 | 284        |   |   |
| Thereafter |       |                                 | 229        |   |   |
|       |       |                                 | $          | 1,792 |   |   |

 

**5.**                 DEPOSITS

TimeDeposits of $100,000 or more were $158.3 million and $101.6 million at December 31,2006 and 2005, respectively. At December 31, 2006, scheduled maturities oftime deposits are as follows:

| ** ** | ** ** | **Amount**                           | ** ** |
|------------|------------|--------------------------------------|------------|
| ** ** | ** ** | **(Dollars in thousands)** | ** ** |
| 2007       |       |                                 | $          | 269,033 |   |   |
| 2008       |       |                                 | 67,989     |   |   |
| 2009       |       |                                 | 34,050     |   |   |
| 2010       |       |                                 | 10,838     |   |   |
| 2011       |       |                                 | 5,845      |   |   |
| Thereafter |       |                                 | 470        |   |   |
| ** ** |       |                                 | $          | 388,225 |   |   |

 

**6.**                 SHORT-TERMBORROWINGS

Short-term borrowingsconsist of federal funds purchased and securities sold under agreements torepurchase. We had short-term borrowings of $68.5 million and $19.5 millionfrom the FHLB of Cincinnati at December 31, 2006 and 2005. Theseborrowings averaged a rate of 5.31% and 4.05% for 2006 and 2005.

**7.**                 ADVANCES FROMFEDERAL HOME LOAN BANK

Under the collateral requirements of the Federal HomeLoan Bank (FHLB) of Cincinnati, we have the capacity to borrow an additional$41.6 million from the FHLB at December 31, 2006. During January 2001,we entered into a $25.0 million convertible fixed rate advance with a fixedrate of 5.05% and a maturity of ten years. This advance was fixed for a periodof three years. At the end of the fixed rate term and quarterly thereafter, theFHLB has the right to convert this advance to a variable rate advance tied tothe three-month LIBOR index. Upon conversion, we can prepay the advance at nopenalty.

60

----

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**7.**                 ADVANCESFROM FEDERAL HOME LOAN BANK—(Continued)

Advances from the FHLB atyear-end are as follows:

| ** **                                                                               | ** ** | **December 31,**                | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                               | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **                                                                               | ** ** | **Weighted-**                        | ** ** | ** ** | ** ** | **Weighted-** | ** ** | ** ** | ** ** |
| ** **                                                                               | ** ** | **Average**                          | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                                                                               | ** ** | **Rate**                             | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** |
| ** **                                                                               | ** ** | **(Dollars in Thousands)** | ** ** |
| Fixed rate advances:                                                                     |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Mortgage matched advances with interest rates from  5.30% to 7.80% due through 2009 |       |                                 | 6.09       | % |   | $ | 19 |   |   | 6.35 | % |   | $ | 42 |   |
| Convertible fixed rate advances with an interest  rate of 5.05% due through 2011         |       |                                 | 5.05       | % |   | 25,000 |   |   | 4.92 | % |   | 75,000 |   |
| Other fixed rate advances with interest rates from  4.19% to 5.72% due through 2020 |       |                                 | 4.93       | % |   | 3,205 |   |   | 4.93 | % |   | 3,333 |   |
| Total borrowings                                                                         |       |                                 |       |   |   | $ | 28,224 |   |   |   |   |   | $ | 78,375 |   |

 

The aggregate minimumannual repayments of borrowings as of December 31, 2006 is as follows:

| ** ** | ** ** | **(Dollars in thousands)** | ** ** |
|------------|------------|--------------------------------------|------------|
| 2007       |       |                                 | $          | 139 |   |   |
| 2008       |       |                                 | 137        |   |   |
| 2009       |       |                                 | 131        |   |   |
| 2010       |       |                                 | 131        |   |   |
| 2011       |       |                                 | 25,131     |   |   |
| Thereafter |       |                                 | 2,555      |   |   |
|       |       |                                 | $          | 28,224 |   |   |

 

**8.**                 SUBORDINATEDDEBENTURES

In March 2002, a trust we formed completed theprivate placement of 10,000 shares of cumulative trust preferred securitieswith a liquidation preference of $1,000 per security for a total outstanding of$10 million. The proceeds of the offering were loaned to us in exchange forfloating rate junior subordinated deferrable interest debentures. In accordancewith FASB Interpretation 46, the trust is not consolidated with our financialstatements but rather the subordinated debentures are shown as a liability.Issuance costs of $302,000 paid from the proceeds are being amortized tomaturity. Distributions on the Trust Preferred Securities are payable quarterlyin arrears at the annual rate (adjusted quarterly) of three-month LIBOR plus3.60% (8.97% as of the last adjustment), and are included in interest expense.The annual rate cannot exceed 11% prior to March 26, 2007. Thesubordinated debentures are considered as Tier I capital for the Corporationunder current regulatory guidelines.

The subordinateddebentures, which mature March 26, 2032, are redeemable prior to thematurity date at our option on or after March 26, 2007, at their principalamount plus accrued interest. Similar subordinated debentures are currentlybeing offered at approximately 1.70% plus three-month LIBOR. Since we arecurrently paying 3.60% plus three-month LIBOR, we anticipate calling ourcurrent subordinated debentures and refinancing at a lower interest rate afterthe March 26, 2007, redemption date.

