**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-K**

 

**(Mark One)**

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

 

**For the fiscal year ended December 31,2008**

 

**or**

 

**o****          ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For the transition period from                                        to                                        **

 

**Commission File Number:  33-96358**

 

**KENTUCKY BANCSHARES, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Kentucky**                     | ** ** | **61-0993464**                        |
|----------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)  |       |                                  |

 

| **P.O. Box  157, Paris, Kentucky**   | ** ** | **40362-0157** |
|-------------------------------------------|------------|----------------|
| (Address of  principal executive offices) |       | (Zip Code)     |

 

Registrant’s telephonenumber, including area code:  **(859)987-1795**

 

Securities registeredpursuant to Section 12(b) of the Act: **None**

 

Securities registeredpursuant to Section 12(g) of the Act: **None**

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.  Yes o  Nox

 

IndicatebycheckmarkiftheregistrantisnotrequiredtofilereportstoSection13orSection15(d)oftheExchangeAct.Yeso  Nox

 

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 90 days. Yes x  Noo

 

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 to this Form 10-K.  o

 

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

 
| Large accelerated filer  o | Accelerated filer o          |
|----------------------------|------------------------------|
| Non-accelerated filer x    | Smaller reporting  company o |

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  Nox

 

Aggregate market value ofvoting stock held by non-affiliates as of June 30, 2008 was approximately$60.0 million.  For purposes of thiscalculation, it is assumed that the Bank’s Trust Department, directors,executive officers and beneficial owners of more than 5% of the registrant’soutstanding voting stock are affiliates.

 

Number of shares ofCommon Stock outstanding as of March 5, 2009:  2,745,729.

 

 

** **

----

** **

**PART I**

** **

**Item 1.  Business**

 

General

 

Kentucky Bancshares, Inc.(“Company” or “Kentucky”) is a bank holding company headquartered in Paris,Kentucky.  The Company was organized in1981 and is registered under the Bank Holding Company Act of 1956, as amended (“BHCA”)and the Home Owners Loan Act of 1933, as amended (“HOLA”).

 

The Company conducts itsbusiness in the Commonwealth of Kentucky through one banking subsidiary,Kentucky Bank.

 

Kentucky Bank is acommercial bank and trust company organized under the laws of Kentucky.  Kentucky Bank has its main office in Paris(Bourbon County), with additional offices in Paris, Cynthiana (HarrisonCounty), Georgetown (Scott County), Morehead (Rowan County), Nicholasville(Jessamine County), North Middletown (Bourbon County), Sandy Hook (ElliottCounty), Versailles (Woodford County), Wilmore (Jessamine County) andWinchester (Clark County).  The depositsof Kentucky Bank are insured up to prescribed limits by the Deposit InsuranceFund (“DIF”) of the Federal Deposit Insurance Corporation (“FDIC”).

 

On July 7, 2006,Kentucky Bank acquired Peoples Bancorp of Sandy Hook, Inc. and itssubsidiary bank, Peoples Bank, with offices in Sandy Hook and Morehead,Kentucky.

 

The Company had totalassets of $679 million, total deposits of $521 million and stockholders’ equityof $57 million as of December 31, 2008. The Company’s principal executive office is located at 339 Main Street,Paris, Kentucky  40361, and the telephonenumber at that address is (859) 987-1795.

 

Business Strategy

 

The Company’s currentbusiness strategy is to operate a well-capitalized, profitable and independentcommunity bank with a significant presence in Central and EasternKentucky.  Management believes theoptimum way to grow the Company is by attracting new loan and deposit customerswithin its existing markets through it product offerings and customerservice.  Management continues toconsider opportunities for branch expansion and will also consider acquisitionopportunities that help advance its strategic objectives.

 

Lending

 

Kentucky Bank is engagedin general full-service commercial and consumer banking.  A significant part of Kentucky Bank’soperating activities include originating loans, approximately 72% of which aresecured by real estate at December 31, 2008.  Kentucky Bank makes commercial, agriculturaland real estate loans to its commercial customers, with emphasis onsmall-to-medium-sized industrial, service and agricultural businesses.  It also makes residential mortgage,installment and other loans to its individual and other non-commercialcustomers.

 

*LoanRates: *Kentucky Bankoffers variable and fixed rate loans.  Loan rates on variable rateloans generally adjust upward or downward based on changes in the loan’sindex.  Rate adjustments on variable rate loans are made from 1 dayto 5 years.  Variable rate loans may contain provisions that cap theamount of interest rate increases or decreases over the life of the loan.  In addition to the lifetime caps and floorson rate adjustments, loans secured by residential real estate may containprovisions that limit annual increases at a maximum of 200 basis points.  There is usually no annual limit applied toloans secured by commercial real estate.

 

2

----

* *

*CreditRisk: *Commerciallending and real estate construction lending, generally includes a higherdegree of credit risk than other loans, such as residential mortgageloans.  Commercial loans, like other loans, are evaluated at the timeof approval to determine the adequacy of repayment sources and collateralrequirements.  Collateral requirements vary to some degree among borrowersand depend on the borrower’s financial strength, the terms and amount ofthe loan, and collateral available to secure the loan.  Credit riskresults from the decreased ability or willingness to pay by aborrower.  Credit risk also results when a liquidation of collateraloccurs and there is a shortfall in collateral value as compared to a loansoutstanding balance.  For construction loans, inaccurate initialestimates of a project’s costs and the property’s completed value could weakenthe Company’s position and lead to the property having a value that isinsufficient to satisfy full payment of the amount of funds advanced for theproperty.  Secured and unsecured consumer loans generally are madefor automobiles, boats, and other motor vehicles.  In most casesloans are restricted to the subsidiaries’ general market area.

 

*OtherProducts:** *Kentucky Bank offers its customersa variety of other services, including checking, savings, money marketaccounts, certificates of deposits, safe deposit facilities, a credit card andother consumer-oriented financial services. Kentucky Bank has Internet banking, including bill payment available toits customers at www.kybank.com.  Throughits Wealth Management Department, Kentucky Bank provides brokerage services,annuities, life and long term care insurance, personal trust and agencyservices (including management agency services).

 

Competition and MarketServed

 

*Competition:* The banking businessis highly competitive.  Competitionarises from a number of sources, including other bank holding companies andcommercial banks, consumer finance companies, thrift institutions, otherfinancial institutions and financial intermediaries.  In addition to commercial banks, savings andloan associations, savings banks and credit unions actively compete to providea wide variety of banking services. Mortgage banking firms, finance companies, insurance companies,brokerage companies, financial affiliates of industrial companies andgovernment agencies provide additional competition for loans and for many otherfinancial services.  Kentucky Bank alsocurrently competes for interest-bearing funds with a number of other financialintermediaries, including brokerage firms and mutual funds, which offer adiverse range of investment alternatives. Some of the Company’s competitors are not subject to the same degree ofregulatory review and restrictions that apply to the Company and its subsidiarybank.  In addition, the Company mustcompete with much larger financial institutions that have greater financialresources than the Company.

 

*MarketServed.*  The Company’sprimary market areas consist of Bourbon, Clark, Elliott, Harrison, Jessamine,Rowan, Scott, Woodford and surrounding counties in Kentucky.

 

3

----

 

Supervision andRegulation

 

*GoverningRegulatory Institutions:* As a bank holding company, the Company is subject to the regulation andsupervision of the Federal Reserve Board. The Company’s subsidiary is subject to supervision and regulation byapplicable state and federal banking agencies, including the Federal ReserveBoard, the Federal Deposit Insurance Corporation and the Kentucky Office ofFinancial Institutions.  Kentucky Bank isalso subject to various requirements and restrictions under federal and statelaw, including requirements to maintain reserves against deposits, restrictionson the types and amounts of loans that may be granted and the interest that maybe charged thereon, and limitations on the types of investments that may bemade and the types of services that may be offered.  In addition to the impact of regulation,Kentucky Bank is affected significantly by the actions of the Federal ReserveBoard as it attempts to control the money supply and credit availability inorder to influence the economy.

 

*LawsProtecting Deposits: *Thereare a number of obligations and restrictions imposed on bank holding companiesand their depository institution subsidiaries by federal law and regulatorypolicy.  These obligations andrestrictions are designed to reduce potential loss exposure to the depositorsof such depository institutions and to the FDIC insurance funds in the eventthe depository institution becomes in danger of default or is in default.  For example, under a policy of the FederalReserve Board with respect to bank holding company operations, a bank holdingcompany is required to serve as a source of financial strength to itssubsidiary depository institutions and commit resources to support suchinstitutions in circumstances where it might not do so absent such policy.  In addition, the “cross-guarantee” provisionsof federal law require insured depository institutions under common control toreimburse the FDIC for any loss suffered or reasonably anticipated as a resultof the default of a commonly controlled insured depository institution or forany assistance provided by the FDIC to a commonly controlled insured depositoryinstitution in danger of default.

 

The federal bankingagencies also have broad powers under current federal law to take promptcorrective action to resolve problems of insured depository institutions.  The extent of these powers depends uponwhether the institutions in question are “well capitalized”, “adequatelycapitalized”, “undercapitalized”, “significantly undercapitalized” or “criticallyundercapitalized”, as such terms are defined under uniform regulation definingsuch capital levels issued by each of the federal banking agencies.

 

*DepositInsurance:*  The Company’ssubsidiary bank is a member of the FDIC, and their deposits are insured by theFDIC’s Deposit Insurance Fund up to the amount permitted by law.  The Company’s subsidiary bank is thus subjectto FDIC deposit insurance assessments. The FDIC utilizes a risk-based assessment system that imposes insurancepremiums based upon a risk matrix that takes into account a bank’s capital leveland supervisory rating.  Under theFederal Deposit Insurance Reform Act of 2005, which became law in 2006, theCompany received a one-time assessment credit of $434 thousand that can beapplied against future premiums, subject to certain limitations.  Based on the one-time assessment credit, theCompany was not required to pay any deposit insurance premiums in 2006 andunused credits from 2006 resulted in the amount of deposit insurance premiumsbeing zero 2007.  Lower credits remainedto offset assessments for 2008, which was the primary factor in higher depositinsurance net assessments of $175 thousand. Financing Corporation (“FICO”) assessment costs were $54 thousand for2008.  FICO is a mixed-ownershipgovernment corporation established by the Competitive Equality Banking Act of1987 possessing assessment powers in addition to the FDIC.  The FDIC acts as a collection agent for FICO,whose sole purpose was to function as a financing vehicle for the now defunctFederal Savings & Loan Insurance Corporation.

 

4

----

 

The Company’sparticipation in the FDIC’s Transaction Account Guarantee Program initiatedduring the fourth quarter of 2008 also contributed to an increase in depositinsurance premiums in the current period. More information about this program can be found under the heading “TemporaryLiquidity Guarantee Program” that follows. During the fourth quarter of 2008 the FDIC increased the depositinsurance from generally $100 thousand for each separately insured depositor to$250 thousand effective until December 31, 2009.

 

In February 2009,the FDIC adopted a long-term deposit insurance fund (“DIF”) restoration plan aswell as an additional emergency assessment for 2009.  The restoration plan increases baseassessment rates for banks in all risk categories with the goal of raising theDIF reserve ratio from its current .40% to 1.15% within seven years. Banks inthe best risk category, which include the Company’s subsidiary bank, will payinitial base rates ranging from 12 to 16 basis points of assessable depositsbeginning April 1, 2009, up from the initial base rate range of 12 to 14basis points.  Additionally, the FDICapproved an interim rule imposing a special emergency assessment to allfinancial institutions of 20 basis points of insured deposits as of June 30,2009.  The interim rule is subjectto a 30-day comment period and in early March 2009 a proposal wasintroduced in Congress to lower the special emergency assessment to 10 basispoints from the initial 20 basis points. The special emergency assessment is estimated to be $1.1 million for theCompany as currently adopted under the 20 basis point rule and will becollected on September 30, 2009. The amount of the special emergency assessment would decrease to $530thousand if the 10 basis point scenario is adopted.  The FDIC is also permitted to impose anemergency special assessment after June 30, 2009 of up to 10 basis pointsif necessary to maintain public confidence in federal deposit insurance.  The increase in assessments by the FDIC couldhave a material adverse effect on the Company’s earnings.

 

*TemporaryLiquidity Guarantee Program (“TLGP”):*  The TLGP consists of two separate programsimplemented by the FDIC in October 2008. This includes the Debt Guarantee Program (“DGP”) and the TransactionAccount Guarantee Program (“TAGP”). These programs were initially provided at no cost to participants duringthe first 30 days.  Eligible institutionsthat do not “opt out” of either of these programs become participants bydefault and will incur the fees assessed for taking part.

 

Under the DGP, the FDICwill guarantee senior unsecured debt issued on or after October 14, 2008through June 30, 2009 up to certain limits by participating entities.  The FDIC will provide guarantee coverage fordebt issued between those dates until the earlier of the maturity date of thedebt or June 30, 2012.  The Companychose to opt out of the DGP.

 

Under the TAGP, the FDICguarantees 100% of certain noninterest bearing transaction accounts up to anyamount to participating FDIC insured institutions. The unlimited coverage isapplicable until December 31, 2009. The Company opted to participate in the TAGP; as such, it will incur anadditional quarterly-assessed 10 basis point fee on balances in noninterestbearing transaction accounts exceeding the recently increased $250 thousanddeposit limit that became effective on November 13, 2008.  The previous deposit insurance limit amountwas $100 thousand.

 

*EmergencyEconomic Stabilization Act of 2008 (“EESA”)*:  EESA was signed into law by the President on October 3,2008 as a measure to stabilize and provide liquidity to the U.S. financialmarkets.  Under EESA, the Troubled AssetRelief Program (“TARP”) was created. TARP granted the Treasury authority to, among other things, invest infinancial institutions and purchase troubled assets in an aggregate amount upto $700 billion.

 

5

----

 

In connection with TARP,the Capital Purchase Program (“CPP”) was launched on October 14,2008.  Under the CPP, the Treasuryannounced a plan to use up to $250 billion of TARP funds to purchase equitystakes in certain eligible financial institutions, including the Company.  The Company was preliminarily approved for$13 million of equity capital in December 2008, and subsequently withdrewits application.

 

*ConsumerRegulations: *In addition to the laws and regulationsdiscussed above, Kentucky Bank is also subject to certain consumer laws andregulations that are designed to protect consumers in transactions withbanks.  While the list set forth hereinis not exhaustive, these laws and regulations include the Truth in Lending Act,the Truth in Savings Act, the Electronic Funds Transfer Act, the ExpeditedFunds Availability Act, the Equal Credit Opportunity Act, the Real EstateSettlement Procedures Act, the Fair Housing Act and the Fair and AccurateTransactions Act, among others.  Theselaws and regulations mandate certain disclosure requirements and regulate themanner in which financial institutions must deal with clients when takingdeposits or making loans. These laws also limit Kentucky Bank’s ability toshare information with affiliated and unaffiliated entities.  The bank must comply with the applicableprovisions of these consumer protection laws and regulations as part of itsongoing business operations.

 

*DividendRestrictions: *Thereare various legal and regulatory limits on the extent to which the Company’ssubsidiary bank may pay dividends or otherwise supply funds to theCompany.  In addition, federal and stateregulatory agencies also have the authority to prevent a bank or bank holdingcompany from paying a dividend or engaging in any other activity that, in theopinion of the agency, would constitute an unsafe or unsound practice.  Dividends paid by the subsidiary bank haveprovided substantially all of the Company’s operating funds, and this mayreasonably be expected to continue for the foreseeable future.

 

Employees

 

At December 31,2008, the number of full time equivalent employees of the Company was 214.

 

Nature of Company’sBusiness

 

The business of theCompany is not seasonal.  The Company’sbusiness does not depend upon a single customer, or a few customers, the lossof any one or more of which would have material adverse effect on theCompany.  No material portion of theCompany’s business is subject to renegotiation of profits or termination ofcontracts or subcontracts at the election of any governmental entity.

 

Available Information

 

The Company files annualreports on Form 10-K, quarterly reports on Form 10-Q, current reportson Form 8-K, and amendments to those reports with the Securities andExchange Commission (“SEC”) pursuant to section 13(a) or 15(d) of theSecurities Exchange Act of 1934.  Thepublic may read and copy any material the Company files with the SEC at the SEC’sPublic Reference Room at 100 F Street, NE, Washington, DC  20549 and may obtain information on theoperation of the Public Reference Room by calling the SEC at1-800-SEC-0330.  The SEC maintains anInternet site that contains reports, proxy and information statements, andother information regarding issuers that file electronically with the SEC onits website at www.sec.gov.

 

6

----

** **

**Item 1A.**** ****Risk Factors**

** **

Thereare factors, many beyond our control, which may significantly change theresults or expectations of the Company. Some of these factors are described below in the sections titledfinancial risk, business risk and operational risk.  These risks are not totally independent ofeach other.  Some factors affect morethan one type of risk.  These includeregulatory, economic, and competitive environments.  As part of the annual audit plan, ourinternal risk management department meets with management to assess these risksthroughout the Company.  Many risks are further addressed in othersections of this Form 10-K document.