61

----

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**9.**                 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,** | ** ** |
|---------------------------|------------|--------------------------------------------|------------|
| ** **                | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                | ** ** | **(Dollars in thousands)**       | ** ** |
| Current                   |       | $                                          | 4,654      |   | $ | 4,178 |   | $ | 3,334 |   |
| Deferred                  |       | (20                                        | )          | 234 |   | 401 |   |
| Total income tax  expense |       | $                                          | 4,634      |   | $ | 4,412 |   | $ | 3,735 |   |

 

Theprovision for income taxes differs from the amount computed at the statutoryrates as follows:

| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                         | ** ** | **(Dollars in thousands)**       | ** ** |
| Federal statutory  rate                            |       |                                       | 34.0       | % |   |   | 34.0 | % |   |   | 34.0 | % |   |
| Tax-exempt interest income                         |       |                                       | (0.7       | ) |   |   | (0.3 | ) |   |   | (0.1 | ) |   |
| Increase in cash surrender value of life insurance |       |                                       | (0.7       | ) |   |   | (0.7 | ) |   |   | (0.9 | ) |   |
| Dividends to ESOP                                  |       |                                       | (0.3       | ) |   |   | (0.3 | ) |   |   | (0.4 | ) |   |
| Stock option expense                               |       |                                       | 0.3        |   |   |   | — |   |   |   | — |   |   |
| Tax contingency reserve                            |       |                                       | (1.9       | ) |   |   | — |   |   |   | — |   |   |
| Other                                              |       |                                       | 0.2        |   |   |   | (0.2 | ) |   |   | (0.2 | ) |   |
| Effective rate                                     |       |                                       | 30.9       | % |   |   | 32.5 | % |   |   | 32.4 | % |   |

 

During the fourth quarter we re-evaluated our taxcontingency reserves and determined that approximately $281,000 was no longerrequired. As a result, tax expense was reduced by this amount, resulting in aneffective tax rate of 25% in the fourth quarter of 2006 compared to 32% in2005.

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

| ** **                                            | ** ** | **December 31,**                | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
| **Deferred tax assets:**                              | ** ** |                                 | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Allowance for  loan losses                            |       |                                 | $          | 2,612 | ** ** |   |   | $ | 2,508 | ** ** |   |
| Accrued  liabilities and other                        |       |                                 | 143        | ** ** |   |   | 109 | ** ** |   |
|                                                  |       |                                 | 2,755      | ** ** |   |   | 2,617 | ** ** |   |
| **Deferred tax liabilities:**                         | ** ** |                                 | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Depreciation                                          |       |                                 | $          | 1,527 | ** ** |   |   | $ | 1,509 | ** ** |   |
| Net unrealized  gain on securities available-for-sale |       |                                 | 44         | ** ** |   |   | 30 | ** ** |   |
| Federal Home Loan  Bank stock                         |       |                                 | 1,449      | ** ** |   |   | 1,304 | ** ** |   |
| Intangibles                                           |       |                                 | 905        | ** ** |   |   | 704 | ** ** |   |
| Deferred gain on  like-kind exchange                  |       |                                 | 30         | ** ** |   |   | 30 | ** ** |   |
| Other                                                 |       |                                 | 173        | ** ** |   |   | 419 | ** ** |   |
|                                                  |       |                                 | 4,128      | ** ** |   |   | 3,996 | ** ** |   |
| **Net deferred tax liability**                        |       |                                 | $          | 1,373 | ** ** |   |   | $ | 1,379 | ** ** |   |

 

62

----

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**9.**                 INCOMETAXES—(Continued)

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, 2006 and 2005. 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.

**10.**          STOCKHOLDERS’EQUITY

**(a) RegulatoryCapital Requirements—**The Corporation and the Bank are subjectto regulatory 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 defined) to average assets (as defined). As of December 31,2006 and 2005, the Corporation and the Bank met all capital adequacyrequirements 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.

The actual and requiredcapital amounts and ratios are presented below.

| ** **                                          | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **To Be Considered** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|----------------------------|------------|----------------------------|------------|----------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Well Capitalized**      | ** ** |
| ** **                                          | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Under Prompt**          | ** ** |
| ** **                                          | ** ** | ** **                           | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Correction** | ** ** |
| ** **                                          | ** ** | **Actual**                           | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| ** **                                          | ** ** | **Amount**                           | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**      | ** ** | **Amount**                     | ** ** | **Ratio** | ** ** |
| ** **                                          | ** ** | **(Dollars in thousands)** | ** ** |
| **As of December 31, 2006:**                   |       |                                 |       |                       |       |                       |       |           |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total risk-based capital (to risk- weighted assets) |       |                                 |       |                       |       |                       |       |           |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consolidated                                        |       |                                 | $          | 81,583                     |       |                       |       | 11.6           | %          |                           |       | $ | 56,504 |   |   |   | 8.0 | % |   |   | N/A |   |   |   | N/A |   |   |
| Bank                                                |       |                                 | 78,653     |                       |       |                       | 11.2       |           |       |                           | 56,376     |   |   |   | 8.0 |   |   |   | 70,470 |   |   |   | 10.0 |   |   |
| Tier  I capital (to risk-weighted assets)           |       |                                 |       |                       |       |                       |       |           |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consolidated                                        |       |                                 | 73,639     |                       |       |                       | 10.4       |           |       |                           | 28,252     |   |   |   | 4.0 |   |   |   | N/A |   |   |   | N/A |   |   |
| Bank                                                |       |                                 | 70,709     |                       |       |                       | 10.0       |           |       |                           | 28,188     |   |   |   | 4.0 |   |   |   | 42,282 |   |   |   | 6.0 |   |   |
| Tier  I capital (to average assets)                 |       |                                 |       |                       |       |                       |       |           |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consolidated                                        |       |                                 | 73,639     |                       |       |                       | 9.2        |           |       |                           | 32,014     |   |   |   | 4.0 |   |   |   | N/A |   |   |   | N/A |   |   |
| Bank                                                |       |                                 | 70,709     |                       |       |                       | 8.9        |           |       |                           | 31,962     |   |   |   | 4.0 |   |   |   | 39,953 |   |   |   | 5.0 |   |   |
|                                                     |            |                                      |            |                            |            |                            |            |                |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

63

----

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**10.**          STOCKHOLDERS’ EQUITY—(Continued)

| ** **                                           | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **To Be Considered** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|----------------------------|------------|----------------------------|------------|----------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Well Capitalized**      | ** ** |
| ** **                                           | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Under Prompt**          | ** ** |
| ** **                                           | ** ** | ** **                           | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Correction** | ** ** |
| ** **                                           | ** ** | **Actual**                           | ** ** | **Adequacy Purposes** | ** ** | **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 |   |   |
|                                                      |            |                                      |            |                            |            |                            |            |                |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**(b) Dividend Restrictions—**Ourprincipal source of funds for dividend payments is dividends received from theBank. Banking regulations limit the amount of dividends that may be paidwithout prior approval of regulatory agencies. Under these regulations, theamount of dividends that may be paid in any calendar year is limited to thecurrent year’s net profits, combined with the retained net profits of thepreceding two years, subject to the capital requirements described above. During2007, the Bank could, without prior approval, declare dividends ofapproximately $12.3 million plus any 2007 net profits retained to the date ofthe dividend declaration.

**(c) Liquidation Account—**Inconnection with our conversion from mutual to stock form of ownership during1987, we established a “liquidation account”, currently in the amount of$567,289 for the purpose of granting to eligible deposit account holders apriority in the event of future liquidation. Only in such an event, an eligibleaccount holder who continues to maintain a deposit account will be entitled toreceive a distribution from the liquidation account. The total amount of theliquidation account decreases in an amount proportionately corresponding todecreases in the deposit account balances of the eligible account holders.

**11.**          EARNINGSPER SHARE

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

| ** **                                      | ** ** | **Year Ended**                                                | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                      | ** ** | **December 31,**                                              | ** ** |
| ** **                                      | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                      | ** ** | **(In thousands, except per share data)** | ** ** |
| Net income available to  common shareholders    |       | $                                                                  | 10,337     |   |   | $ | 9,144 |   |   |   | $ | 7,790 |   |   |
| Basic EPS:                                      |       |                                                               |       |   |   |   |   |   |   |   |   |
| Weighted average common  shares                 |       | 4,383                                                              |       |   | 4,398 |   |   |   | 4,428 |   |   |
| Diluted EPS:                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Weighted average common  shares                 |       | 4,383                                                              |       |   | 4,398 |   |   |   | 4,428 |   |   |
| Dilutive effect of stock  options               |       | 44                                                                 |       |   | 30 |   |   |   | 19 |   |   |
| Weighted average common  and incremental shares |       | 4,427                                                              |       |   | 4,428 |   |   |   | 4,447 |   |   |
| Earnings Per Share:                             |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                           |       | $                                                                  | 2.36       |   |   | $ | 2.08 |   |   |   | $ | 1.76 |   |   |
| Diluted                                         |       | $                                                                  | 2.34       |   |   | $ | 2.07 |   |   |   | $ | 1.75 |   |   |

 

64

----

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**11.**          EARNINGS PERSHARE—(Continued)

Stock options for 26,000and 10,000 shares of common stock were not included in the December 31,2006 and 2004 computation of diluted earnings per share because their impactwas anti-dilutive.  All of theoutstanding stock options for the year ended December 31, 2005 wereincluded in the computation of diluted earnings per share.

**12.**          EMPLOYEEBENEFIT PLANS

**(a) Pension Plan**—Weare a participant in the Pentegra Defined Benefit Plan for FinancialInstitutions (formerly known as Financial Institutions Retirement Fund) whichis a non-contributory, multiple-employer defined benefit pension plan, coveringemployees hired before June 1, 2002. Because the plan was curtailed,employees hired on or after that date are not eligible for membership in thefund. Eligible employees are 100% vested at the completion of five years ofparticipation in the plan. Our policy is to contribute annually the minimumfunding amounts. Employer contributions and administrative expenses charged tooperations for the years ended December 31, 2006, 2005 and 2004 totaled$340,000,****$210,000, and $253,000, respectively. Accruedliabilities associated with the plan as of December 31, 2006 and 2005 were$19,000 and $52,000, respectively. There were no accrued liabilities associatedwith the plan as of December 31, 2004.