 

*Significant decline in general economic conditions, locallyand nationally, will negatively affect the financial results of our bankingoperations.*  Our success depends on general economicconditions both locally and nationally. Economic conditions in the United States and abroad deterioratedsignificantly in the latter part of 2008. The United States is currently in a recession.  The housing market is in decline reflected byfalling home prices and increases in foreclosures.  Unemployment has increased.  These factors have affected the performanceof mortgage loans and resulted in financial institutions, includinggovernment-sponsored entities, in making significant write-downs of assetvalues of mortgage-backed securities, credit default swaps and other derivativeand cash securities.  Some financial institutionshave failed.  Many financial institutionsand institutional investors have tightened the availability of credit toborrowers and other financial institutions, which, in turn, results in moreloan defaults and decreased business activity. Consumer confidence regarding the economy is low and the financialmarkets reflect this lack of confidence. Most of our customers are in the Central Kentucky area.  This recession has directly affected ourcustomers.  Local economic conditionshave affected the demand of customers for loans, the ability of some borrowersto repay these loans and the value of the collateral securing these loans.  As these factors affect the overall businessclimate, they can have and have had a significant effect on loan demand.  Loan growth is critical to our profitability.  We do not expect significant improvement inthe economy in the near future, and future declines in the economy will likelymake the credit market crisis worse.

 

*The exercise of regulatory power may have negative impact onour results of operations and financial condition.*  We are subject to extensive regulation,supervision and examination by federal and state banking authorities.  Any change in applicable regulations orfederal or state legislation could have a substantial impact on our operations. Additional legislation and regulationsmay be enacted or adopted in the future that could significantly affect ourpowers, authority and operations, which could have a material adverse effect onthe financial condition and results of operations.  For example, in response to the economicdownturn and financial crisis, the U.S. government has enacted legislation bypassing the Emergency Economic Stabilization Act of 2008 followed by theAmerican Recovery and Reinvestment Act of 2009 (the “Recovery Act”).  These Acts have enabled the U.S. Treasury,the FDIC and the Federal Reserve Board to develop programs, such as the TARPCapital Purchase Program, the Financial Stability Plan and the foreclosureprevention program, to improve funding to consumers, increase interbank lendingand reduce home foreclosures.  The U.S.government continues to closely evaluate the economy, the effect of itslegislation and resulting programs and initiatives on the economy.  We expect that the U.S. government willcontinue to refine these programs and develop new programs.  We do not know whether these Acts andprograms will positively affect the economy, help stabilize the financialmarkets and increase the availability of credit.  Our business, financial condition, results ofoperations, liquidity and access to capital and credit will likely benegatively affected if the economy worsens or the financial markets do notstabilize.

 

7

----

* *

*We face vigorous competition from banks and other financialinstitutions.  This competition mayreduce or limit our margins on banking services, reduce market share andadversely affect results of operations and financial condition.*  A number of these banks and other financialinstitutions have substantially greater resources and lending limits, largerbranch systems and a wider array of banking services.  Additionally, we encounter competition fromboth de novo and smaller community banks entering the markets we are currentlyin.  We also compete with other providersof financial services, such as money market mutual funds, brokerage firms,consumer finance companies and insurance companies.

 

**Financial Risk**

 

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

** **

*Defaults in the repayment ofloans may negatively impact our business. *Creditrisk is most closely associated with lending activities at financialinstitutions.  Credit risk is the risk toearnings and capital when a customer fails to meet the terms of any contract orotherwise fails to perform as agreed. Credit risk arises from all activities where the Company is dependent onissuer, borrower, or counterparty performance, not just traditional lendingactivities.  For example, the investmentsecurity portfolio has inherent credit risk as do counterparties in derivativecontracts.  Credit risk encompasses abroad range of financial institution activities and includes items reflectedboth on and off the balance sheet.

 

Managementmakes various assumptions and judgments about the collectibility of our loanportfolio, including the creditworthiness of its borrowers and the value ofreal estate and other assets serving as collateral for repayment of many of theloans.  In determining the size of theallowance for loan losses, management considers, among other factors, theCompany’s loan loss experience and an evaluation of economic conditions.  If these assumptions prove to be incorrect,the current allowance may not be sufficient to cover future loan losses andadjustments may be necessary to allow for different economic conditions oradverse developments in the loan portfolio. Material additions to the Company’s allowance would materially decreaseour net income.

 

*Fluctuations in interest ratesmay negatively impact our banking business. *Interestrate risk focuses on the impact to earnings and capital arising from movementsin interest rates.  Interest rate riskfocuses on the value implications for accrual portfolios (e.g., held-to-maturityand available-for-sale portfolios) and includes the potential impact to theCompany’s accrual earnings as well as the economic perspective of the marketvalue of portfolio equity.  The interestrate risk is comprised of repricing risk, basis risk, yield curve risk andoptions risk.  Repricing risk representsthe risk associated with the differences in timing of cash flows and ratechanges with our products.  Basis risk representsthe risk associated with changing rate relationships among varying yieldcurves.  Yield curve risk is associatedwith changing rate relationships over the maturity structure.  Options risk is associated withinterest-related options, which are embedded in our products.

 

8

----

* *

*Changes in market factors maynegatively affect the value of our investment assets. *Market risk focuses on theimpact to earnings and capital arising from changes in market factors (e.g.,interest rates, market liquidity, volatilities, etc.) that affect the value oftraded instruments.  Market risk includesitems reflected both on and off the balance sheet.  Market risk focuses primarily onmark-to-market portfolios (e.g., accounts revalued for financial statementpresentation), including trading accounts and certain derivatives.

 

*Our inability to maintainappropriate levels of liquidity may have a negative impact on our results ofoperations and financial condition. *Liquidity risk focuses on the impact toearnings and capital resulting from our inability to meet our obligations asthey become due in the normal course of business without incurring significantlosses.  It also includes the managementof unplanned decreases or changes in funding sources as well as managingchanges in market conditions, which could affect the ability to liquidateassets in the normal course of business without incurring significantlosses.  Liquidity risk includes itemsboth on and off the balance sheet.

 

**Business Risk**

** **

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

 

*Our results of operations and financial condition aresusceptible to legal or compliance risks. *Legal or compliance riskis the risk to earnings or capital arising from the impact of unenforceablecontracts, lawsuits, adverse judgments, violations or nonconformance with laws,rules, regulations, prescribed practices, or ethical standards.  The risk also arises in situations where lawsor rules governing certain products or activities of our customers may beambiguous or untested.  This risk is notlimited to the traditional thinking that legal/compliance risk is onlyassociated with consumer protection laws. It includes the exposure to litigation from all aspects of bothtraditional and nontraditional financial institution activities.

* *

*Incorrectstrategic decisions may have a negative impact on our results of operations andfinancial condition. *Strategicrisk is the risk to earnings and capital arising from adverse businessdecisions or improper implementation of those decisions.  Strategic risk focuses on more than ananalysis of the written strategic plan. Its focus is on how plans, systems and implementation affect franchisevalue.  It also incorporates howmanagement analyzes external factors that affect the Company’s strategicdirection.

 

*Adverse publicity may have anegative impact on our business. *Reputationrisk is the risk to earnings and capital arising from negative publicopinion.  This affects the ability toestablish new relationships or services or to continue servicing existingrelationships.  Examiners will assessreputation risk by recognizing the potential effect the public’s opinion couldhave on our franchise value.

 

**Operational Risk**

** **

*An inability to process transactions may have a negativeimpact on our business. *Operationalrisk is present on a daily basis through our processing of transactions and ispervasive in all products and services provided to our customers.  It can be defined as the impact to earningsand capital from problems encountered in processing transactions.  Operational risk is a function of internalcontrols, operating processes, management information systems, and employeeintegrity.

 

9

----

 

**Item 1B.      UnresolvedStaff Comments**

 

None.

 

**Item 2.         Properties**

 

The main banking officeof Kentucky Bank is located at 401 Main Street, Paris, Kentucky 40361.  The principal office of Kentucky Bancshares, Inc.is located at 339 Main Street, Paris, KY 40631. In addition, Kentucky Bank serves customer needs at 14 otherlocations.  All locations offer a fullrange of banking services.  Kentucky Bankowns all of the properties at which it conducts its business.  The Company owns approximately 118,000 squarefeet of office space.

 

Note 5 to the Company’sconsolidated financial statements included in this report contains additionalinformation relating to amounts invested in premises and equipment.

 

**Item 3.         Legal Proceedings**

 

The Company and itssubsidiary are from time to time involved in routine legal proceedingsoccurring in the ordinary course of business that, in the aggregate, managementbelieves will not have a material impact on the Company’s financial conditionand results of operation.

 

**Item 4.         Submission of Matters to a Vote ofSecurity Holders**

 

Not Applicable.

 

**PART II**

 

**Item 5.         Market for Common Equity and RelatedStockholder Matters**

 

There is no establishedpublic trading market for the Company’s Common Stock.  The Company’s Common Stock is not listed onany national securities exchange nor is it quoted on the NASDAQ system.  However, it is traded on the OTC BulletinBoard under the symbol “KTYB.OB”. Trading in the Common Stock has been infrequent, with retail brokeragefirms making the market.  The followingtable sets forth the high and low closing sales prices of the Common Stock fromthe OTC Bulletin Board and the dividends declared thereon, for the periodsindicated below:

 
| ** ** | ** **           | **High** | ** ** | **Low** | ** ** | **Dividend** | ** ** |
|------------|----------------------|----------|------------|---------|------------|--------------|------------|
| 2008       | Quarter  4 |     | $          | 26.50   |       | $            | 15.75      |   | $ | .28 |   |
|       | Quarter  3 |     | 27.25      |    | 24.00      |         | .28        |   |
|       | Quarter  2 |     | 30.00      |    | 27.00      |         | .28        |   |
|       | Quarter  1 |     | 31.75      |    | 29.50      |         | .28        |   |
| 2007       | Quarter  4 |     | 34.00      |    | 31.75      |         | .27        |   |
|       | Quarter  3 |     | 34.00      |    | 30.50      |         | .27        |   |
|       | Quarter  2 |     | 30.50      |    | 29.00      |         | .27        |   |
|       | Quarter  1 |     | 32.35      |    | 30.00      |         | .27        |   |
|            |                      |          |            |         |            |              |            |  |  |  |  |

 

10

----

 

Note 16 to the Company’sconsolidated financial statements included in this report contains additionalinformation relating to amounts available to be paid as dividends.

 

As of December 31,2008 the Company had 2,745,729 shares of Common Stock outstanding andapproximately 559 holders of record of its Common Stock.

 

Thetable below lists issuer purchases of equity securities.

 
| ** **          | ** ** | ** **          | ** ** | ** **          | ** ** | **(c) Total Number**          | ** ** | **(d) Maximum Number**               | ** **         |
|---------------------|------------|---------------------|------------|---------------------|------------|-----------------------------------------|------------|------------------------------------------------|--------------------|
| ** **          | ** ** | **(a) Total**  | ** ** | **(b)**             | ** ** | **of Shares (or Units)** | ** ** | **(or Approximate Dollar**           | ** **         |
| ** **          | ** ** | **Number of**  | ** ** | **Average**         | ** ** | **Purchased as Part**         | ** ** | **Value) of Shares (or**        | ** **         |
| ** **          | ** ** | **Shares (or** | ** ** | **Price Paid** | ** ** | **of Publicly**                    | ** ** | **Units) that May Yet Be** | ** **         |
| ** **          | ** ** | **Units)**          | ** ** | **Per Share**  | ** ** | **Announced Plans**                | ** ** | **Purchased Under the**              | ** **         |
| **Period**          | ** ** | **Purchased**       | ** ** | **(or Unit)**  | ** ** | **Or Programs**                    | ** ** | **Plans or Programs**                | ** **         |
| 10/1/08 -  10/31/08 |       | 510                 |       | $                   | 23.50      |                                    | 510        |                                           | 42,999 shares |   |
|                |       |                |       |                |       |                                    |       |                                           |               |
| 11/1/08 -  11/30/08 |       | —              |       | —              |       | —                                  |       | 42,999 shares                             |               |
|                |       |                |       |                |       |                                    |       |                                           |               |
| 12/1/08 -  12/31/08 |       | 1,000               |       | 18.25               |       | 1,000                                   |       | 41,999 shares                             |               |
|                |       |                |       |                |       |                                    |       |                                           |               |
| Total               |       | 1,510               |       |                |       | 1,510                                   |       | 41,999 shares                             |               |
|                     |            |                     |            |                     |            |                                         |            |                                                |                    |  |

 

On October 25, 2000, the Company announced that its Board of Directors approved a stock repurchase program.  The Company is authorized to purchase up to 100,000 shares of its outstanding common stock.  On November 11, 2002, the Board of Directors approved and authorized the Company’s repurchase of an additional 100,000 shares.  On May 20, 2008, the Board of Directors approved and authorized an additional 100,000 shares.  Shares will be purchased from time to time in the open market depending on market prices and other considerations.  Through December 31, 2008, 258,001 shares have been purchased, with the most recent share repurchase under the Board-approved stock repurchase program having occurred on December 22, 2008.

 

11

 

**PerformanceGraph**

 

The information includedunder the caption “Performance Graph” in this Item 5 of this Form 10-K isnot deemed to be “soliciting material” or to be “filed” with the SEC or subjectto Regulation 14A or 14C under the Securities Exchange Act of 1934 or to theliabilities of Section 18 of the Securities Exchange Act of 1934, and willnot be deemed to be incorporated by reference into any filings we make underthe Securities Act of 1933 or the Securities Exchange Act of 1934, except tothe extent we specifically incorporate it by reference into such a filing.

 

The following graphcompares the change in the cumulative total stockholder return on our commonstock with the cumulative total return of the SIC Code 6022 State CommercialBanks <$100 million and the Russell Microcap Index from 2004 through2008.  This comparison assumes $100 invested on December 31,2003 in (a) our common stock, (b) SIC Code 6022 State CommercialBanks <$100 million, and (c) the Russell Microcap Index.

 

**COMPARISONOF 5 YEAR CUMULATIVE TOTAL RETURN***

Among KentuckyBankshares Inc.,  The Russell MicroCapIndex

And SIC Code 6022State Commercial Banks <$100mil

 

 

 

----

*$100 invested on12/31/03 in stock & index-including reinvestment of dividends.

Fiscal year endingDecember 31.

 

Copyright ©2009 Dow Jones& Co. All rights reserved.

 

12

----

 

## **Item 6.         Selected Financial Data**

## ** **

The following selectedfinancial data should be read in conjunction with the Company’s ConsolidatedFinancial Statements and the accompanying notes presented elsewhere herein.

 
|                                                                 |       | **At or For the Year Ended December 31** |       |
|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| **(dollars and shares in thousands)**            | ** ** | **2008**                                                                    | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| CONDENSED STATEMENT OF INCOME:                                       |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Total Interest Income                                                |       | $                                                                           | 35,129     |   | $ | 39,219 |   | $ | 35,593 |   | $ | 28,897 |   | $ | 25,846 |   |
| Total Interest Expense                                               |       | 15,359                                                                      |       | 19,034 |   | 16,718 |   | 11,766 |   | 9,067 |   |
| Net Interest Income                                                  |       | 19,770                                                                      |       | 20,185 |   | 18,875 |   | 17,131 |   | 16,779 |   |
| Provision for Losses                                                 |       | 3,700                                                                       |       | 1,000 |   | 475 |   | 508 |   | 840 |   |
| Net Interest Income After Provision for Losses                       |       | 16,070                                                                      |       | 19,185 |   | 18,400 |   | 16,623 |   | 15,939 |   |
| Noninterest Income                                                   |       | 8,354                                                                       |       | 7,936 |   | 7,236 |   | 6,495 |   | 6,547 |   |
| Noninterest Expense                                                  |       | 20,027                                                                      |       | 18,131 |   | 16,682 |   | 15,220 |   | 14,506 |   |
| Income Before Income Tax Expense                                     |       | 4,397                                                                       |       | 8,990 |   | 8,954 |   | 7,898 |   | 7,980 |   |
| Income Tax Expense                                                   |       | 684                                                                         |       | 2,404 |   | 2,468 |   | 2,078 |   | 2,218 |   |
| Net Income                                                           |       | 3,713                                                                       |       | 6,586 |   | 6,486 |   | 5,820 |   | 5,762 |   |
|                                                                 |       |                                                                        |       |   |   |   |   |   |   |   |   |
| SHARE DATA:                                                          |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Basic Earnings per Share (EPS)                                       |       | $                                                                           | 1.34       |   | $ | 2.31 |   | $ | 2.35 |   | $ | 2.17 |   | $ | 2.09 |   |
| Diluted EPS                                                          |       | 1.33                                                                        |       | 2.30 |   | 2.34 |   | 2.16 |   | 2.07 |   |
| Cash Dividends Declared                                              |       | 1.12                                                                        |       | 1.08 |   | 1.00 |   | 0.92 |   | 0.84 |   |
| Book Value                                                           |       | 20.77                                                                       |       | 20.65 |   | 19.59 |   | 17.45 |   | 16.77 |   |
| Average Common Shares-Basic                                          |       | 2,778                                                                       |       | 2,852 |   | 2,762 |   | 2,677 |   | 2,757 |   |
| Average Common Shares-Diluted                                        |       | 2,782                                                                       |       | 2,862 |   | 2,774 |   | 2,692 |   | 2,777 |   |
|                                                                 |       |                                                                        |       |   |   |   |   |   |   |   |   |
| SELECTED BALANCE SHEET DATA:                                         |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Loans, including loans held for sale                                 |       | $                                                                           | 418,812    |   | $ | 412,509 |   | $ | 439,159 |   | $ | 366,602 |   | $ | 354,294 |   |
| Investment Securities                                                |       | 172,834                                                                     |       | 147,750 |   | 127,891 |   | 160,652 |   | 126,767 |   |
| Total Assets                                                         |       | 678,775                                                                     |       | 630,939 |   | 629,542 |   | 572,750 |   | 528,544 |   |
| Deposits                                                             |       | 520,808                                                                     |       | 486,005 |   | 468,808 |   | 431,631 |   | 387,955 |   |
| Securities sold under agreements to repurchase and other  borrowings |       | 10,717                                                                      |       | 6,735 |   | 11,327 |   | 16,838 |   | 25,593 |   |
| Federal Home Loan Bank advances                                      |       | 77,301                                                                      |       | 63,993 |   | 80,030 |   | 66,749 |   | 59,750 |   |
| Stockholders’ Equity                                            |       | 57,041                                                                      |       | 58,844 |   | 55,281 |   | 46,546 |   | 45,027 |   |
|                                                                 |       |                                                                        |       |   |   |   |   |   |   |   |   |
| PERFORMANCE RATIOS:                                                  |       |                                                                        |       |   |   |   |   |   |   |   |   |
| (Average Balances)                                                   |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Return on Assets                                                     |       | 0.58                                                                        | %          | 1.04 | % | 1.09 | % | 1.08 | % | 1.11 | % |
| Return on Stockholders’ Equity                                  |       | 6.45                                                                        | %          | 11.59 | % | 12.82 | % | 12.69 | % | 12.57 | % |
| Net Interest Margin (1)                                              |       | 3.49                                                                        | %          | 3.56 | % | 3.48 | % | 3.50 | % | 3.60 | % |
| Equity to Assets (annual average)                                    |       | 8.96                                                                        | %          | 8.97 | % | 8.48 | % | 8.50 | % | 8.82 | % |
|                                                                 |       |                                                                        |       |   |   |   |   |   |   |   |   |
| SELECTED STATISTICAL DATA:                                           |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Dividend Payout Ratio                                                |       | 84.05                                                                       | %          | 46.89 | % | 42.68 | % | 42.30 | % | 39.97 | % |
| Number of Employees (at period end)                                  |       | 214                                                                         |       | 204 |   | 203 |   | 172 |   | 167 |   |
|                                                                 |       |                                                                        |       |   |   |   |   |   |   |   |   |
| ALLOWANCE COVERAGE RATIOS:                                           |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Allowance to Total Loans                                             |       | 1.29                                                                        | %          | 1.17 | % | 1.12 | % | 1.16 | % | 1.16 | % |
| Net Charge-offs as a Percentage of Average Loans                     |       | 0.75                                                                        | %          | 0.26 | % | 0.14 | % | 0.10 | % | 0.15 | % |