**(b) KSOP**—We have acombined 401(k)/Employee Stock Ownership Plan. The plan is available to allemployees meeting certain eligibility requirements. The plan allows employeecontributions up to 50% of their compensation up to the annual dollar limit setby the IRS. The employer matches 100% of the employee contributions up to 6% ofthe employee’s compensation. If the employee does not contribute at least 2% ofthe employee’s compensation, then the employer makes a minimum contribution forthe employee of 2% of the employee’s compensation. Employees are 100% vested inmatching contributions upon meeting the eligibility requirements of the plan. Sharesof our common stock are acquired in non-leveraged transactions. At the time ofpurchase, the shares are released and allocated to eligible employeesdetermined by a formula specified in the plan agreement. Accordingly, the planhas no unallocated shares. The number of shares to be purchased and allocatedis at the Board of Directors discretion. Employer matching contributions andadministrative expenses charged to operations for the plan forthe years ended December 31, 2006, 2005 and 2004 were $446,000, $334,000,and $302,000, respectively.

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

| ** **            | ** ** | **Year Ended**   | ** ** |
|-----------------------|------------|-----------------------|------------|
| ** **            | ** ** | **December 31,** | ** ** |
| ** **            | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ESOP shares  (ending) |       | 181,861               |       | 178,803 |   | 182,709 |   |
| Shares released       |       | 3,058                 |       | 2,923 |   | 2,148 |   |
| Compensation expense  |       | $                     | 96,000     |   | $ | 83,081 |   | $ | 54,000 |   |
|                       |            |                       |            |  |  |  |  |  |  |  |

 

65

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**12.**          EMPLOYEEBENEFIT PLANS—(Continued)

**(c) Stock Option Plan**—Our2006 Stock Incentive Plan, which is shareholder approved, succeeded our 1998Stock Option and Incentive Plan. Under the 2006 Plan, we may grant eitherincentive or non-qualified stock options to****keyemployees and directors****for atotal of 588,500 shares of our common stock at not less than fair value at thedate such options are granted. Options available for future grant under the1998 Plan totaled 35,000 shares and were rolled into the 2006 Plan. We believethat the ability to award stock options and other forms of stock-basedincentive compensation can assist us in attracting and retaining key employees.Stock-based incentive compensation is also a means to align the interests ofkey employees with those of our shareholders by providing awards intended to rewardrecipients for our long-term growth. The option to purchase shares vest overperiods of one to five years and expire ten years after the date of grant. Weissue new shares of common stock upon the exercise of stock options. At December 31,2006 options available for future grant under the 2006 Plan totaled 562,500. Compensationcost related to options granted under the 1998 and 2006 Plans that was chargedagainst earnings for the year ended December 31, 2006****was$129,212.

The fair value of each option award is estimated onthe date of grant using the Black-Scholes option valuation model that usesvarious weighted-average assumptions. The risk-free interest rate is based onthe U.S. Treasury yield curve in effect at the time of grant. The expectedvolatility is based on the fluctuation in the price of a share of stock overthe period for which the option is being valued and the expected life of theoptions granted represents the period of time the options are expected to beoutstanding.

Theweighted-average assumptions for options granted during the years ended December 31,2006 and 2004 and the resulting estimated weighted average fair value per shareis presented below. There were no options granted for the year ended December 31,2005.

| ** **                                    | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2006**              | ** ** | **2004** | ** ** |
| **Assumptions:**                              |       |                  |       |   |   |
| Risk-free interest rate                       |       | 4.71                  | %          | 4.13 | % |
| Expected dividend yield                       |       | 2.47                  | %          | 2.84 | % |
| Expected life (years)                         |       | 10                    |       | 10 |   |
| Expected common stock market price volatility |       | 25                    | %          | 26 | % |
| Estimated fair  value per share               |       | $                     | 9.30       |   | $ | 7.03 |   |
|                                               |            |                       |            |  |  |  |  |

 

Asummary of option activity under the 1998 and 2006 Plans for the year ended December 31,2006 is presented below:

| ** **                           | ** ** | ** **  | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **                           | ** ** |
|--------------------------------------|------------|-------------|------------|--------------|------------|-----------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | ** **  | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **                           | ** ** |
| ** **                           | ** ** | **Number**  | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate**                        | ** ** |
| ** **                           | ** ** | **of**      | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic**                        | ** ** |
| ** **                           | ** ** | **Options** | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**                            | ** ** |
| ** **                           | ** ** | ** **  | ** ** | ** **   | ** ** | ** **      | ** ** | **(Dollars In Thousands)** | ** ** |
| Outstanding,  beginning of period    |       | 144,075     |       |         | $          | 18.42           |       |                                 |       |   | ** ** |   |   | ** ** | ** ** |   |   |
| Granted during  period               |       | 26,000      | ** ** |         | 30.80      |            |       |                                 |       | ** ** |   |   | ** ** | ** ** |   |   |
| Exercised during  the period         |       | (915        | )          |         | 13.41      |            |       |                                 |       | ** ** |   |   | ** ** | ** ** |   |   |
| Outstanding, end  of period          |       | 169,160     |       |         | $          | 20.35           |       |                                 |       | 6.0 | ** ** |   |   | $ | 1,768 | ** ** |   |   |
| Eligible for  exercise at period end |       | 100,365     |       |         | $          | 17.70           |       |                                 |       | 4.3 | ** ** |   |   | $ | 1,314 | ** ** |   |   |

 

66

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**12.**          EMPLOYEEBENEFIT PLANS—(Continued)

The total intrinsic value of options exercised duringthe periods ended December 31, 2006, 2005 and 2004 was $12,695, $40,030 and $0 respectively. There was no taxbenefit recognized from the option exercises as they are considered incentivestock options.