 

----

(1)          Tax equivalent

 

13

----

 

**Item 7.         Management’s Discussion and Analysis**

 

The following discussionand analysis of financial condition and results of operations should be read inconjunction with the Consolidated Financial Statements and accompanying notesincluded as Exhibit 13.  Whennecessary, reclassifications have been made to prior years’ data throughout thefollowing discussion and analysis for purposes of comparability with 2008 data.

 

Critical AccountingPolicies

 

The accounting andreporting policies of the Company and its subsidiary are in accordance withaccounting principles generally accepted in the United States and conform togeneral practices within the banking industry. Significant accounting policies are listed in Note 1 in the “Notes toConsolidated Financial Statements”. Critical accounting and reporting policies include accounting for loansand the allowance for loan losses. Different assumptions in the application of these policies could resultin material changes in the consolidated financial position or consolidatedresults of operations.

 

Loans are stated at theamount of unpaid principal, reduced by an allowance for loan losses.  Interest on loans is recognized on theaccrual basis, except for those loans on the nonaccrual status.  Interest income received on such loans isaccounted for on the cash basis or cost recovery method.  The allowance for loan losses is a valuationallowance for probable incurred credit losses. Management estimates the allowance balance required using past loan lossexperience, the nature and volume of the portfolio, information about specificborrower situations and estimated collateral values, economic conditions, andother factors.  The accounting policiesrelating to the allowance for loan losses involve the use of estimates andrequire significant judgments to be made by management.

 

Forward-LookingStatements

 

Thisdiscussion contains forward-looking statements under the Private SecuritiesLitigation Reform Act of 1995 that involve risks and uncertainties.  Although the Company believes that theassumptions underlying the forward-looking statements contained herein arereasonable, any of the assumptions could be inaccurate, and therefore, therecan be no assurance that the forward-looking statements included herein willprove to be accurate.  Factors that couldcause actual results to differ from the results discussed in theforward-looking statements include, but are not limited to:  economic conditions (both generally and morespecifically in the markets, including the tobacco market, in which the Companyand its bank operate); competition for the Company’s customers from otherproviders of financial and mortgage services; government legislation,regulation and monetary policy (which changes from time to time and over whichthe Company has no control); changes in interest rates (both generally and morespecifically mortgage interest rates); material unforeseen changes in theliquidity, results of operations, or financial condition of the Company’scustomers; and other risks detailed in the Company’s filings with theSecurities and Exchange Commission, all of which are difficult to predict andmany of which are beyond the control of the Company.  The Company undertakes no obligation torepublish revised forward-looking statements to reflect events or circumstancesafter the date hereof or to reflect the occurrence of unanticipated events.

 

14

----

 

Overview

 

Net income for the yearended December 31, 2008 was $3.7 million, or $1.34 per common sharecompared to $6.6 million, or $2.31 for 2007 and $6.5 million, or $2.35 for2006.  Earnings per share assumingdilution were $1.33, $2.30 and $2.34 for 2008, 2007 and 2006, respectively.  For 2008, net income decreased $2.9 million,or 43.6%.  Net interest income decreased$415 thousand, the loan loss provision increased $2.7 million, total otherincome increased $418 thousand, while total other expenses increased $1.9million.  In July 2006, the Companypurchased Peoples Bancorp of Sandy Hook, Inc. (Peoples Bancorp) and itssubsidiary, Peoples Bank (Peoples) of Sandy Hook, to strengthen its businessand grow its customer base.

 

For 2007, net incomeincreased $100 thousand, or 1.5%.  Netinterest income increased $1.3 million, the loan loss provision increased $525thousand, total other income increased $700 thousand, while total otherexpenses increased $1.4 million.

 

Return on average equitywas 6.5% in 2008 compared to 11.6% in 2007 and 12.8% in 2006.  Return on average assets was 0.58% in 2008compared to 1.04% in 2007 and 1.09% in 2006.

 

Non-performing loans as apercentage of loans (including held for sale) were 1.73%, 1.57% and 0.59% as ofDecember 31, 2008, 2007 and 2006, respectively.

 

RESULTS OF OPERATIONS

 

Net Interest Income

 

Net interest income, theCompany’s largest source of revenue, on a tax equivalent basis increased from$19.5 million in 2006 to $20.9 million in 2007 and decreased to $19.8 millionin 2008.  The taxable equivalentadjustment (nontaxable interest income on state and municipal obligations netof the related non-deductible portion of interest expense) is based on ourFederal income tax rate of 34%.

 

Average earning assetsand interest bearing liabilities both increased from 2007 to 2008.  Average earning assets increased $7 million,or 1%.  Investment securities increased$23 million primarily due to lower level of loan demand.  Loans decreased $14 million as a result ofthe slower demand during 2008.  Averageinterest bearing liabilities increased $5 million, or 1% during this sameperiod.  This change was primarily fromthe increase in FHLB advances.  TheCompany continues to actively pursue quality loans and fund these primarilywith deposits and FHLB advances.

 

After peaking in 2006,bank prime rates have been decreasing. Bank prime rates decreased 100 basis points in 2007, and another 400basis points in 2008.  As a result ofthis, the tax equivalent yield on earning assets decreased from 6.80% in 2007to 6.07% in 2008.

 

The volume rate analysisfor 2008 that follows indicates that $4.0 million of the decrease in interestincome is attributable to the decrease in rates, while the change in volumecontributed to a decrease of $53 thousand in interest income.  The rate decrease also caused a decrease inthe cost of interest bearing liabilities. The average rate of these liabilities decreased from 3.94% in 2007 to3.15% in 2008.  Based on the volume rateanalysis that follows, the lower level of interest rates contributed to adecrease of $3.8 million to interest expense, while the change in volume wasresponsible for a $104 thousand increase in interest expense.  As a result, the 2008 net interest incomeincrease is attributed to decreases in rates.

 

15

----

 

The volume rate analysisthat follows, during 2007, indicates that $2.0 million of the increase ininterest income is attributable to the change in volume, while the higher levelof rates contributed to an increase of $1.6 million in interest income.  This higher level of rates also caused anincrease in the cost of interest bearing liabilities.  The average rate of these liabilitiesincreased from 3.62% in 2006 to 3.94% in 2007. In addition, the change in volume contributed to an increase of $915thousand in interest expense, while the higher level of rates was responsiblefor a $1.4 million increase in interest expense.  As a result, the 2007 net interest incomeincrease is primarily attributed to increases in volume.

 

In addition to thenegative impact on net interest income that may result from the decreasing rateenvironment that began in 2007 and continued into 2008, competitive pressureson interest rates will continue and are likely to result in continued downwardpressure on net interest margins.

 

Theaccompanying analysis of changes in net interest income in the following tableshows the relationships of the volume and rate portions of these changes in2008 and 2007.  Changes in interestincome and expenses due to both rate and volume are allocated on a pro ratabasis.

 
| ** **                                                              | ** ** | **2008 vs. 2007** | ** ** | **2007 vs. 2006** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                              | ** ** | **Increase**                | ** ** | **(Decrease)**              | ** ** | **Due to Change in** | ** ** | **Increase** | ** ** | **(Decrease)** | ** ** | **Due to Change in** | ** ** |
| ** **                                                              | ** ** | **Volume**                  | ** ** | **Rate**                    | ** ** | **Net Change** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Net Change** | ** ** |
| INTEREST INCOME                                                         |       |                        |       |                        |       |   |   |   |   |   |   |   |   |
| Loans                                                                   |       | $                           | (1,023     | )                           | $          | (3,294 | ) | $ | (4,317 | ) | $ | 1,656 |   | $ | 1,073 |   | $ | 2,729 |   |
| Investment Securities                                                   |       | 1,068                       |       | (152                        | )          | 916 |   | (604 | ) | 571 |   | (33 | ) |
| Federal Funds Sold and Securities Purchased under Agreements to  Resell |       | (108                        | )          | (576                        | )          | (684 | ) | 919 |   | 9 |   | 928 |   |
| Deposits with Banks                                                     |       | 10                          |       | (15                         | )          | (5 | ) | 0 |   | 1 |   | 1 |   |
| Total Interest Income                                                   |       | (53                         | )          | (4,037                      | )          | (4,090 | ) | 1,971 |   | 1,654 |   | 3,625 |   |
| INTEREST EXPENSE                                                        |       |                        |       |                        |       |   |   |   |   |   |   |   |   |
| Deposits                                                                |       |                        |       |                        |       |   |   |   |   |   |   |   |   |
| Demand                                                                  |       | (202                        | )          | (1,864                      | )          | (2,066 | ) | 99 |   | (160 | ) | (61 | ) |
| Savings                                                                 |       | 79                          |       | (61                         | )          | 18 |   | (62 | ) | (75 | ) | (137 | ) |
| Negotiable Certificates of Deposit and Other Time Deposits              |       | (71                         | )          | (1,624                      | )          | (1,695 | ) | 1,739 |   | 1,466 |   | 3,205 |   |
| Securities sold under agreements to repurchase and other  borrowings    |       | 117                         |       | (220                        | )          | (103 | ) | (750 | ) | 94 |   | (656 | ) |
| Federal Home Loan Bank advances                                         |       | 181                         |       | (10                         | )          | 171 |   | (111 | ) | 76 |   | (35 | ) |
| Total Interest Expense                                                  |       | 104                         |       | (3,779                      | )          | (3,675 | ) | 915 |   | 1,401 |   | 2,316 |   |
| Net Interest Income                                                     |       | $                           | (157       | )                           | $          | (258 | ) | $ | (415 | ) | $ | 1,056 |   | $ | 253 |   | $ | 1,309 |   |

 

16

----

 

Average ConsolidatedBalance Sheets and Net Interest Analysis (dollars in thousands)

 
| ** **                                                                             | ** ** | **2008**    | ** ** | **2007**           | ** ** | **2006**          | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------|------------|--------------------|------------|-------------------|------------|
| ** **                                                                             | ** ** | **Average** | ** ** | ** **         | ** ** | ** Average** | ** ** | **Average** | ** ** | ** ** | ** ** | ** Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                                             | ** ** | **Balance** | ** ** | **Interest ** | ** ** | **Rate**          | ** ** | **Balance** | ** ** | **Interest ** | ** ** | **Rate** | ** ** | **Balance ** | ** ** | **Interest ** | ** ** | **Rate** | ** ** |
| ASSETS                                                                                 |       |        |       |               |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-Earning Assets                                                                |       |        |       |               |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Securities Available for Sale (1)                                                      |       |        |       |               |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and Federal Agency Securities                                            |       | 88,272      |       | 4,348              |       | 4.93              | %          | 74,648 |   | 3,727 |   | 4.99 | % | 101,130 |   | 4,354 |   | 4.31 | % |
| State and Municipal obligations                                                        |       | 63,463      |       | 2,581              |       | 4.07              | %          | 52,674 |   | 2,134 |   | 4.05 | % | 41,030 |   | 1,666 |   | 4.06 | % |
| Other Securities                                                                       |       | 6,796       |       | 358                |       | 5.27              | %          | 8,046 |   | 510 |   | 6.34 | % | 6,622 |   | 384 |   | 5.80 | % |
| Total Securities Available for Sale                                                    |       | 158,531     |       | 7,287              |       | 4.60              | %          | 135,368 |   | 6,371 |   | 4.71 | % | 148,782 |   | 6,404 |   | 4.30 | % |
| Tax Equivalent Adjustment                                                              |       |        |       | 944                |       | 0.60              | %          |   |   | 715 |   | 0.53 | % |   |   | 624 |   | 0.42 | % |
| Tax Equivalent Total                                                                   |       |        |       | 8,231              |       | 5.19              | %          |   |   | 7,086 |   | 5.23 | % |   |   | 7,028 |   | 4.72 | % |
| Federal Funds Sold and Agreements to Repurchase                                        |       | 18,324      |       | 346                |       | 1.89              | %          | 20,735 |   | 1,030 |   | 4.97 | % | 2,212 |   | 102 |   | 4.61 | % |
| Interest-Bearing Deposits with Banks                                                   |       | 799         |       | 14                 |       | 1.75              | %          | 432 |   | 19 |   | 4.40 | % | 432 |   | 18 |   | 4.17 | % |
| Loans, Net of Deferred Loan Fees (2)                                                   |       |        |       |               |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                                                                             |       | 45,309      |       | 2,852              |       | 6.29              | %          | 46,508 |   | 3,731 |   | 8.02 | % | 46,194 |   | 3,520 |   | 7.62 | % |
| Real Estate Mortgage                                                                   |       | 358,067     |       | 23,442             |       | 6.55              | %          | 370,699 |   | 26,802 |   | 7.23 | % | 351,239 |   | 24,597 |   | 7.00 | % |
| Installment                                                                            |       | 13,292      |       | 1,187              |       | 8.93              | %          | 13,677 |   | 1,265 |   | 9.25 | % | 10,698 |   | 952 |   | 8.90 | % |
| Total Loans                                                                            |       | 416,668     |       | 27,481             |       | 6.60              | %          | 430,884 |   | 31,798 |   | 7.38 | % | 408,131 |   | 29,069 |   | 7.12 | % |
| Total Interest-Earning Assets                                                          |       | 594,322     |       | 36,072             |       | 6.07              | %          | 587,419 |   | 39,933 |   | 6.80 | % | 559,557 |   | 36,217 |   | 6.47 | % |
| Allowance for Loan Losses                                                              |       | (5,123      | )          |               |       |              |       | (4,935 | ) |   |   |   |   | (4,766 | ) |   |   |   |   |
| Cash and Due From Banks                                                                |       | 13,387      |       |               |       |              |       | 13,642 |   |   |   |   |   | 11,844 |   |   |   |   |   |
| Premises and Equipment                                                                 |       | 17,196      |       |               |       |              |       | 15,246 |   |   |   |   |   | 12,421 |   |   |   |   |   |
| Other Assets                                                                           |       | 22,729      |       |               |       |              |       | 21,934 |   |   |   |   |   | 17,676 |   |   |   |   |   |
| Total Assets                                                                           |       | 642,511     |       |               |       |              |       | 633,306 |   |   |   |   |   | 596,732 |   |   |   |   |   |
|                                                                                   |       |        |       |               |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES                                                                            |       |        |       |               |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-Bearing Deposits                                                              |       |        |       |               |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Negotiable Order of Withdrawal (“NOW”) and Money Market  Investment Accounts |       | 110,022     |       | 1,254              |       | 1.14              | %          | 117,610 |   | 3,320 |   | 2.82 | % | 114,195 |   | 3,381 |   | 2.96 | % |
| Savings                                                                                |       | 38,962      |       | 398                |       | 1.02              | %          | 31,722 |   | 380 |   | 1.20 | % | 36,425 |   | 517 |   | 1.42 | % |
| Certificates of Deposit and Other Deposits                                             |       | 242,884     |       | 9,729              |       | 4.01              | %          | 244,408 |   | 11,424 |   | 4.67 | % | 204,649 |   | 8,219 |   | 4.02 | % |
| Total Interest-Bearing Deposits                                                        |       | 391,868     |       | 11,381             |       | 2.90              | %          | 393,740 |   | 15,124 |   | 3.84 | % | 355,269 |   | 12,117 |   | 3.41 | % |
| Securities sold under agreements to repurchase and other  borrowings                   |       | 21,346      |       | 898                |       | 4.21              | %          | 18,935 |   | 1,001 |   | 5.29 | % | 33,213 |   | 1,657 |   | 4.99 | % |
| Federal Home Loan Bank advances                                                        |       | 74,508      |       | 3,080              |       | 4.13              | %          | 70,132 |   | 2,909 |   | 4.15 | % | 72,843 |   | 2,944 |   | 4.04 | % |
| Total Interest-Bearing Liabilities                                                     |       | 487,722     |       | 15,359             |       | 3.15              | %          | 482,807 |   | 19,034 |   | 3.94 | % | 461,325 |   | 16,718 |   | 3.62 | % |
| Noninterest-Bearing Earning Demand Deposits                                            |       | 91,244      |       |               |       |              |       | 86,951 |   |   |   |   |   | 80,904 |   |   |   |   |   |
| Other Liabilities                                                                      |       | 5,983       |       |               |       |              |       | 6,745 |   |   |   |   |   | 3,919 |   |   |   |   |   |
| Total Liabilities                                                                      |       | 584,949     |       |               |       |              |       | 576,503 |   |   |   |   |   | 546,148 |   |   |   |   |   |
| STOCKHOLDERS’ EQUITY                                                              |       | 57,562      |       |               |       |              |       | 56,803 |   |   |   |   |   | 50,584 |   |   |   |   |   |
| Total Liabilities and Shareholders’ Equity                                        |       | 642,511     |       |               |       |              |       | 633,306 |   |   |   |   |   | 596,732 |   |   |   |   |   |
| Average Equity to Average Total Assets                                                 |       | 8.96        | %          |               |       |              |       | 8.97 | % |   |   |   |   | 8.48 | % |   |   |   |   |
| Net Interest Income                                                                    |       |        |       | 19,769             |       |              |       |   |   | 20,184 |   |   |   |   |   | 18,875 |   |   |   |
| Net Interest Income (tax equivalent) (3)                                          |       |        |       | 20,713             |       |              |       |   |   | 20,899 |   |   |   |   |   | 19,499 |   |   |   |
| Net Interest Spread (tax equivalent) (3)                                          |       |        |       |               |       | 2.92              | %          |   |   |   |   | 2.86 | % |   |   |   |   | 2.85 | % |
| Net Interest Margin (tax equivalent) (3)                                          |       |        |       |               |       | 3.49              | %          |   |   |   |   | 3.56 | % |   |   |   |   | 3.48 | % |