As of December 31,2006 there was $354,308 of total unrecognized compensation cost related tonon-vested share-based compensation arrangements granted under the 1998 and2006 Plans. That cost is expected to be recognized over a weighted-averageperiod of 3.7 years. Cash received from option exercise under all share-basedpayment arrangements for the periods ended December 31, 2006, 2005 and2004 were $12,273, $84,813 and $0 respectively.

**(d)Employee Stock Purchase Plan**—We maintain an Employee StockPurchase Plan whereby eligible employees have the option to common stock of theCorporation through payroll deduction at a 5% discount. The purchase price ofthe shares under the plan will be 95% of the closing price of the common stockat the date of purchase. The plan provides for the purchase of up to 100,000shares of common stock, which may be obtained by purchases on the open market. Fundingfor the purchase of common stock is from employee contributions. The plan wasconsidered non-compensatory under APB No. 25, and as a result no compensationexpense was recorded in 2006.

**13.**          CASHFLOW ACTIVITIES

The following information is presented as supplementaldisclosures to the statement of cash flows.

**(a)****          CashPaid for:**

| ** **       | ** ** | **Year Ended  December 31,** | ** ** |
|------------------|------------|----------------------------------------|------------|
| ** **       | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **       | ** ** | **(Dollars in thousands)**   | ** ** |
| Interest expense |       | $                                      | 24,224     |   | $ | 17,886 |   | $ | 14,795 |   |
| Income taxes     |       | $                                      | 4,410      |   | $ | 4,625 |   | $ | 3,532 |   |

 

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

| ** **                                                                               | ** ** | **Year Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                               | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                               | ** ** | **(Dollars in thousands)**   | ** ** |
| Loans to  facilitate sales of real estate owned and repossessed  assets                  |       | $                                      | 1,352      |   | $ | 1,561 |   | $ | 1,124 |   |
| Transfers from  loans to real estate acquired through foreclosure and repossessed assets |       | $                                      | 1,209      |   | $ | 1,981 |   | $ | 1,396 |   |

 

67

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**14.**          CONDENSEDFINANCIAL INFORMATION (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,**                | ** ** |
|------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                     | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **                                     | ** ** | **(Dollars in thousands)** | ** ** |
| **Assets**                                     | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Cash and interest  bearing deposits            |       | $                                    | 401        |   | $ | 179 |   |
| Investment in  Bank                            |       | 79,168                               |       | 72,077 |   |
| Securities  available-for sale                 |       | 1,560                                |       | 1,431 |   |
| Land                                           |       | 752                                  |       | 752 |   |
| Other assets                                   |       | 318                                  |       | 328 |   |
|                                           |       | $                                    | 82,199     |   | $ | 74,767 |   |
| **Liabilities and Stockholders’  Equity** | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Subordinated  debentures                       |       | $                                    | 10,000     |   | $ | 10,000 |   |
| Other liabilities                              |       | 101                                  |       | 26 |   |
| Stockholders’  equity                     |       | 72,098                               |       | 64,741 |   |
|                                           |       | $                                    | 82,199     |   | $ | 74,767 |   |

 

**CondensedStatements of Income**

| ** **                                                | ** ** | **Year Ended  December 31,** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                | ** ** | **(Dollars in thousands)**   | ** ** |
| Dividend from  Bank                                       |       | $                                      | 4,212      |   | $ | 4,022 |   | $ | 4,500 |   |
| Interest income                                           |       | 57                                     |       | 80 |   | 114 |   |
| Interest expense                                          |       | (895                                   | )          | (712 | ) | (529 | ) |
| Gain on sale of  investments                              |       | —                                 |       | 381 |   | 202 |   |
| Other expenses                                            |       | (408                                   | )          | (223 | ) | (223 | ) |
| Income before  income tax benefit                         |       | 2,966                                  |       | 3,548 |   | 4,064 |   |
| Income tax  benefit                                       |       | 483                                    |       | 222 |   | 220 |   |
| Income before  equity in undistributed net income of Bank |       | 3,449                                  |       | 3,770 |   | 4,284 |   |
| Equity in  undistributed net income of Bank               |       | 6,888                                  |       | 5,374 |   | 3,506 |   |
| Net income                                                |       | $                                      | 10,337     |   | $ | 9,144 |   | $ | 7,790 |   |

 

68

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**14.**          CONDENSEDFINANCIAL INFORMATION (PARENT COMPANY ONLY)—(Continued)

**CondensedStatements of Cash Flows**

| ** **                                                                     | ** ** | **Year Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                     | ** ** | **(Dollars in thousands)**   | ** ** |
| Operating Activities:                                                          |       |                                   |       |   |   |   |   |
| Net income                                                                     |       | $                                      | 10,337     |   | $ | 9,144 |   | $ | 7,790 |   |
| Adjustments to  reconcile net income to cash provided by operating activities: |       |                                   |       |   |   |   |   |
| Equity in undistributed net income of Bank                                     |       | (6,888                                 | )          | (5,374 | ) | (3,506 | ) |
| Gain on sale of investments available-for-sale                                 |       | —                                 |       | (381 | ) | (202 | ) |
| Compensation expense for stock options                                         |       | 129                                    |       | — |   | — |   |
| Changes in:                                                                    |       |                                   |       |   |   |   |   |
| Other assets                                                                   |       | (94                                    | )          | 101 |   | 10 |   |
| Accounts payable and other liabilities                                         |       | 75                                     |       | (136 | ) | (106 | ) |
| Net cash from  operating activities                                            |       | 3,559                                  |       | 3,354 |   | 3,986 |   |
| Investing  Activities:                                                         |       |                                   |       |   |   |   |   |
| Purchases of securities available-for-sale                                     |       | (200                                   | )          | (506 | ) | (640 | ) |
| Sales of securities available-for-sale                                         |       | —                                 |       | 1,431 |   | 745 |   |
| Net purchases of premises and equipment                                        |       | —                                 |       | (752 | ) | — |   |
| Net change in receivable from Bank                                             |       | —                                 |       | — |   | 165 |   |
| Net cash from  investing activities                                            |       | (200                                   | )          | 173 |   | 270 |   |
| Financing  Activities:                                                         |       |                                   |       |   |   |   |   |
| Issuance of common stock for options and employee  benefit plans               |       | 64                                     |       | 85 |   | — |   |
| Dividends paid                                                                 |       | (3,185                                 | )          | (2,830 | ) | (2,708 | ) |
| Common stock repurchases                                                       |       | (16                                    | )          | (760 | ) | (1,560 | ) |
| Net cash from  financing activities                                            |       | (3,137                                 | )          | (3,505 | ) | (4,268 | ) |
| Net change in cash and interest bearing deposits                               |       | 222                                    |       | 22 |   | (12 | ) |
| Cash and interest bearing deposits, beginning of  year                         |       | 179                                    |       | 157 |   | 169 |   |
| Cash and interest  bearing deposits, end of year                               |       | $                                      | 401        |   | $ | 179 |   | $ | 157 |   |

 

69

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**15.**          FAIRVALUES OF FINANCIAL INSTRUMENTS

Theestimated fair value of financial instruments is as follows:

| ** **                           | ** ** | **December 31, 2006**      | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **Carrying**                         | ** ** | **Fair**                        | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                           | ** ** | **Value**                            | ** ** | **Value**                       | ** ** | **Value** | ** ** | **Value** | ** ** |
| ** **                           | ** ** | **(Dollars in thousands)** | ** ** |
| **Financial assets:**                | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and due from banks              |       | $ 19,082                        |       | $ 19,082                   |       | $ 20,451 |   | $ 20,451 |   |
| Securities available-for-sale        |       | 28,223                               |       | 28,223                          |       | 28,324 |   | 28,324 |   |
| Securities held-to-maturity          |       | 24,224                               |       | 23,817                          |       | 33,231 |   | 32,434 |   |
| Loans held for sale                  |       | 673                                  |       | 687                             |       | 597 |   | 608 |   |
| Loans, net                           |       | 697,353                              |       | 700,579                         |       | 635,143 |   | 640,079 |   |
| Federal Home Loan Bank stock         |       | 7,621                                |       | 7,621                           |       | 7,194 |   | 7,194 |   |
| Accrued interest receivable          |       | 4,094                                |       | 4,094                           |       | 3,051 |   | 3,051 |   |
| **Financial  liabilities:**          | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                             |       | 641,037                              |       | 634,617                         |       | 591,106 |   | 587,642 |   |
| Short-term borrowings                |       | 68,500                               |       | 68,500                          |       | 19,500 |   | 19,500 |   |
| Advances from Federal Home Loan Bank |       | 28,224                               |       | 27,392                          |       | 78,375 |   | 78,703 |   |
| Subordinated debentures              |       | 10,000                               |       | 10,000                          |       | 10,000 |   | 10,000 |   |
| Accrued interest  payable            |       | 273                                  |       | 273                             |       | 389 |   | 389 |   |

 

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.

**16.**          FINANCIALINSTRUMENTS WITH 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 lines and letters of credit, and involve, tovarying degrees, elements of credit and interest-rate risk in excess of theamount recognized in the balance sheet. The contract or notional amounts ofthese instruments reflect the extent of our involvement in particular classesof financial instruments.

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 those 

70

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**16.**          FINANCIALINSTRUMENTS WITH OFF-BALANCE-SHEET RISK—(Continued)

instruments. Creditworthinessfor all instruments is evaluated on a case-by-case basis in accordance with ourcredit policies. We use the same credit policies in making commitments andconditional obligations as we do for on-balance-sheet instruments. Collateralfrom the customer may be required based on management’s credit evaluation ofthe customer and may include business assets of commercial customers as well aspersonal property and real estate 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, 2006**      | ** **    | **December 31, 2005** | ** ** |
|----------------------------|------------|--------------------------------------|---------------|---------------------------------|------------|
| ** **                 | ** ** | **Fixed**                            | ** **    | **Variable**                    | ** ** | **Fixed** | ** ** | **Variable** | ** ** |
| ** **                 | ** ** | **Rate**                             | ** **    | **Rate**                        | ** ** | **Rate** | ** ** | **Rate** | ** ** |
| ** **                 | ** ** | **(Dollars in thousands)** | ** **    |
| Commitments to  make loans | ** ** |                                 | $ — |                            |       | $      476 |   |   | $ 38 |   |   | $      882 |   |
| Unused lines of  credit    | ** ** |                                 | —        |                            |       | 96,501 | ** ** | ** ** | — |   |   | 118,598 |   |
| Standby letters  of credit | ** ** |                                 | —        |                            |       | 11,927 | ** ** | ** ** | — |   |   | 12,536 |   |
|                       | ** ** |                                 | $ — |                            |       | $ 108,904 |   |   | $ 38 |   |   | $ 132,016 |   |