 

----

(1)                  Averages computed at amortized cost.

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

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

 

17

----

 

Noninterest Income andExpenses

 

Noninterest income was$8.4 million in 2008 compared to $7.9 million in 2007 and $7.2 million in2006.  In 2008, increases in securitiesgains and other income were offset by decreases in service charges and loan servicefee income.  In 2007, increasing servicecharges and increasing gain on sale of mortgage loans account for the majorityof the increase.

 

Securities gains were$658 thousand in 2008, $37 thousand in 2007 and $34 thousand in 2006.  These are primarily attributable to declininginterest rates and the related inverse relationship of interest rates andmarket values.  Some securities gainswere taken in 2008 and used to offset addition to the loan loss reserve andcosts related to the pension plan termination.

 

Gains on loans sold were$411 thousand, $432 thousand and $290 thousand in 2008, 2007 and 2006,respectively.  Loans held for sale aregenerally sold after closing to the Federal Home Loan Mortgage Corporation.  During 2008, the loan service fee income decreased$187 thousand ($213 thousand write down of mortgage servicing rights), comparedto an increase of $25 thousand in 2007. Proceeds from the sale of loans were $19 million, $16 million and $17million in 2008, 2007 and 2006, respectively. The volume of loan originations is inverse to rate changes.  The volume of loan originations during 2008was $19 million, comparable to $16 million in 2007, and $17 million in 2006.

 

Other noninterest incomeexcluding security net gains and gain on sale of mortgage loans was $7.3million in 2008, $7.5 million in 2007 and $6.9 million in 2006.  Service charge income, and more particularlyoverdraft income, is the largest contributor to these numbers.  Overdraft income was $4.3 million in 2008,$4.6 million in 2007 and $4.1 million in 2006. The decrease in 2008 is primarily attributable to the slower economy,while the increase in 2007 is primarily attributable to the Peoples acquisitionin July 2006.  Other income was $1.1million in 2006, $1.4 million in 2007 and $1.6 million in 2008.  The increase in 2008 is primarilyattributable to a $153 thousand increase in interchange income, and theincrease in 2007 is primarily attributable to a $200 thousand increase ininterchange income and a $137 thousand increase in brokerage income.

 

Noninterest expenseincreased $1.9 million in 2008 to $20.0 million, and increased $1.4 million in2007 to $18.1 million from $16.7 million in 2006.  The increases in salaries and benefits from$9.6 million in 2006 to $10.6 million in 2007 and to $11.1 million in 2008 areattributable to normal salary and benefit increases, and in 2006 and 2007 tothe Peoples acquisition.  Bonuscompensation was $481 thousand lower in 2008 compared to 2007 and $38 thousandhigher in 2007 compared to 2006.  The 2008decrease is mainly a result of a decline in net income, while the 2007 increaseis from higher compensation (the percentage payout of base salaries was lowerin 2007 versus 2006).  Occupancy expenseincreased $240 thousand in 2007 to $2.6 million and increased $178 thousand, or7% in 2008 to $2.7 million.  The largestexpense, depreciation, increased $85 thousand to $1.0 million in 2007, andincreased $113 thousand to $1.1 million in 2008.  Other noninterest expense increased from $4.7million in 2006 to $5.0 million in 2007 and increased to $6.2 million in2008.  Additional pension plan costs dueto its December 31, 2008 termination were $563 thousand in 2008.  FDIC insurance increased $196 thousand in2008 compared to 2007.  Legal andprofessional fees increased $140 thousand from 2007 to 2008, mainly fromadditional loan collection efforts. Check card processing fees increased $114 thousand from 2007 to2008.   Amortization of core depositsrelated to the Peoples acquisition was $169 thousand in 2008, compared to $175thousand in 2007.  See Note 6 in thenotes to consolidated financial statements included as Exhibit 13 for moredetail of the goodwill and intangible assets.

 

18

----

 

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

 
| ** **                                                 | ** ** | **For the Year Ended December 31  (in thousands)** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2008**                                                                         | ** ** | **2007** | ** ** | **2006** | ** ** |
| NON-INTEREST INCOME                                        |       |                                                                             |       |   |   |   |   |
| Service Charges                                            |       | $                                                                                | 5,332      |   | $ | 5,495 |   | $ | 5,224 |   |
| Loan Service Fee Income (Loss), net                        |       | (130                                                                             | )          | 58 |   | 33 |   |
| Trust Department Income                                    |       | 478                                                                              |       | 515 |   | 603 |   |
| Investment Securities Gains (Losses),net                   |       | 658                                                                              |       | 37 |   | 34 |   |
| Gains on Sale of Mortgage Loans                            |       | 411                                                                              |       | 432 |   | 290 |   |
| Other                                                      |       | 1,605                                                                            |       | 1,399 |   | 1,052 |   |
| Total Non-interest Income                                  |       | 8,354                                                                            |       | 7,936 |   | 7,236 |   |
|                                                       |       |                                                                             |       |   |   |   |   |
| NON-INTEREST EXPENSE                                       |       |                                                                             |       |   |   |   |   |
| Salaries and Employee Benefits                             |       | 11,082                                                                           |       | 10,594 |   | 9,613 |   |
| Occupancy Expenses                                         |       | 2,738                                                                            |       | 2,560 |   | 2,320 |   |
| Other                                                      |       | 6,207                                                                            |       | 4,977 |   | 4,749 |   |
| Total Non-interest Expense                                 |       | 20,027                                                                           |       | 18,131 |   | 16,682 |   |
|                                                       |       |                                                                             |       |   |   |   |   |
| Net Non-interest Expense as a Percentage of Average Assets |       | 1.82                                                                             | %          | 1.61 | % | 1.58 | % |
|                                                            |            |                                                                                  |            |  |  |  |  |  |  |  |

 

Income Taxes

 

The Company had incometax expense of $684 thousand in 2008 and $2.4 million in 2007 and $2.5 millionin 2006.  This represents an effectiveincome tax rate of 15.6% in 2008, 26.7% in 2007 and 27.6% in 2006.  The difference between the effective tax rateand the statutory federal rate of 34% is primarily due to tax exempt income oncertain investment securities and loans.

 

Balance Sheet Review

 

Assets grew from $631million at December 31, 2007 to $679 million at December 31,2008.  Securities increased $25 millionand loans increased $7 million in 2008. Deposits grew $35 million and FHLB borrowings increased $13 million.  The gain in deposits of 7% is primarily fromnormal growth and the addition of public money. Assets at year-end 2007 totaled $631 million compared to $630 million in2006.  Loan decline was $27 million in2007.  Deposits grew $17 million and FHLBborrowings decreased $16 million.  Thegain in deposits of 4% is primarily from normal growth.  See Note 15 in the notes to consolidatedfinancial statements included as Exhibit 13 for additional information onthe business combination.

 

Loans

 

Total loans (includingloans held for sale) were $424 million at December 31, 2008 compared to$417 million at the end of 2007 and $444 million in 2006.  The slight increase in 2008 is mainlyattributable to normal loan demand. Loans declined in 2007, following growth in 2006.  The decline in 2007 is primarily attributableto the softening economy.  As of the endof 2008 and compared to the prior year-end, commercial loans decreased $1.4million, real estate construction loans decreased $9.4 million, real estatemortgage loans (including loans held for sale) increased $16.3 million andinstallment loans increased $2.2 million. As of the end of 2007 and compared to the prior year-end, commercialloans decreased $6.4 million, real estate construction loans decreased $2.9million, real estate mortgage loans (including loans held for sale) decreased$19.6 million, agricultural loans increased $1.1 million and installment loansincreased $.9 million.

 

19

----

 

As of December 31,2008, the real estate mortgage portfolio comprised 68% of total loans comparedto 65% in 2007.  Of this, 1-4 familyresidential property represented 54% in 2008 and 62% in 2007.  Agricultural loans comprised 19% in 2008 and19% in 2007 of the loan portfolio. Approximately 73% of the agricultural loans are secured by real estatein 2008 compared to 72% in 2007.  Theremainder of the agricultural portfolio is used to purchase livestock,equipment and other capital improvements and for general operation of the farm.  Generally, a secured interest is obtained inthe capital assets, equipment, livestock or crops.  Automobile loans account for 29% in 2008 and36% in 2007 of the consumer loan portfolio, while the purpose of the remainderof this portfolio is used by customers for purchasing retail goods, homeimprovement or other personal reasons. The commercial loan portfolio is mainly for capital outlays and businessoperation.  Collateral is requesteddepending on the creditworthiness of the borrower.  Unsecured loans are made to individuals orcompanies mainly based on the creditworthiness of the customer.  Approximately 7% of the loan portfolio isunsecured.  Management is not aware ofany significant concentrations that may cause future material risks, which mayresult in significant problems with future income and capital requirements.

 

The following tablerepresents a summary of the Company’s loan portfolio by category for each ofthe last five years.  There is noconcentration of loans (greater than 5% of the loan portfolio) in anyindustry.  The Company has no foreignloans or highly leveraged transactions in its loan portfolio.

 

Loans Outstanding

 
| ** **                             | ** ** | **December 31 (in thousands)** | ** ** |
|----------------------------------------|------------|-----------------------------------------------|------------|
| ** **                             | ** ** | **2008**                                      | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Commercial                             |       | $                                             | 21,505     |   | $ | 22,924 |   | $ | 29,335 |   | $ | 27,302 |   | $ | 19,999 |   |
| Real Estate Construction               |       | 16,819                                        |       | 26,172 |   | 29,034 |   | 29,822 |   | 32,256 |   |
| Real Estate Mortgage                   |       | 287,032                                       |       | 270,749 |   | 290,324 |   | 245,326 |   | 238,661 |   |
| Agricultural                           |       | 80,779                                        |       | 80,774 |   | 79,627 |   | 59,328 |   | 57,497 |   |
| Installment                            |       | 17,643                                        |       | 15,421 |   | 15,684 |   | 8,954 |   | 9,062 |   |
| Other                                  |       | 685                                           |       | 1,603 |   | 402 |   | 368 |   | 991 |   |
| Total Loans                            |       | 424,463                                       |       | 417,643 |   | 444,406 |   | 371,100 |   | 358,466 |   |
| Less Deferred Loan Fees                |       | 186                                           |       | 255 |   | 256 |   | 188 |   | 10 |   |
| Total Loans, Net of Deferred Loan Fees |       | 424,277                                       |       | 417,388 |   | 444,150 |   | 370,912 |   | 358,456 |   |
| Less loans held for sale               |       | —                                        |       | — |   | — |   | — |   | 175 |   |
| Less Allowance For Loan Losses         |       | 5,465                                         |       | 4,879 |   | 4,991 |   | 4,310 |   | 4,163 |   |
| Net Loans                              |       | 418,812                                       |       | 412,509 |   | 439,159 |   | 366,602 |   | 354,118 |   |
|                                        |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

20

----

 

Thefollowing table sets forth the maturity distribution and interest sensitivityof selected loan categories at December 31, 2008.  Maturities are based upon contractualterm.  The total loans in this reportrepresent loans net of deferred loan fees, including loans held for sale butexcluding the allowance for loan losses. In addition, deferred loan fees on the above schedule is netted withreal estate mortgage loans on the following schedule.

 

Loan Maturities and Interest Sensitivity

 
| ** **                             | ** ** | **December 31, 2008 (in thousands)** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                             | ** ** | **One Year**                                        | ** ** | **One Through** | ** ** | **Over** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | **or Less**                                         | ** ** | **Five Years ** | ** ** | **Five Years** | ** ** | **Loans** | ** ** |
| Commercial                             |       | $                                                        | 7,503      |   | $ | 12,028 |   | $ | 1,974 |   | $ | 21,505 |   |
| Real Estate Construction               |       | 12,688                                                   |       | 4,114 |   | 17 |   | 16,819 |   |
| Real Estate Mortgage                   |       | 40,798                                                   |       | 101,622 |   | 144,426 |   | 286,846 |   |
| Agricultural                           |       | 15,474                                                   |       | 35,091 |   | 30,214 |   | 80,779 |   |
| Installment                            |       | 5,078                                                    |       | 8,345 |   | 4,220 |   | 17,643 |   |
| Other                                  |       | 685                                                      |       | — |   | — |   | 685 |   |
| Total Loans, Net of Deferred Loan Fees |       | 82,226                                                   |       | 161,200 |   | 180,851 |   | 424,277 |   |
| Fixed Rate Loans                       |       | 40,787                                                   |       | 115,204 |   | 37,813 |   | 193,804 |   |
| Floating Rate Loans                    |       | 41,439                                                   |       | 45,996 |   | 143,038 |   | 230,473 |   |
| Total Loans, Net of Deferred Loan Fees |       | 82,226                                                   |       | 161,200 |   | 180,851 |   | 424,277 |   |
|                                        |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |

 

Mortgage Banking

 

TheCompany has been in Mortgage Banking since the early 1980’s.  The activity in origination and sale of theseloans fluctuates, mainly due to changes in interest rates.  Mortgage loan originations decreased from $17million in 2006 to $16 million in 2007, but increased to $19 million in2008.  Proceeds from the sale of loanswere $19 million, $16 million and $17 million for the years 2008, 2007 and2006, respectively.  Mortgage loans heldfor sale were zero at December 31, 2008 and December 31, 2007.  Loans are generally sold when they aremade.  The volume of loan originations isinverse to rate changes.  The rateenvironment rose in 2006, resulting in decreased loan originations.  Declining rates toward the end of 2007 andinto 2008, resulted in higher loan orginations in the latter portion of 2007and in 2008.  The effect of these changeswas also reflected on the income statement. As a result, the gain on sale of mortgage loans was $411 thousand in 2008compared to $432 thousand in 2007 and $290 thousand in 2006.

 

The Bank has soldvarious loans to the Federal Home Loan Mortgage Corporation (FHLMC) whileretaining the servicing rights.  Gainsand losses on loan sales are recorded at the time of the cash sale, whichrepresents the premium or discount paid by the FHLMC.  The Bank receives a servicing fee from theFHLMC on each loan sold.  Servicingrights are capitalized based on the relative fair value of the rights and theexpected life of the loan and are included in intangible assets on the balancesheet and expensed in proportion to, and over the period of, estimated netservicing revenues.  Mortgage servicingrights were $465 thousand at December 31, 2008, $697 thousand at December 31,2007 and $746 thousand at December 31, 2006.  Amortization of mortgage servicing rights was$417 thousand (including $213 thousand in write downs), $214 thousand and $235thousand for the years ended December 31, 2008, 2007 and 2006,respectively.  See Note 4 in the notes toconsolidated financial statements included as Exhibit 13 for additionalinformation.