 

At December 31, 2006and 2005, we had $59.5 million, and****$54.7 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 Federal HomeLoan Bank.)

**17.**          RELATEDPARTY TRANSACTIONS

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, 2006 and 2005 were $3.0 million and $3.1million. A summary of the related party loan activity, for loans aggregating$60,000 or more to any one related party, is as follows:

| ** **        | ** ** | **Year Ended  December 31,** | ** ** |
|-------------------|------------|----------------------------------------|------------|
| ** **        | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **        | ** ** | **(Dollars in  thousands)**       | ** ** |
| Beginning of year |       | $ 291                             |       | $ 315 |   |
| New loans         |       | 22                                     |       | — |   |
| Repayments        |       | (25                                    | )          | (24 | ) |
| End of year       |       | $ 288                             |       | $ 291 |   |

 

71

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**18.**          SUMMARYOF QUARTERLY FINANCIAL DATA—(Unaudited)

| **Year Ended December 31, 2006:** | ** ** | ** **                                                                     | ** **    | **March 31,** | ** ** | **June 30,** | ** ** | **September 30,** | ** **    | **December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------------------------------------|---------------|--------------------|------------|-------------------|------------|------------------------|---------------|-----------------------|------------|
| ** **                                            | ** ** | **(Dollars in thousands except per share data)** | ** **    |
| Total interest  income                                |       |                                                                           | $ 12,492 |               |       | $ 13,111     |       |                   | $ 13,822 |                  |       |   | $ 14,407 |   |   |
| Total interest  expense                               |       |                                                                           | 5,256         |               |       | 5,740             |       |                   | 6,341         |                  |       |   | 6,771 |   |   |
| Net interest  income                                  |       |                                                                           | 7,236         |               |       | 7,371             |       |                   | 7,481         |                  |       |   | 7,636 |   |   |
| Provision for  loan losses                            |       |                                                                           | 89            |               |       | 9                 |       |                   | 249           |                  |       |   | 193 |   |   |
| Non-interest  income                                  |       |                                                                           | 1,712         |               |       | 2,076             |       |                   | 2,033         |                  |       |   | 1,916 |   |   |
| Non-interest  expense                                 |       |                                                                           | 5,409         |               |       | 5,314             |       |                   | 5,437         |                  |       |   | 5,791 |   |   |
| Net income                                            |       |                                                                           | 2,338         |               |       | 2,755             |       |                   | 2,571         |                  |       |   | 2,672 |   |   |
| Earnings per share:                                   |       |                                                                           |          |               |       |              |       |                   |          |                  |       |   |   |   |   |
| Basic                                                 |       |                                                                           | 0.54          |               |       | 0.63              |       |                   | 0.59          |                  |       |   | 0.61 |   |   |
| Diluted                                               |       |                                                                           | 0.53          |               |       | 0.63              |       |                   | 0.58          |                  |       |   | 0.60 |   |   |

 

| **Year Ended December 31, 2005:** | ** ** | ** ** | ** **    | **March 31,** | ** ** | **June 30,** | ** ** | **September 30,** | ** **    | **December 31,** | ** ** |
|-------------------------------------------------------|------------|------------|---------------|--------------------|------------|-------------------|------------|------------------------|---------------|-----------------------|------------|
| 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                                                 |       |       | 0.50          |               |       | 0.52              |       |                   | 0.53          |                  |       |   | 0.54 |   |   |
| Diluted                                               |       |       | 0.50          |               |       | 0.52              |       |                   | 0.52          |                  |       |   | 0.53 |   |   |

 

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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 ofDecember 31, 2006, an evaluation was performed under the supervision andwith the participation of management, including the Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures. Based on that evaluation, managementconcluded that disclosure controls and procedures as of December 31, 2006were 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, 2006 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, 2006, 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 ofDecember 31, 2006, our system of internal control over financial reportingmet those criteria and is effective.

There have been no significant changes in our internalcontrols or in other factors that could significantly affect internal controlsafter December 31, 2006.

**Item 9B.**               OtherInformation

Effective January 1,2007, the annual salary for B. Keith Johnson, President and Chief ExecutiveOfficer, is $247,000.

**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 2007 Annual Meeting of Shareholders (the “Proxy Statement”) is incorporatedherein by reference.

(a)           Code of Ethics

You may obtain copies ofFirst Financial Service Corporation’s code of ethics free of charge bycontacting Janelle Poppe, 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 “Executive Compensation” in the Proxy Statement isincorporated herein by reference.