 

21

----

 

Deposits

 

For 2008, total depositsincreased $35 million to $521 million.  Noninterest bearing deposits increased $2 million, while time depositsof $100 thousand and over increased $30 million, and other interest bearingdeposits increased $3 million.  Publicfunds totaled $55 million at the end of 2008 ($48 million were interestbearing).

 

Total deposits increasedto $486 million in 2007, up $17 million from 2006.  Noninterest bearing deposits increased $1million, time deposits of $100 thousand and over increased $11 million, andother interest bearing deposits increased $5 million.  Public funds totaled $59 million at the endof 2007 ($58 million were interest bearing), a decrease of $1 million from theend of 2006.

 

The table below providesinformation on the maturities of time deposits of $100,000 or more at December 31,2008:

 

Maturity of Time Deposits of $100,000 ofMore

 
| ** **                               | **At December 31, 2008** | ** ** |
|------------------------------------------|-----------------------------------------|------------|
| ** **                               | **(in thousands)**                 | ** ** |
| Maturing 3 Months or Less                | $                                       | 10,894     |   |
| Maturing over 3 Months through 6 Months  | 12,798                                  |       |
| Maturing over 6 Months through 12 Months | 19,818                                  |       |
| Maturing over 12 Months                  | 64,956                                  |       |
|                                     |                                    |       |
| Total                                    | $                                       | 108,466    |   |

 

Borrowings

 

The Company utilizes bothlong and short term borrowings.  Longterm borrowing at the Bank is mainly from the Federal Home Loan Bank(FHLB).  This borrowing is mainly used tofund longer term, fixed rate mortgages, as part of a leverage strategy and toassist in asset/liability management. Advances are either paid monthly or at maturity.  As of December 31, 2008, $77 million wasborrowed from FHLB, an increase of $13 million from 2007.  During 2008, $51 million of FHLB borrowingwas paid, and advances were made for an additional $64 million.  The 2008 advances were obtained mainly tofund fixed rate loans, as detailed above. In 2007, $16 million of FHLB advances were paid and no additionaladvances were obtained.  The followingtable depicts relevant information concerning our short term borrowings.

 

22

----

 

Short Term Borrowings

 
| ** **                      | ** ** | **As of and for the year ended** | ** ** |
|---------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                      | ** ** | **December 31 (in thousands)**                  | ** ** |
| ** **                      | ** ** | **2008**                                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| Federal Funds Purchased:        |       |                                                           |       |   |   |   |   |
| Balance at Year end             |       | $                                                              | —     |   | $ | — |   | $ | — |   |
| Average Balance During the Year |       | 1,643                                                          |       | 117 |   | 8,616 |   |
| Maximum Month End Balance       |       | —                                                         |       | — |   | 27,723 |   |
| Year end rate                   |       | —                                                         |       | — |   | — |   |
| Average annual rate             |       | 2.25                                                           | %          | 5.24 | % | 5.37 | % |
| Repurchase Agreements:          |       |                                                           |       |   |   |   |   |
| Balance at Year end             |       | $                                                              | 6,617      |   | $ | 5,977 |   | $ | 9,628 |   |
| Average Balance During the Year |       | 9,686                                                          |       | 10,415 |   | 15,661 |   |
| Maximum Month End Balance       |       | 13,125                                                         |       | 16,073 |   | 18,372 |   |
| Year end rate                   |       | 3.09                                                           | %          | 4.72 | % | 3.83 | % |
| Average annual rate             |       | 2.97                                                           | %          | 4.18 | % | 3.79 | % |
| Other Borrowed Funds:           |       |                                                           |       |   |   |   |   |
| Balance at Year end             |       | $                                                              | 4,100      |   | $ | 758 |   | $ | 1,699 |   |
| Average Balance During the Year |       | 2,800                                                          |       | 1,186 |   | 1,719 |   |
| Maximum Month End Balance       |       | 4,500                                                          |       | 2,036 |   | 8,508 |   |
| Year end rate                   |       | 2.46                                                           | %          | 4.79 | % | 5.90 | % |
| Average annual rate             |       | 3.68                                                           | %          | 5.58 | % | 6.15 | % |

 

ContractualObligations

 

TheBank has required future payments for a defined benefit retirement plan, timedeposits and long-term debt.  See Note 13 in the notes to consolidatedfinancial statements included as Exhibit 13 for further information on thedefined benefit retirement plan.  The other required payments under suchcommitments at December 31, 2008 are as follows:

 
| ** **                       | ** ** | **Payments due by period (in thousands)** | ** ** |
|----------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                       | ** ** | ** **                                                         | ** ** | **Less** | ** ** | ** ** | ** ** | ** ** | ** ** | **More** | ** ** |
| ** **                       | ** ** | ** **                                                         | ** ** | **than 1** | ** ** | **1-3** | ** ** | **3-5** | ** ** | **than 5** | ** ** |
| **Contractual Obligations** | ** ** | **Total**                                                          | ** ** | **year** | ** ** | **years** | ** ** | **years** | ** ** | **years** | ** ** |
|                             |       |                                                               |       |   |   |   |   |   |   |   |   |
| FHLB advances                    |       | $                                                                  | 77,301     |   | $ | 32,168 |   | $ | 20,495 |   | $ | 18,974 |   | $ | 5,664 |   |
| Subordinated  debentures         |       | 7,217                                                              |       | — |   | — |   | — |   | 7,217 |   |
| Time deposits                    |       | 276,957                                                            |       | 124,066 |   | 148,537 |   | 3,675 |   | 679 |   |
|                                  |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Asset Quality

 

With respect to assetquality, management considers three categories of assets to merit closescrutiny.  These categories include:  loans that are currently nonperforming, otherreal estate, and loans that are currently performing but which managementbelieves require special attention.

 

During periods ofeconomic slowdown, the Company may experience an increase in nonperformingloans.

 

23

----

 

The Company discontinuesthe accrual of interest on loans that become 90 days past due as to principalor interest unless reasons for delinquency are documented such as the loanbeing well collateralized and in the process of collection.  A loan remains in a non-accrual status untilfactors indicating doubtful collection no longer exist.  A loan is classified as a restructured loanwhen the interest rate is materially reduced or the term is extended beyond theoriginal maturity date because of the inability of the borrower to service theinterest payments at market rates.  Otherreal estate is recorded at fair market value less estimated costs to sell.  A summary of the components of nonperformingassets, including several ratios using period-end data, is shown below.

 

Nonperforming Assets

 
| ** **                                                                                    | ** ** | **At December 31 (dollars in thousands)** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2008**                                                           | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Non-accrual Loans                                                                             |       | $                                                                  | 6,562      |   | $ | 6,358 |   | $ | 2,379 |   | $ | 774 |   | $ | 1,781 |   |
| Accruing Loans which are Contractually past due 90 days or more                               |       | 779                                                                |       | 195 |   | 253 |   | 206 |   | 308 |   |
| Restructured Loans                                                                            |       | —                                                             |       | — |   | — |   | — |   | — |   |
| Total Nonperforming Loans                                                                     |       | 7,341                                                              |       | 6,553 |   | 2,632 |   | 980 |   | 2,089 |   |
| Other Real Estate                                                                             |       | 1,840                                                              |       | 768 |   | 411 |   | 141 |   | 676 |   |
| Total Nonperforming Assets                                                                    |       | 9,181                                                              |       | 7,321 |   | 3,043 |   | 1,121 |   | 2,765 |   |
| Total Nonperforming Loans as a Percentage of Loans (including loans  held for sale) (1)  |       | 1.73                                                               | %          | 1.57 | % | 0.59 | % | 0.26 | % | 0.58 | % |
| Total Nonperforming Assets as a Percentage of Total Assets                                    |       | 1.35                                                               | %          | 1.16 | % | 0.48 | % | 0.20 | % | 0.52 | % |
| Allowance to nonperforming assets                                                             |       | 0.60                                                               |       | 0.67 |   | 1.64 |   | 3.84 |   | 1.51 |   |
|                                                                                               |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)  Net of deferredloan fees

 

Total nonperformingassets at December 31, 2008 were $9.2 million compared to $7.3 million at December 31,2007 and $3.0 million at December 31, 2006.  The increase from 2007 to 2008 is primarilyattributable to an increase in other real estate.  The increase from 2006 to 2007 isattributable to the increase in various loans being put on non-accrual andadditions to other real estate.  Totalnonperforming loans were $7.3 million, $6.6 million, and $2.6 million at December 31,2008, 2007 and 2006, respectively.  Theincrease in loans past due 90 days or more is primarily attributable to 3borrowers totaling $482 thousand and ranging from $147 thousand to $179thousand.  All are secured by realestate.  The non-accrual loan increasefrom 2006 to 2007 is mainly attributable to a $2.0 million loan, a $921 thousandloan and 13 other loans greater than $100,000, but less than $245,000.  All these loans are secured by realestate.  The amount of lost interest onour non-accrual loans is immaterial.  At December 31,2008, loans currently performing but which management believes require specialattention were not significant.  TheCompany continues to follow its long-standing policy of not engaging ininternational lending and not concentrating lending activity in any oneindustry.

 

Impaired loans as of December 31,2008 were $5.1 million compared to $2.1 million in 2007 and $3.4 million in2006.  These amounts are generallyincluded in the total nonperforming and restructured loans presented in thetable above.  See Note 4 in the notes toconsolidated financial statements included as Exhibit 13.

 

24

----

 

A loan is consideredimpaired when it is probable that all principal and interest amounts will notbe collected according to the loan contract. The allowance for loan losses on impaired loans is determined using thepresent value of estimated future cash flows of the loan, discounted at theloan’s effective interest rate or the fair value of the underlyingcollateral.  The entire change in presentvalue of expected cash flows is reported as a provision for loan losses in thesame manner in which impairment initially was recognized or as a reduction inthe amount of provision for loan losses that otherwise would be reported.  The total allowance for loan losses relatedto these loans was $320 thousand, $692 thousand and $955 thousand on December 31,2008, 2007 and 2006, respectively.

 

Loan Losses

 

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

 
| ** **                                             | ** ** | **For the Year Ended December 31 (in thousands)** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **2008**                                                                             | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Balance at Beginning of Year                           |       | $                                                                                    | 4,879      |   | $ | 4,991 |   | $ | 4,310 |   | $ | 4,163 |   | $ | 3,820 |   |
| Balance of Allowance for Loan                          |       |                                                                                 |       |   |   |   |   |   |   |   |   |
| Losses of Acquired Bank at Acquisition Date            |       | —                                                                               |       | — |   | 775 |   | — |   | — |   |
| Amounts Charged-off:                                   |       |                                                                                 |       |   |   |   |   |   |   |   |   |
| Commercial                                             |       | 114                                                                                  |       | 131 |   | 15 |   | 146 |   | 197 |   |
| Real Estate Construction                               |       | 637                                                                                  |       | 374 |   | 28 |   | — |   | — |   |
| Real Estate Mortgage                                   |       | 1,981                                                                                |       | 289 |   | 232 |   | 134 |   | 110 |   |
| Agricultural                                           |       | 101                                                                                  |       | 25 |   | 3 |   | 21 |   | 88 |   |
| Consumer                                               |       | 563                                                                                  |       | 449 |   | 365 |   | 225 |   | 293 |   |
| Total Charged-off Loans                                |       | 3,396                                                                                |       | 1,268 |   | 643 |   | 526 |   | 688 |   |
| Recoveries on Amounts Previously Charged-off:          |       |                                                                                 |       |   |   |   |   |   |   |   |   |
| Commercial                                             |       | 6                                                                                    |       | 24 |   | 2 |   | 3 |   | 10 |   |
| Real Estate Construction                               |       | 27                                                                                   |       | 19 |   | — |   | — |   | — |   |
| Real Estate Mortgage                                   |       | 165                                                                                  |       | 10 |   | 2 |   | 11 |   | 42 |   |
| Agricultural                                           |       | 30                                                                                   |       | 64 |   | 21 |   | 16 |   | 21 |   |
| Consumer                                               |       | 54                                                                                   |       | 39 |   | 49 |   | 135 |   | 118 |   |
| Total Recoveries                                       |       | 282                                                                                  |       | 156 |   | 74 |   | 165 |   | 191 |   |
| Net Charge-offs                                        |       | 3,114                                                                                |       | 1,112 |   | 569 |   | 361 |   | 497 |   |
| Provision for Loan Losses                              |       | 3,700                                                                                |       | 1,000 |   | 475 |   | 508 |   | 840 |   |
| Balance at End of Year                                 |       | 5,465                                                                                |       | 4,879 |   | 4,991 |   | 4,310 |   | 4,163 |   |
| Total Loans (1)                                        |       |                                                                                 |       |   |   |   |   |   |   |   |   |
| Average                                                |       | 416,668                                                                              |       | 430,884 |   | 408,131 |   | 361,732 |   | 338,465 |   |
| At December 31                                    |       | 424,277                                                                              |       | 417,388 |   | 444,150 |   | 370,912 |   | 358,456 |   |
| As a Percentage of Average Loans (1):                  |       |                                                                                 |       |   |   |   |   |   |   |   |   |
| Net Charge-offs                                        |       | 0.75                                                                                 | %          | 0.26 | % | 0.14 | % | 0.10 | % | 0.15 | % |
| Provision for Loan Losses                              |       | 0.89                                                                                 | %          | 0.23 | % | 0.12 | % | 0.14 | % | 0.25 | % |
| Allowance as a Percentage of Year-end Loans (1)        |       | 1.29                                                                                 | %          | 1.17 | % | 1.12 | % | 1.16 | % | 1.16 | % |
| Beginning Allowance as a Multiple of Net Charge-offs   |       | 1.6                                                                                  |       | 4.5 |   | 7.6 |   | 11.5 |   | 7.7 |   |
| Ending Allowance as a Multiple of Nonperforming Assets |       | 0.60                                                                                 |       | 0.67 |   | 1.64 |   | 3.84 |   | 1.51 |   |
|                                                        |            |                                                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)  Including loansheld for sale, net of deferred loan fees

 

25

----

 

Loans are typicallycharged-off after being 120 days delinquent.  Limited exceptions for not charging-off a loanwould be well documented and approved by the appropriate responsible party orcommittee.  The provision for loan lossesfor 2008 was $3.7 million dollars compared to $1.0 million in 2007 and $475thousand in 2006.  Net charge-offs were$3.1 million in 2008, $1.1 million in 2007 and $569 thousand in 2006.  Net charge-offs to average loans were 0.75%,0.26% and 0.14% in 2008, 2007 and 2006, respectively.  Based on the quality of the loan portfolio,the loan loss provision increased $2.7 million from 2007 to 2008 and $525thousand from 2006 to 2007.  Inevaluating the allowance for loan losses, management considers the compositionof the loan portfolio, the historical loan loss experience, the overall qualityof the loans and an assessment of current economic conditions.  The recent decline in the economy hasresulted in more loan losses, higher loan loss provision and declining loanquality numbers over the past year.  At December 31,2008, the allowance for loan losses was 1.29% of loans outstanding compared to1.17% at year-end 2007 and 1.12% at year-end 2006.  Management believes the allowance for loanlosses at the end of 2007 is adequate to cover probable incurred credit losseswithin the portfolio.

 

26

----

 

The following tables setforth an allocation for the allowance for loan losses and loans by category anda percentage distribution of the allowance allocation.  In making the allocation, managementevaluates the risk in each category, current economic conditions and charge-offexperience.  An allocation for theallowance for loan losses is an estimate of the portion of the allowance thatwill be used to cover future charge-offs in each loan category, but it does notpreclude any portion of the allowance allocated to one type of loan being usedto absorb losses of another loan type.

 

Allowance for Loan Losses

 
| ** **               | ** ** | **2008**    | ** ** | **2007**       | ** ** | **2006**    | ** ** | **2005**       | ** ** | **2004**    | ** ** |
|--------------------------|------------|-------------|------------|----------------|------------|-------------|------------|----------------|------------|-------------|------------|
| ** **               | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Commercial               |       | $           | 529        |           | 9.68       | %           | $          | 537            |       | 11.01       | %          | $ | 594 |   | 11.90 | % | $ | 507 |   | 11.77 | % | $ | 350 |   | 8.41 | % |
| Real Estate Construction |       | 623         |       | 11.40          | %          | 633         |       | 12.97          | %          | 638         |       | 12.78 | % | 566 |   | 13.14 | % | 566 |   | 13.60 | % |
| Real Estate Mortgage     |       | 2,211       |       | 40.46          | %          | 1,827       |       | 37.45          | %          | 1,806       |       | 36.19 | % | 1,785 |   | 41.42 | % | 1,801 |   | 43.26 | % |
| Agricultural             |       | 1,259       |       | 23.04          | %          | 1,180       |       | 24.19          | %          | 1,241       |       | 24.86 | % | 1,023 |   | 23.74 | % | 1,028 |   | 24.69 | % |
| Consumer                 |       | 843         |       | 15.42          | %          | 702         |       | 14.39          | %          | 712         |       | 14.27 | % | 428 |   | 9.93 | % | 418 |   | 10.04 | % |
| Total                    |       | 5,465       |       | 100.00         | %          | 4,879       |       | 100.00         | %          | 4,991       |       | 100.00 | % | 4,309 |   | 100.00 | % | 4,163 |   | 100.00 | % |
|                          |            |             |            |                |            |             |            |                |            |             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Loans

 
| ** **               | ** ** | **2008**    | ** ** | **2007**       | ** ** | **2006**    | ** ** | **2005**       | ** ** | **2004**    | ** ** |
|--------------------------|------------|-------------|------------|----------------|------------|-------------|------------|----------------|------------|-------------|------------|
| ** **               | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Commercial               |       | $           | 21,505     |           | 5.07       | %           | $          | 22,924         |       | 5.49        | %          | $ | 29,335 |   | 6.60 | % | $ | 27,302 |   | 7.36 | % | $ | 19,999 |   | 5.58 | % |
| Real Estate Construction |       | 16,819      |       | 3.96           | %          | 26,172      |       | 6.27           | %          | 29,034      |       | 6.54 | % | 29,822 |   | 8.04 | % | 32,256 |   | 9.00 | % |
| Real Estate Mortgage     |       | 286,846     |       | 67.61          | %          | 270,494     |       | 64.81          | %          | 290,068     |       | 65.31 | % | 245,138 |   | 66.09 | % | 238,651 |   | 66.58 | % |
| Agricultural             |       | 80,779      |       | 19.04          | %          | 80,774      |       | 19.35          | %          | 79,627      |       | 17.93 | % | 59,328 |   | 16.00 | % | 57,497 |   | 16.04 | % |
| Consumer                 |       | 17,643      |       | 4.16           | %          | 15,421      |       | 3.69           | %          | 15,684      |       | 3.53 | % | 8,954 |   | 2.41 | % | 9,062 |   | 2.53 | % |
| Other                    |       | 685         |       | 0.16           | %          | 1,603       |       | 0.38           | %          | 402         |       | 0.09 | % | 368 |   | 0.10 | % | 991 |   | 0.28 | % |
| Total, Net (1)           |       | 424,277     |       | 100.00         | %          | 417,388     |       | 100.00         | %          | 444,150     |       | 100.00 | % | 370,912 |   | 100.00 | % | 358,456 |   | 100.00 | % |
|                          |            |             |            |                |            |             |            |                |            |             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)  Including loansheld for sale, net of deferred loan fees

 

27

----

 

Off-balance SheetArrangements

 

Some financialinstruments, such as loan commitments, credit lines, letters of credit, andoverdraft protection, are issued to meet customer financing needs.  These are agreements to provide credit or tosupport the credit of others, as long as conditions established in the contractare met, and usually have expiration dates. Commitments may expire without being used.  Off-balance sheet risk to credit loss existsup to the face amount of these instruments, although material losses are notanticipated.  The same credit policiesare used to make such commitments as are used for loans, including obtainingcollateral at exercise of the commitment.

 

Financial instrumentswith off-balance sheet risk were as follows at year-end:

 
| ** **                 | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|----------------------------|------------|------------|------------|------------|------------|
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unused lines of  credit    |       | $          | 64,791,109 |       | $          | 65,298,282 |   |
| Commitments to  make loans |       | 5,214,000  |       | 1,871,000  |       |
| Letters of  credit         |       | 794,066    |       | 907,335    |       |
|                            |            |            |            |            |            |  |  |

 

Unused lines of creditare substantially all at variable rates. Commitments to make loans are generally made for a period of 60 days orless and are primarily fixed at current market rates ranging from 4.38% to6.14% with maturities ranging from 15 to 30 years and are intended to be sold.

 

Capital

 

As displayed by thefollowing table, the Company’s Tier I capital (as defined by the FederalReserve Board under the Board’s risk-based guidelines) at December 31,2008 increased $2.8 million to $54.4 million. During 2008, the Company purchased 114,148 shares of its stock for $3.1million.  These repurchases partiallyoffset the $3.7 million in net income for 2008. Stockholders’ equity, excluding accumulated other comprehensive income,was $57.0 million at December 31, 2008. Included in Tier I capital is $7 million of trust preferred securities issuedin August 2003.  The disallowedamount of stockholders’ equity is mainly attributable to the goodwill and coredeposit intangible, resulting from the Peoples acquisition in 2006 and theKentucky First acquisition in 2003 (see Note 6 in the notes to consolidatedfinancial statements included as Exhibit 13 for more information on thegoodwill and core deposit intangible assets). The Company’s risk-based capital and leverage ratios, as shown in thefollowing table, exceeded the levels required to be considered “wellcapitalized”.  The leverage ratiocompares Tier I capital to total average assets less disallowed amounts ofgoodwill.

 
| ** **                             | ** ** | **At December 31 (dollars in thousands)** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                             | ** ** | **2008**                                                           | ** ** | **2007** | ** ** | **Change** | ** ** |
| Stockholders’ Equity (1)          |       | $                                                                  | 57,026     |   | $ | 59,432 |   | (2,406 | ) |
| Trust Preferred Securities             |       | 7,000                                                              |       | 7,000 |   | — |   |
| Less Disallowed Amount                 |       | 9,662                                                              |       | 14,904 |   | (5,242 | ) |
| Tier I Capital                         |       | 54,364                                                             |       | 51,528 |   | 2,836 |   |
| Allowance for Loan Losses              |       | 5,540                                                              |       | 4,954 |   | 586 |   |
| Other                                  |       | 9                                                                  |       | 9 |   | — |   |
| Tier II Capital                        |       | 5,549                                                              |       | 4,963 |   | 586 |   |
| Total Capital                          |       | 59,913                                                             |       | 56,491 |   | 3,422 |   |
| Total Risk Weighted Assets             |       | 445,222                                                            |       | 414,171 |   | 31,251 |   |
| Ratios:                                |       |                                                               |       |   |   |   |   |
| Tier I Capital to Risk-weighted Assets |       | 12.2                                                               | %          | 12.4 | % | -0.2 | % |
| Total Capital to Risk-weighted Assets  |       | 13.5                                                               | %          | 13.6 | % | -0.2 | % |
| Leverage                               |       | 8.3                                                                | %          | 8.4 | % | -0.1 | % |
|                                        |            |                                                                    |            |  |  |  |  |  |  |

 

----

(1)    Excludingaccumulated other comprehensive income.

 

28

----

 

The Federal DepositInsurance Corporation Improvement Act of 1991 (“FDICIA”) established fivecapital categories for insured depository institutions under its PromptCorrective Action Provisions.  The bankregulatory agencies adopted regulations, which became effective in 1992,defining these five capital categories for banks they regulate.  The categories vary from “well capitalized”to “critically undercapitalized”.  A “wellcapitalized” bank is defined as one with a total risk-based capital ratio of10% or more, a Tier I risk-based capital ratio of 6% or more, a leverage ratioof 5% or more, and one not subject to any order, written agreement, capitaldirective, or prompt corrective action directive to meet or maintain a specificcapital level.  At December 31,2008, the bank had ratios that exceeded the minimum requirements establishedfor the “well capitalized” category.

 

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

 

Securities and FederalFunds Sold

 

Securities,classified as available for sale, increased from $147.8 million at December 31,2007 to $172.8 million at December 31, 2008.  The increase is mainly attributable to ashort term increase in deposits.  Federalfunds sold totaled $20.7 million at December 31, 2008 and $10.4 million atDecember 31, 2007.

 

Per Company policy, fixedrate asset backed securities will not have an average life exceeding sevenyears, but final maturity may be longer. Adjustable rate securities shall adjust within three years per Companypolicy.  As of December 31, 2008 and2007, the Company held no adjustable rate mortgage backed securities.  Unrealized gains (losses) on investmentsecurities are temporary and change inversely with movements in interest rates.  In addition, some prepayment risk exists onmortgage-backed securities and prepayments are likely to increase withdecreases in interest rates.  Thefollowing tables present the investment securities for each of the past threeyears and the maturity and yield characteristics of securities as of December 31,2008.

 

Investment Securities atmarket value

 
| ** **                        | ** ** | **At December 31 (in thousands)** | ** ** |
|-----------------------------------|------------|-------------------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Available for Sale                |       |                                                  |       |   |   |   |   |
| U.S. government agencies          |       | $                                                     | 19,350     |   | $ | 36,021 |   | $ | 31,492 |   |
| States and political subdivisions |       | 63,971                                                |       | 59,361 |   | 44,130 |   |
| Mortgage-backed                   |       |                                                  |       |   |   |   |   |
| Fixed -                           |       |                                                  |       |   |   |   |   |
| GNMA, FNMA, FHLMC Passthroughs    |       | 76,028                                                |       | 40,261 |   | 38,262 |   |
| GNMA, FNMA, FHLMC CMO’s      |       | 13,195                                                |       | 11,817 |   | 13,720 |   |
| Total mortgage-backed             |       | 89,223                                                |       | 52,078 |   | 51,982 |   |
| Other                             |       | 290                                                   |       | 290 |   | 287 |   |
| Total                             |       | $                                                     | 172,834    |   | $ | 147,750 |   | $ | 127,891 |   |

 

29

----

 

Maturity Distribution ofSecurities

 
| ** **                        | ** ** | **December 31, 2008 (in thousands)** | ** ** | ** **                | ** ** | ** **         | ** ** |
|-----------------------------------|------------|----------------------------------------------------------|------------|---------------------------|------------|--------------------|------------|
| ** **                        | ** ** | ** **                                               | ** ** | **Over One**         | ** ** | **Over Five** | ** ** | ** ** | ** ** | **Asset** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **                                               | ** ** | **Year**                  | ** ** | **Years**          | ** ** | ** ** | ** ** | **Backed** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **One Year**                                        | ** ** | **Through**               | ** ** | **Through**        | ** ** | **Over Ten** | ** ** | **& Equity** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **or Less**                                         | ** ** | **Five Years ** | ** ** | **Ten Years** | ** ** | **Years** | ** ** | **Securities** | ** ** | **Total** | ** ** |
| Available for Sale                |       |                                                     |       |                      |       |               |       |   |   |   |   |   |   |
| U.S. government agencies          |       | $                                                        | 2,997      |                      | $          | 7,078              |       | $ | 8,269 |   | $ | 1,006 |   | $ | — |   | $ | 19,350 |   |
| States and political subdivisions |       | 587                                                      |       | 6,814                     |       | 17,635             |       | 38,935 |   | — |   | 63,971 |   |
| Mortgage-backed                   |       | —                                                   |       | —                    |       | —             |       | — |   | 89,223 |   | 89,223 |   |
| Equity Securities                 |       | —                                                   |       | —                    |       | —             |       | — |   | 290 |   | 290 |   |
| Total                             |       | 3,584                                                    |       | 13,892                    |       | 25,904             |       | 39,941 |   | 89,513 |   | 172,834 |   |
| Percent of Total                  |       | 2.1                                                      | %          | 8.0                       | %          | 15.0               | %          | 23.1 | % | 51.8 | % | 100.0 | % |
| Weighted Average Yield (1)        |       | 3.40                                                     | %          | 4.94                      | %          | 5.50               | %          | 5.89 | % | 5.33 | % | 5.41 | % |
|                                   |            |                                                          |            |                           |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)     TaxEquivalent yield

 

Impact of Inflation andChanging Prices

 

The majority of theCompany’s assets and liabilities are monetary in nature.  Therefore, the Company differs greatly frommost commercial and industrial companies that have significant investments innonmonetary assets and inventories. However, inflation does have an important impact on the growth of assetsin the banking industry and the resulting need to increase equity capital athigher than normal rates in order to maintain an appropriate equity to assetsratio.  Inflation also affects otherexpenses, which tend to rise during periods of inflation.

 

**Item 7A.  Quantitative and Qualitative Disclosuresabout Market Risk**

 

Asset/Liabilitymanagement control is designed to ensure safety and soundness, maintainliquidity and regulatory capital standards, and achieve acceptable net interestincome.  The Company’s exposure to market risk is reviewed on a regular basis bythe Asset/Liability Committee.

 

Managementconsiders interest rate risk to be the most significant market risk.  Interestrate risk is the potential of economic losses due to future interest ratechanges.  These economic losses can bereflected as a loss of future net interest income and/or a loss of current fairmarket values.  The objective is tomeasure the effect on net interest income and to adjust the balance sheet tominimize the inherent risk while at the same time maximize income.

 

Managementrealizes certain risks are inherent and that the goal is to identify andminimize the risks.  The primary toolused by management is an interest rate shock simulation model.  Certain assumptions, such as prepaymentrisks, are included in the model. However, actual prepayments may differ from those assumptions.  In addition, immediate withdrawal of interestchecking and other savings accounts may have an effect on the results of themodel.  The Bank has no market risksensitive instruments held for trading purposes.

 

Thefollowing table depicts the change in net interest income resulting from 100and 300 basis point changes in rates. The projections are based on balance sheet growth assumptions andrepricing opportunities for new, maturing and adjustable rate amounts.  In addition, the projected percentage changesfrom level rates are outlined below along with the Board of Directors approvedlimits.  As of December 31, 2008 theprojected net interest income percentages are within the Board of Directorslimits.  Please note that at the currentlow level of interest rates, many rates cannot decline by 300 or 100 basispoints, so the projected net interest income changes below as of December 31,2008 for a declining rates is not relevant. The projected net interest income 

 

30

----

 

reportsummarizing the Company’s interest rate sensitivity as of December 31,2008 and December 31, 2007 is as follows:

 

ProjectedNet Interest Income (December 31, 2008)

 
| ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | **Level** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|-----------|------------|------------|------------|------------|------------|
| ** **                            | ** ** | **-300**   | ** ** | **-100**   | ** ** | **Rates** | ** ** | **+100**   | ** ** | **+300**   | ** ** |
| Net interest income                   |       | 18,889     |       | 19,918     |       | 21,191    |       | 22,380     |       | 23,237     |       |
|                                  |       |       |       |       |       |      |       |       |       |       |       |
| Net interest income dollar change     |       | (2,302     | )          | (1,273     | )          | —    |       | 1,189      |       | 2,046      |       |
|                                  |       |       |       |       |       |      |       |       |       |       |       |
| Net interest income percentage change |       | -10.9      | %          | -6.0       | %          | N/A       |       | 5.6        | %          | 9.7        | %          |
|                                  |       |       |       |       |       |      |       |       |       |       |       |
| Limitation on % Change                |       | >-18.0  | %          | >-6.0   | %          | N/A       |       | >-4.0   | %          | >-10.0  | %          |

 

ProjectedNet Interest Income (December 31, 2007)

 
| ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | **Level** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|-----------|------------|------------|------------|------------|------------|
| **Rate Change:**                 | ** ** | **-300**   | ** ** | **-100**   | ** ** | **Rates** | ** ** | **+100**   | ** ** | **+300**   | ** ** |
|                                  |       |       |       |       |       |      |       |       |       |       |       |
| Year One (1/08 – 12/08)          |       |       |       |       |       |      |       |       |       |       |       |
| Net interest income                   |       | 21,293     |       | 21,608     |       | 21,815    |       | 21,758     |       | 21,943     |       |
|                                  |       |       |       |       |       |      |       |       |       |       |       |
| Net interest income dollar change     |       | (522       | )          | (207       | )          | —    |       | (57        | )          | 128        |       |
|                                  |       |       |       |       |       |      |       |       |       |       |       |
| Net interest income percentage change |       | -2.4       | %          | -0.9       | %          | N/A       |       | -0.3       | %          | 0.6        | %          |
|                                  |       |       |       |       |       |      |       |       |       |       |       |
| Limitation on % Change                |       | >-18.0  | %          | >-6.0   | %          | N/A       |       | >-4.0   | %          | >-10.0  | %          |

 

The numbers in 2008 showmore fluctuation when compared to 2007. In 2008, year one reflected an increase in net interest income of 5.6%compared to 0.3% projected decrease from 2007 with a 100 basis pointincrease.  The 300 basis point increasein rates reflected a 9.7% increase in net interest income in 2008 compared to a0.6% increase in 2007.  The risk is morein 2008 due to the current status of existing interest rates and their effecton rate sensitive assets and rate sensitive liabilities.  Based on the model, a 300 basis pointincrease in rates would increase net interest income.

 

Managementmeasures the Company’s interest rate risk by computing estimated changes in netinterest income in the event of a range of assumed changes in market interestrates.  The Company’s exposure tointerest rates is reviewed on a monthly basis by senior management andquarterly with the Board of Directors. Exposure to interest rate risk is measured with the use of interest ratesensitivity analysis to determine the change in net interest income in theevent of hypothetical changes in interest rates, while interest ratesensitivity gap analysis is used to determine the repricing characteristics ofthe Company’s assets and liabilities.  Ifestimated changes to net interest income are not within the limits establishedby the Board, the Board may direct management to adjust the Company’s asset andliability mix to bring interest rate risk within Board approved limits.

 

Liquidity risk is thepossibility that the Company may not be able to meet its cashrequirements.  Management of liquidityrisk includes maintenance of adequate cash and sources of cash to fundoperations and meet the needs of borrowers, depositors and creditors.  Excess liquidity generally has a negativeimpact on earnings resulting from the lower yields on short-term assets.

 

In addition to cash andcash equivalents, the securities portfolio provides an important source ofliquidity.  Total securities maturing 

 

31

----

 

within one year alongwith cash and cash equivalents totaled $24.3 million at December 31,2008.  Additionally, securitiesavailable-for-sale with maturities greater than one year totaled $169.2 millionat December 31, 2008.  The availablefor sale securities are available to meet liquidity needs on a continuingbasis.

 

The Company maintains arelatively stable base of customer deposits and its steady growth is expectedto be adequate to meet its funding demands. In addition, management believes the majority of its $100,000 or morecertificates of deposit are no more volatile than its core deposits.  At December 31, 2008 these balancestotaled $108.5 million, approximately 21% of total deposits.