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

(a)           Security Ownership ofCertain Beneficial Owners

Informationrequired by this item is incorporated herein by reference to the sectioncaptioned “Voting Securities and Principal Holders Thereof” in the ProxyStatement

(b)          Security Ownership ofManagement

Informationrequired by this item is incorporated herein by reference to the sectionscaptioned “Proposal I—Election of Directors” and “Voting Securities andPrincipal Holders Thereof” in the Proxy Statement.

(c)           Changes in Control

We know of noarrangements, including any pledge by any person of securities of the Company,the operation of which may at a subsequent date result in a change of controlof 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 requiredby this item is incorporated by reference to the section captioned “IndependentPublic Accountants” in the Proxy Statement.

**PART IV**

**Item 15.**                 Exhibitsand Financial Statement Schedules

1.                 FinancialStatements Filed

(a)(1)       Reportof Independent Registered Public Accounting Firm on Consolidated FinancialStatements-Crowe Chizek and Company LLC

(b)                       ConsolidatedBalance Sheets at December 31, 2006 and 2005.

(c)                        ConsolidatedStatements of Income for the years ended December 31, 2006, 2005 and 2004.

(d)                       ConsolidatedStatements of Comprehensive Income for the years ended December 31, 2006,2005 and 2004.

(e)                        ConsolidatedStatements of Changes in Stockholders’ Equity for the years ended December 31,2006, 2005 and 2004.

(f)                          ConsolidatedStatements of Cash Flows for the years ended December 31, 2006, 2005 and2004.

(g)                        Notesto Consolidated Financial Statements

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

All financial statementschedules have been omitted, as the required information is either inapplicableor included in the financial statements or related notes.

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**3.****                 Exhibits**

3 (a), 4 (a)        Articlesof Incorporation*

3 (b), 4 (b)      Amendedand Restated Bylaws**

4 (c)                                        RightsAgreement between First Financial Service Corporation and Illinois StockTranfser Company dated April 15, 2003***

10 (a)                                 2006Stock Option and Incentive Compensation Plan****

10 (b)                                Form ofStock Option Agreement**

21                                                    Subsidiariesof the Registrant

23 (a)                                 Consentof Crowe Chizek and Company LLC, Independent Registered Public Accounting Firm

31.1                                          Certificationof Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act

31.2                                          Certificationof Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act

32                                                    Certificationof 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.

**                                       Incorporatedby reference to Form 10-K dated March 15, 2005.

***                                Incorporatedby reference to Form 8-K dated April 15, 2003.

****                         Incorporatedby reference to Form DEF 14A dated March 28, 2006.

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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: 3/16/07 | 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 Officer & Director* | * * | * * | * * | *Director*                                              |
| Date:    |     | 3/16/07                                      |     | Date:    |     | 3/16/07                                                 |
| By:      |     | /s/ WRENO M. HALL                            |     | By:      |     | /s/ DIANE E. LOGSDON                                    |
|     |     | Wreno M. Hall                                |     |     |     | Diane E. Logsdon                                        |
| * * | * * | *Director*                                   | * * | * * | * * | *Director*                                              |
| Date:    |     | 3/16/07                                      |     | Date:    |     | 3/16/07                                                 |
| By:      |     | /s/ J. ALTON RIDER                           |     | By:      |     | /s/ JOHN L. NEWCOMB, JR.                           |
|     |     | J. Alton Rider                               |     |     |     | John L. Newcomb, Jr.                               |
| * * | * * | *Director*                                   | * * | * * | * * | *Director*                                              |
| Date:    |     | 3/16/07                                      |     | Date:    |     | 3/16/07                                                 |
| By:      |     | /s/ WALTER D. HUDDLESTON                     |     | By:      |     | /s/ MICHAEL THOMAS, DVM                                 |
|     |     | Walter D. Huddleston                         |     |     |     | Michael Thomas, DVM                                     |
| * * | * * | *Director*                                   | * * | * * | * * | *Director*                                              |
| Date:    |     | 3/16/07                                      |     | Date:    |     | 3/16/07                                                 |
| By:      |     | /s/ STEPHEN MOUSER                           |     | By:      |     | /s/ DONALD SCHEER                                       |
|     |     | Stephen Mouser                               |     |     |     | Donald Scheer                                           |
| * * | * * | *Director*                                   | * * | * * | * * | *Director*                                              |
| Date:    |     | 3/16/07                                      |     | Date:    |     | 3/16/07                                                 |
| By:      |     | /s/ GAIL SCHOMP                              |     | By:      |     | /s/ GREGORY SCHREACKE                                   |
|     |     | Gail Schomp                                  |     |     |     | Gregory Schreacke                                       |
| * * | * * | *Director*                                   | * * | * * | * * | *Chief Financial Officer  Principal Accounting Officer* |
| Date:    |     | 3/16/07                                      |     | Date:    |     | 3/16/07                                                 |

 

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**INDEXTO 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)        |       | 2006 Stock Option  and Incentive Compensation Plan****                                                                                                                                     |
| 10               | (b)        |       | Form of  Stock Option Agreement**                                                                                                                                                     |
| 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.

**                          Incorporatedby reference to Form 10-K dated March 15, 2005.

***                   Incorporatedby reference to Form 8-K dated April 15, 2003.

****            Incorporatedby reference to Form DEF 14A dated March 28, 2006.

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