 

The Company also relieson FHLB advances for both liquidity and asset/liability managementpurposes.  These advances are usedprimarily to fund long-term fixed rate residential mortgage loans.  We have sufficient collateral to borrow anadditional $25 million from the FHLB at December 31, 2008.

 

Generally, the Companyrelies upon net cash inflows from financing activities, supplemented by netcash inflows from operating activities, to provide cash used in its investingactivities.  As is typical of manyfinancial institutions, significant financing activities include depositgathering, and the use of short-term borrowings, such as federal fundspurchased and securities sold under repurchase agreements along with long-termdebt.  The Company’s primary investingactivities include purchasing investment securities and loan originations.  Management believes there is sufficient cashflow from operations to meet investing and liquidity needs related to reasonableborrower, depositor and creditor needs in the present economic environment.

 

The cash flow statementsfor the periods presented provide an indication of the Company’s sources anduses of cash as well as an indication of the ability of the Company to maintainan adequate level of liquidity.

 

A number of othertechniques are used to measure the liquidity position, including the ratiospresented below.  These ratios arecalculated based on annual averages for each year.

 

Liquidity Ratios

 
| ** **                                                                                  | ** ** | **December 31** | ** ** |
|---------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                  | ** ** | **2008**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Average Loans (including loans held for sale) /Average Deposits                             |       | 86.2                 | %          | 89.6 | % | 93.6 | % |
| Average Securities sold under agreements to repurchase and other  borrowings/Average Assets |       | 3.3                  | %          | 3.0 | % | 5.6 | % |

 

Thischart shows that the loan to deposit ratio decreased in 2008 and 2007.  The decrease in the ratio in 2008 compared to2007 is mainly attributable to an increase in deposits.  The decrease in the ratio in 2007 compared to2006 is mainly attributable to a larger increase in deposits and a decrease inloans.

 

**Item 8.  Financial Statements**

 

The consolidatedfinancial statements of the Company together with the notes thereto and reportof independent registered public accountants are contained in the Company’s2008 Annual Report to Stockholders included as Exhibit 13, and areincorporated herein by reference.  Noother portion of the 2008 Annual Report to Stockholders is to be deemed “filed”as part of this filing.

 

32

----

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM

 

Audit Committee

Kentucky Bancshares, Inc.

Paris, Kentucky

 

We have audited theaccompanying balance sheets of Kentucky Bancshares, Inc. as of December 31,2008 and 2007, and the related statements of income, comprehensive income,changes in stockholders’ equity, and cash flows for each of the three years inthe period ended December 31, 2008. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

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

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the financial position of the Company as of December 31, 2008and 2007, and the results of its operations and its cash flows for each of thethree years in the period ended December 31, 2008, in conformity with U.S.generally accepted accounting principles.

 

 
|                |   | /s/Crowe Horwath LLP |
|---------------------|--------|----------------------|
|                |   | Crowe Horwath LLP    |
| Lexington, Kentucky |   |                 |
| March 30, 2009 |   |                 |

 

33

----

 

KENTUCKY BANCSHARES, INC.

Paris, Kentucky

 

CONSOLIDATED FINANCIALSTATEMENTS

December 31, 2008,2007 and 2006

 

34

----

 

CONSOLIDATEDBALANCE SHEETS

December 31

 
| ** **                                                                                                                         | ** ** | **2008**    | ** **  | **2007**    | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
| **ASSETS**                                                                                                                         | ** ** | ** **  | ** **  | ** **  | ** ** |
| Cash and due  from banks                                                                                                           |       | $           | 16,410,988  |        | $          | 15,445,596 |   |
| Federal funds  sold                                                                                                                |       | 20,695,000  |        | 10,361,000  |       |
| Cash and cash  equivalents                                                                                                         |       | 37,105,988  |        | 25,806,596  |       |
| Securities  available for sale                                                                                                     |       | 172,833,766 |        | 147,749,546 |       |
| Loans                                                                                                                              |       | 424,276,517 |        | 417,388,048 |       |
| Allowance for  loan losses                                                                                                         |       | (5,464,864  | )           | (4,878,732  | )          |
| Net loans                                                                                                                          |       | 418,811,653 |        | 412,509,316 |       |
|                                                                                                                               |       |        |        |        |       |
| Federal Home  Loan Bank stock                                                                                                      |       | 6,730,600   |        | 6,468,200   |       |
| Bank premises  and equipment, net                                                                                                  |       | 17,874,706  |        | 16,323,314  |       |
| Interest  receivable                                                                                                               |       | 5,155,727   |        | 5,219,814   |       |
| Mortgage  servicing rights                                                                                                         |       | 465,271     |        | 696,826     |       |
| Goodwill                                                                                                                           |       | 13,116,710  |        | 13,116,710  |       |
| Other intangible  assets                                                                                                           |       | 1,522,677   |        | 1,787,413   |       |
| Other assets                                                                                                                       |       | 5,158,130   |        | 1,261,106   |       |
|                                                                                                                               |       |        |        |        |       |
| **Total  assets**                                                                                                                  |       | $           | 678,775,228 |        | $          | 630,938,841 |   |
| ** **                                                                                                                         |       |        |        |        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                     | ** ** | ** **  | ** **  | ** **  | ** ** |
| Deposits                                                                                                                           |       |        |        |        |       |
| Non-interest  bearing                                                                                                              |       | $           | 90,479,772  |        | $          | 88,520,944 |   |
| Time deposits,  $100,000 and over                                                                                                  |       | 108,465,600 |        | 78,060,572  |       |
| Other interest  bearing                                                                                                            |       | 321,862,857 |        | 319,423,702 |       |
| Total deposits                                                                                                                     |       | 520,808,229 |        | 486,005,218 |       |
| Repurchase  agreements and other borrowings                                                                                        |       | 10,717,277  |        | 6,734,630   |       |
| Federal Home  Loan Bank advances                                                                                                   |       | 77,300,931  |        | 63,993,472  |       |
| Subordinated  debentures                                                                                                           |       | 7,217,000   |        | 7,217,000   |       |
| Interest payable                                                                                                                   |       | 2,874,192   |        | 4,983,549   |       |
| Other  liabilities                                                                                                                 |       | 2,817,043   |        | 3,160,874   |       |
| Total  liabilities                                                                                                                 |       | 621,734,672 |        | 572,094,743 |       |
|                                                                                                                               |       |        |        |        |       |
| Stockholders’  equity                                                                                                         |       |        |        |        |       |
| Preferred stock,  300,000 shares authorized and unissued                                                                           |       | —      |        | —      |       |
| Common stock, no  par value; 10,000,000 shares authorized; 2,745,729 and 2,849,056 shares  issued and outstanding in 2008 and 2007 |       | 12,343,958  |        | 12,672,582  |       |
| Retained  earnings                                                                                                                 |       | 44,682,526  |        | 46,759,262  |       |
| Accumulated  other comprehensive income (loss)                                                                                     |       | 14,072      |        | (587,746    | )          |
| Total stockholders’  equity                                                                                                   |       | 57,040,556  |        | 58,844,098  |       |
|                                                                                                                               |       |        |        |        |       |
| **Total  liabilities and stockholders’ equity**                                                                               |       | $           | 678,775,228 |        | $          | 630,938,841 |   |

 

See Accompanyingnotes.

 

35

----

 

CONSOLIDATED STATEMENTSOF INCOME

Years Ended December 31

 
| ** **                                           | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Interest income                                      |       |       |       |       |       |       |       |
| Loans, including  fees                               |       | $          | 27,481,123 |       | $          | 31,798,307 |       | $ | 29,068,728 |   |
| Securities                                           |       |       |       |       |       |       |       |
| Taxable                                              |       | 4,360,377  |       | 3,810,348  |       | 4,395,404  |       |
| Tax exempt                                           |       | 2,580,740  |       | 2,134,600  |       | 1,666,382  |       |
| Other                                                |       | 706,621    |       | 1,475,831  |       | 462,333    |       |
|                                                 |       | 35,128,861 |       | 39,219,086 |       | 35,592,847 |       |
| Interest expense                                     |       |       |       |       |       |       |       |
| Deposits                                             |       | 11,381,410 |       | 15,124,114 |       | 12,117,444 |       |
| Repurchase  agreements and other borrowings          |       | 428,192    |       | 506,835    |       | 1,162,350  |       |
| Federal Home  Loan Bank advances                     |       | 3,079,895  |       | 2,908,818  |       | 2,944,217  |       |
| Subordinated  debentures                             |       | 469,651    |       | 494,338    |       | 494,197    |       |
|                                                 |       | 15,359,148 |       | 19,034,105 |       | 16,718,208 |       |
|                                                 |       |       |       |       |       |       |       |
| Net interest  income                                 |       | 19,769,713 |       | 20,184,981 |       | 18,874,639 |       |
| Provision for  loan losses                           |       | 3,700,000  |       | 1,000,000  |       | 475,000    |       |
| Net interest  income after provision for loan losses |       | 16,069,713 |       | 19,184,981 |       | 18,399,639 |       |
|                                                 |       |       |       |       |       |       |       |
| Other income                                         |       |       |       |       |       |       |       |
| Service charges                                      |       | 5,332,172  |       | 5,495,499  |       | 5,223,973  |       |
| Loan service fee  income (loss), net                 |       | (129,505   | )          | 57,867     |       | 33,020     |       |
| Trust department  income                             |       | 477,891    |       | 515,149    |       | 602,884    |       |
| Securities  gains, net                               |       | 658,037    |       | 36,556     |       | 34,259     |       |
| Gain on sale of  mortgage loans                      |       | 410,539    |       | 432,314    |       | 290,035    |       |
| Other                                                |       | 1,605,349  |       | 1,398,673  |       | 1,051,765  |       |
|                                                 |       | 8,354,483  |       | 7,936,058  |       | 7,235,936  |       |
|                                                 |       |       |       |       |       |       |       |
| Other expenses                                       |       |       |       |       |       |       |       |
| Salaries and  employee benefits                      |       | 11,082,600 |       | 10,593,544 |       | 9,612,798  |       |
| Occupancy  expenses                                  |       | 2,737,648  |       | 2,560,353  |       | 2,320,418  |       |
| Amortization                                         |       | 264,736    |       | 270,736    |       | 184,736    |       |
| Advertising and  marketing                           |       | 521,105    |       | 545,648    |       | 519,685    |       |
| Taxes other than  payroll, property and income       |       | 705,789    |       | 683,443    |       | 537,485    |       |
| Other                                                |       | 4,715,182  |       | 3,477,231  |       | 3,506,589  |       |
|                                                 |       | 20,027,060 |       | 18,130,955 |       | 16,681,711 |       |
| Income before  income taxes                          |       | 4,397,136  |       | 8,990,084  |       | 8,953,864  |       |
| Provision for  income taxes                          |       | 684,074    |       | 2,404,132  |       | 2,467,810  |       |
|                                                 |       |       |       |       |       |       |       |
| Net income                                           |       | $          | 3,713,062  |       | $          | 6,585,952  |       | $ | 6,486,054 |   |
|                                                 |       |       |       |       |       |       |       |
| Earnings per  share:                                 |       |       |       |       |       |       |       |
| Basic                                                |       | $          | 1.34       |       | $          | 2.31       |       | $ | 2.35 |   |
| Diluted                                              |       | 1.33       |       | 2.30       |       | 2.34       |       |

 

See Accompanyingnotes.

 

36

----

 

CONSOLIDATEDSTATEMENTS OF COMPREHENSIVE INCOME

Years Ended December 31

 
| ** **                                                                                            | ** ** | **2008**  | ** ** | **2007** | ** ** | **2006**  | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------|------------|----------|------------|-----------|------------|
|                                                                                                  |       |      |       |     |       |      |       |
| Net income                                                                                            |       | $         | 3,713,062  |     | $          | 6,585,952 |       | $ | 6,486,054 |   |
|                                                                                                  |       |      |       |     |       |      |       |
| Other  comprehensive income (loss) Unrealized gains (losses) on securities arising  during the period |       | 536,241   |       | 892,171  |       | 735,236   |       |
| Reclassification  of realized amount                                                                  |       | (658,037  | )          | (36,556  | )          | (34,259   | )          |
| Net change in  unrealized gain (loss) on securities                                                   |       | (121,796  | )          | 855,615  |       | 700,977   |       |
| Less: Tax impact                                                                                      |       | (41,411   | )          | 290,909  |       | 238,332   |       |
|                                                                                                  |       |      |       |     |       |      |       |
| Changes related  to SFAS No. 158:                                                                |       |      |       |     |       |      |       |
| Net gain (loss)                                                                                       |       | 1,000,135 |       | 210,941  |       | —    |       |
| Amortization of  net gain (loss)                                                                      |       | 33,506    |       | 34,592   |       | —    |       |
| Total recognized  in other comprehensive income                                                       |       | 1,033,641 |       | 245,533  |       |      |       |
| Less: Tax impact                                                                                      |       | 351,438   |       | 83,481   |       | —    |       |
|                                                                                                  |       |      |       |     |       |      |       |
| Comprehensive  income                                                                                 |       | $         | 4,314,880  |     | $          | 7,312,710 |       | $ | 6,948,699 |   |

 

See Accompanyingnotes.

 

37

----

 

CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

Years Ended December 31,2008, 2007 and 2006

 
| ** **                                                                                                                                           | ** ** | ** **            | ** ** | ** **    | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|---------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                                           | ** ** | ** **            | ** ** | ** **    | ** ** | ** **        | ** ** | **Other**              | ** ** | **Total**  | ** ** |
| ** **                                                                                                                                           | ** ** | **Common Stock** | ** ** | **Retained**  | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                                                                           | ** ** | **Shares**            | ** ** | **Amount(1)** | ** ** | **Earnings**      | ** ** | **Income**             | ** ** | **Equity** | ** ** |
|                                                                                                                                                 |       |                  |       |          |       |              |       |                   |       |       |       |
| Balances,  January 1, 2006                                                                                                                      |       | 2,666,897             |       | $             | 6,812,805  |              | $          | 40,666,332             |       | $          | (932,894   | ) | $ | 46,546,243 |   |
|                                                                                                                                                 |       |                  |       |          |       |              |       |                   |       |       |       |
| Common stock  issued including tax benefit, net (includes options exercised of 7,909 and  stock grants of 3,845 shares)                              |       | 11,754                |       | 117,741       |       | —            |       | —                 |       | 117,741    |       |
| Stock  compensation expense                                                                                                                          |       | —                |       | 59,375        |       | —            |       | —                 |       | 59,375     |       |
| Common stock  purchased                                                                                                                              |       | (12,901               | )          | (56,385       | )          | (322,069          | )          | —                 |       | (378,454   | )          |
| Common stock  issued in connection with purchase of Peoples Bancorp, Inc.                                                                       |       | 198,836               |       | 5,599,878     |       | —            |       | —                 |       | 5,599,878  |       |
| Net change in  unrealized gain (loss) on securities available for sale, net of tax                                                                   |       | —                |       | —        |       | —            |       | 462,645                |       | 462,645    |       |
| Adjustment to  initially apply SFAS No. 158, net of tax                                                                                         |       | —                |       | —        |       | —            |       | (844,255               | )          | (844,255   | )          |
| Net income                                                                                                                                           |       | —                |       | —        |       | 6,486,054         |       | —                 |       | 6,486,054  |       |
| Dividends  declared - $1.00 per share                                                                                                                |       | —                |       | —        |       | (2,768,428        | )          | —                 |       | (2,768,428 | )          |
| Balances,  December 31, 2006                                                                                                                    |       | 2,864,586             |       | $             | 12,533,414 |              | $          | 44,061,889             |       | $          | (1,314,504 | ) | $ | 55,280,799 |   |
|                                                                                                                                                 |       |                  |       |          |       |              |       |                   |       |       |       |
| Common stock  issued including tax benefit, net (includes options exercised of 9,618, stock  grants of 4,961 shares and employee gifts of 93 shares) |       | 14,672                |       | 175,387       |       | —            |       | —                 |       | 175,387    |       |
| Stock  compensation expense                                                                                                                          |       | —                |       | 96,178        |       | —            |       | —                 |       | 96,178     |       |
| Common stock  purchased                                                                                                                              |       | (30,202               | )          | (132,397      | )          | (800,680          | )          | —                 |       | (933,077   | )          |
| Net change in  unrealized gain (loss) on securities available for sale, net of tax                                                                   |       | —                |       | —        |       | —            |       | 564,706                |       | 564,706    |       |
| Net loss and  prior service cost arising during the year on employee pension plan                                                                    |       | —                |       | —        |       | —            |       | 162,052                |       | 162,052    |       |
| Net income                                                                                                                                           |       | —                |       | —        |       | 6,585,952         |       | —                 |       | 6,585,952  |       |
| Dividends  declared - $1.08 per share                                                                                                                |       | —                |       | —        |       | (3,087,899        | )          | —                 |       | (3,087,899 | )          |
| Balances,  December 31, 2007                                                                                                                    |       | 2,849,056             |       | $             | 12,672,582 |              | $          | 46,759,262             |       | $          | (587,746   | ) | $ | 58,844,098 |   |
|                                                                                                                                                 |       |                  |       |          |       |              |       |                   |       |       |       |
| Common stock  issued including tax benefit, net (includes options exercised of 6,705, stock  grants of 4,025 shares and employee gifts of 91 shares) |       | 10,821                |       | 16,829        |       | —            |       | —                 |       | 16,829     |       |
| Stock  compensation expense                                                                                                                          |       | —                |       | 135,327       |       | —            |       | —                 |       | 135,327    |       |
| Common stock  purchased                                                                                                                              |       | (114,148              | )          | (480,780      | )          | (2,668,901        | )          | —                 |       | (3,149,681 | )          |
| Net change in  unrealized gain (loss) on securities available for sale, net of tax                                                                   |       | —                |       | —        |       | —            |       | (80,385                | )          | (80,385    | )          |
| Recognition of  net loss and prior service cost through earnings due to the termination of  the pension plan, net of tax                             |       | —                |       | —        |       | —            |       | 682,203                |       | 682,203    |       |
| Net income                                                                                                                                           |       | —                |       | —        |       | 3,713,062         |       | —                 |       | 3 713,062  |       |
| Dividends  declared - $1.12 per share                                                                                                                |       | —                |       | —        |       | (3,120,897        | )          | —                 |       | (3,120,897 | )          |
| **Balances,  December 31, 2008**                                                                                                                |       | 2,745,729             |       | $             | 12,343,958 |              | $          | 44,682,526             |       | $          | 14,072     |   | $ | 57,040,556 |   |

 

----

(1) Common Stock has nopar value; amount includes Additional Paid-in Capital

 

See Accompanyingnotes.

 

38

----

 

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

Years Ended December 31

 
| ** **                                                                            | ** ** | **2008**     | ** ** | **2007**     | ** ** | **2006**    | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------|------------|--------------|------------|-------------|------------|
| ** **                                                                            | ** ** | ** **   | ** ** | ** **   | ** ** | ** **  | ** ** |
| **Cash  flows from operating activities**                                             | ** ** | ** **   | ** ** | ** **   | ** ** | ** **  | ** ** |
| Net income                                                                            |       | $            | 3,713,062  |         | $          | 6,585,952   |       | $ | 6,486,054 |   |
| Adjustments to  reconcile net income to net cash from operating activities            |       |         |       |         |       |        |       |
| Depreciation and  amortization                                                        |       | 1,850,726    |       | 1,499,855    |       | 1,313,476   |       |
| Provision for  loan losses                                                            |       | 3,700,000    |       | 1,000,000    |       | 475,000     |       |
| Securities  amortization (accretion), net                                             |       | (193,918     | )          | (178,289     | )          | (14,717     | )          |
| Securities  (gains) losses, net                                                       |       | (658,037     | )          | (36,556      | )          | (34,259     | )          |
| Originations of  loans held for sale                                                  |       | (18,605,081  | )          | (16,061,200  | )          | (17,156,711 | )          |
| Proceeds from  sale of loans                                                          |       | 19,015,620   |       | 16,493,514   |       | 17,446,746  |       |
| Gain on sale of  mortgage loans                                                       |       | (410,539     | )          | (432,314     | )          | (290,035    | )          |
| Stock based  compensation expense                                                     |       | 135,327      |       | 96,178       |       | 59,375      |       |
| Federal Home  Loan Bank stock dividends                                               |       | (262,400     | )          | —       |       | (342,200    | )          |
| Losses (gain) on  sale of fixed assets                                                |       | 4,538        |       | (2,672       | )          | (1,100      | )          |
| Changes in:                                                                           |       |         |       |         |       |        |       |
| Interest  receivable                                                                  |       | 64,087       |       | 434,055      |       | (1,318,246  | )          |
| Other assets                                                                          |       | (4,082,385   | )          | (315,071     | )          | (1,906,617  | )          |
| Interest payable                                                                      |       | (2,109,357   | )          | 1,300,764    |       | 836,125     |       |
| Other  liabilities                                                                    |       | 379,782      |       | (164,587     | )          | 723,683     |       |
| **Net  cash from operating activities**                                               |       | 2,541,425    |       | 10,219,629   |       | 6,276,574   |       |
|                                                                                  |       |         |       |         |       |        |       |
| **Cash  flows from investing activities**                                             | ** ** | ** **   | ** ** | ** **   | ** ** | ** **  | ** ** |
| Purchases of  securities                                                              |       | (126,927,213 | )          | (100,874,783 | )          | (30,905,332 | )          |
| Proceeds from  sales of securities                                                    |       | 40,241,628   |       | 19,323,795   |       | 42,207,571  |       |
| Proceeds from  principal payments and maturities of securities                        |       | 62,331,524   |       | 62,762,514   |       | 53,343,210  |       |
| Cash paid for  bank acquisition                                                       |       | —       |       | —       |       | (2,841,873  | )          |
| Net change in  loans                                                                  |       | (10,002,337  | )          | 25,649,797   |       | (22,106,318 | )          |
| Purchases of  bank premises and equipment                                             |       | (2,715,086   | )          | (3,037,632   | )          | (1,540,977  | )          |
| Proceeds from  sale of bank premises and Equipment                                    |       | 5,000        |       | 2,672        |       | 1,100       |       |
| **Net  cash from investing activities**                                               |       | (37,066,484  | )          | 3,826,363    |       | 38,157,381  |       |
|                                                                                  |       |         |       |         |       |        |       |
| **Cash  flows from financing activities**                                             | ** ** | ** **   | ** ** | ** **   | ** ** | ** **  | ** ** |
| Net change in  deposits                                                               |       | 34,803,011   |       | 17,197,299   |       | (35,102,694 | )          |
| Net change in  repurchase agreements and other borrowings                             |       | 1,182,647    |       | (3,892,283   | )          | (9,380,282  | )          |
| Advances from  Federal Home Loan Bank                                                 |       | 64,000,000   |       | —       |       | 90,000,000  |       |
| Payments on  Federal Home Loan Bank advances                                          |       | (50,707,458  | )          | (16,010,495  | )          | (83,074,662 | )          |
| Proceeds from  note payable                                                           |       | 5,500,000    |       | —       |       | 8,000,000   |       |
| Payments on note  payable                                                             |       | (2,700,000   | )          | (700,000     | )          | (7,000,000  | )          |
| Proceeds from  issuance of common stock, including options exercised and tax benefits |       | 16,829       |       | 175,387      |       | 117,741     |       |
| Purchase of  common stock                                                             |       | (3,149,681   | )          | (933,077     | )          | (378,454    | )          |
| Dividends paid                                                                        |       | (3,120,897   | )          | (3,087,899   | )          | (2,768,428  | )          |
| **Net  cash from financing activities**                                               |       | 45,824,451   |       | (7,251,068   | )          | (39,586,779 | )          |
|                                                                                       |            |              |            |              |            |             |            |  |  |  |

 

39

----

 

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

Years Ended December 31

 
| ** **                                                                     | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|--------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Net change in  cash and cash equivalents                                       |       | $          | 11,299,392 |       | $          | 6,794,924  |       | $ | 4,847,176 |   |
|                                                                           |       |       |       |       |       |       |       |
| Cash and cash  equivalents at beginning of year                                |       | 25,806,596 |       | 19,011,672 |       | 14,164,496 |       |
|                                                                           |       |       |       |       |       |       |       |
| **Cash  and cash equivalents at end of year**                                  |       | $          | 37,105,988 |       | $          | 25,806,596 |       | $ | 19,011,672 |   |
| ** **                                                                     |       |       |       |       |       |       |       |
| Supplemental  disclosures of cash flow information                             |       |       |       |       |       |       |       |
| Cash paid during  the year for:                                                |       |       |       |       |       |       |       |
| Interest expense                                                               |       | $          | 17,468,505 |       | $          | 17,733,341 |       | $ | 15,749,929 |   |
| Income taxes                                                                   |       | 1,800,000  |       | 2,600,000  |       | 2,498,021  |       |
|                                                                           |       |       |       |       |       |       |       |
| Supplemental  schedules of non-cash investing activities                       |       |       |       |       |       |       |       |
| Real estate  acquired through foreclosure                                      |       | $          | 1,012,439  |       | $          | 914,000    |       | $ | 396,472 |   |
| Common stock  issued in connection with purchase of Peoples Bancorp, Inc. |       | —     |       | —     |       | 5,599,878  |       |

 

See Accompanyingnotes.

 

40

----

# ** **

# **NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

# ** **

Basis of Presentation: The consolidated financial statements include the accounts of KentuckyBancshares, Inc. (the Company) and its wholly-owned subsidiary, KentuckyBank (the Bank).  Intercompany transactionsand balances have been eliminated in consolidation.  On July 7, 2006, the Company acquired100% of the outstanding shares of Peoples Bancorp of Sandy Hook, Inc.(Peoples), parent of Peoples Bank of Sandy Hook and Morehead in Elliott andRowan Counties, Kentucky, as discussed in Note 16.

 

Nature of Operations: The Bank operates under a state bank charter and provides full bankingservices, including trust services, to customers located in Bourbon, Clark,Elliott, Harrison, Jessamine, Rowan, Scott, Woodford and adjoining counties inKentucky.  As a state bank, the Bank issubject to regulation by the Kentucky Office of Financial Institutions and theFederal Deposit Insurance Corporation (FDIC). The Company, a bank holding company, is regulated by the FederalReserve.

 

Estimates in theFinancial Statements:  The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from those estimates.  Theallowance for loan losses, mortgage servicing rights and fair value offinancial instruments are particularly subject to change.

 

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

 

Securities: The Company is required to classify its securities portfolio into one ofthree categories:  trading securities,securities available for sale and securities held to maturity.  Fair value adjustments are made to thesecurities based on their classification with the exception of the held tomaturity category.  The Company has noinvestments classified as trading securities, or securities held tomaturity.  Securities available for saleare carried at fair value, with unrealized holding gains and losses reported inother comprehensive income.

 

Interest income includesamortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yieldmethod without anticipating prepayments, except for mortgage backed securitieswhere prepayments are anticipated.  Gainsand losses on sales are recorded on the settlement date and determined usingthe specific identification method.

 

Declines in the fairvalue of securities below their cost that are other than temporary arereflected as realized losses.  Inestimating other than temporary losses, management considers:  the length of time and extent that fair valuehas been less than cost, the financial condition and near term prospects of theissuer, and the Company’s ability and intent to hold the security for a periodsufficient to allow for any anticipated recovery in fair value.

 

Loans Held for Sale: Loans held for sale are valued at the lower of cost or market asdetermined by outstanding commitments from investors or current secondarymarket prices, calculated on the aggregate loan basis.  The Company also provides for any losses onuncovered commitments to lend or sell.

 

41

----

 

Loans: Loans are stated at the amount of unpaid principal, reduced by anallowance for loan losses.  Interestincome on loans is recognized on the accrual basis except for those loans on anonaccrual status.  The accrual ofinterest on impaired loans is discontinued when management believes, afterconsideration of economic and business conditions and collection efforts, thatthe borrowers’ financial condition is such that collection of interest isdoubtful.  Interest income on mortgageand consumer loans is discontinued at the time the loan is 90 days delinquent,and interest income on commercial loans is discontinued at the time the loan is120 days delinquent, unless the loan is well-secured and in process ofcollection.  Past due status is based onthe contractual terms of the loan.  Wheninterest accrual is discontinued, interest income received on such loans isaccounted for on the cash-basis or cost-recovery method, until qualifying forreturn to accrual.  Loans are returned toaccrual status when all the principal and interest amounts contractually dueare brought current and future payments are reasonably assured.  Consumer and credit card loans are typicallycharged off no later than 120 days past due. Loans are placed on nonaccrual or charged-off at an earlier date ifcollection of principal or interest is considered doubtful.

 

Loan origination fees andcertain direct origination costs are capitalized and recognized as anadjustment of the yield on the related loan.

 

Concentration of CreditRisk:  Most of the Company’s business activity iswith customers located within Bourbon, Clark, Elliott, Harrison, Jessamine,Rowan, Scott, Woodford and surrounding counties located in Kentucky.  Therefore, the Company’s exposure to creditrisk is significantly affected by changes in the economy in these and counties.

 

Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probableincurred credit losses, increased by the provision for loan losses anddecreased by charge-offs less recoveries. Management estimates the allowance balance required using past loan lossexperience, the nature and volume of the portfolio, information about specificborrower situations and estimated collateral values, economic conditions, andother factors.  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.  Loan losses are charged against the allowancewhen management believes the uncollectibility of a loan balance is confirmed.

 

A loan is impaired whenfull payment under the loan terms is not expected.  Impairment is evaluated in total forsmaller-balance loans of similar nature such as residential mortgage, consumer,and credit card loans, and on an individual loan basis for other loans.  If a loan is impaired, a portion of theallowance is allocated so that the loan is reported, net, at the present valueof estimated future cash flows using the loan’s existing rate or at the fairvalue of collateral if repayment is expected solely from the collateral.  Large groups of smaller balance homogeneousloans, such as consumer and residential real estate loans are collectivelyevaluated for impairment, and accordingly, they are not separately identifiedfor impairment disclosures.

 

42

----

 

Mortgage ServicingRights:  The Bank has sold certain residentialmortgage loans to the Federal Home Loan Mortgage Corporation (FHLMC) whileretaining the servicing rights.

 

Servicing rights arerecognized separately when they are acquired through sales of loans.  When mortgage loans are sold, servicingrights are initially recorded at fair value with the income statement effectrecorded in gain on sale of mortgage loans. Fair value is based on market prices for comparable mortgage servicingcontracts, when available, or alternatively, is based on a valuation model thatcalculates the present value of estimated future net servicing income.  The valuation model incorporates assumptionsthat market participants would use in estimating future net servicing income,such as the cost to service, the discount rate, the custodial earnings rate, aninflation rate, ancillary income, prepayment speeds and default rates andlosses.  The Company compares thevaluation model inputs and results to published industry data in order tovalidate the model results and assumptions. All classes of servicing assets are subsequently measured using theamortization method which requires servicing rights to be amortized intonon-interest income in proportion to, and over the period of, the estimatedfuture net servicing income of the underlying loans.

 

Servicing assets areevaluated for impairment based upon the fair value of the rights as compared tocarrying amount.  Impairment is determinedby stratifying rights into groupings based on predominant risk characteristics,such as interest rate, loan type and investor type.  Impairment is recognized through a valuationallowance for an individual grouping, to the extent that fair value is lessthan the carrying amount.  If the Companylater determines that all or a portion of the impairment no longer exists for aparticular grouping, a reduction of the allowance may be recorded as anincrease to income.  The fair values ofservicing rights are subject to significant fluctuations as a result of changesin estimated and actual prepayment speeds and default rates and losses.

 

Servicing fee income, whichis reported on the income statement as loan service income, net, is recordedfor fees earned for servicing loans.  Thefees are based on a contractual percentage of the outstanding principal; or afixed amount per loan and are recorded as income when earned.  The amortization of mortgage servicing rightsand valuation allowance are netted against loan servicing fee income.  Servicing fees totaled $287,412, $271,934 and$268,194 for the years ended December 31, 2008, 2007 and 2006.  Late fees and ancillary fees related to loanservicing are not material.

 

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

 

Bank Premises andEquipment:  Land is carried at cost.  Bank premises and equipment are stated atcost less accumulated depreciation. Buildings and related components are depreciated using the straight-linemethod with useful lives ranging from 5 to 50 years.** **Furniture, fixtures and equipmentare depreciated using the straight-line (or accelerated) method with usefullives ranging from 3 to 10.

 

Real Estate AcquiredThrough Foreclosure:  Real estate acquired through foreclosure isinitially recorded at fair value less costs to sell when acquired, establishinga new cost basis.  The value of theunderlying loan is written down to the fair value of the real estate to beacquired by a charge to the allowance for loan losses, if necessary.  Any subsequent write-downs are charged tooperating expenses.  Operating expensesof such properties, net of related income, and gains and losses on theirdisposition are included in other expenses.

 

43

----

 

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

 

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

 

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

 

The Company adopted FASB Interpretation 48,Accounting for Uncertainty in Income Taxes (“FIN 48”), as of January 1,2007.  A tax position is recognized as abenefit only if it is “more likely than not” that the tax position would besustained in a tax examination, with a tax examination being presumed tooccur.  The amount recognized is thelargest amount of tax benefit that is greater than 50% likely of being realizedon examination.  For tax positions notmeeting the “more likely than not” test, no tax benefit is recorded.  The adoption had no affect on the Company’sfinancial statements.

 

The Company recognizes interest related to incometax matters as interest expense and penalties related to income tax matters asother expense.

 

RetirementPlans:  Pension expense is the net ofservice cost, interest cost, return on plan assets and amortization of gainsand losses not immediately recognized. Employee 401(k) and profit sharing plan expense is the amount ofmatching contributions.

 

Goodwill:  Goodwill results from prior business acquisitions and represents theexcess of the purchase price over the fair value of acquired tangible assetsand liabilities and identifiable intangible assets.  Goodwill is assessed at least annually forimpairment and any such impairment will be recognized in the period identified.

 

Intangible Assets: Intangible assets consist of core deposit intangible assets arising fromwhole bank and branch acquisitions.  Theyare initially measured at fair value and then are amortized on either anaccelerated or straight-line basis, over ten or fifteen years.

 

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

 

Comprehensive Income: Comprehensive income consists of net income and other comprehensiveincome.  Other comprehensive incomeincludes unrealized gains and losses on securities available for sale andchanges in the funded status of the pension plan, which are also recognized asa separate component of equity.

 

44

----

 

Derivatives: The Company periodically enters into non-exchange traded mandatoryforward sales contracts in conjunction with its mortgage bankingoperation.  These contracts, consideredderivatives, typically last 60 to 90 days and are used to offset the risk of interestrate changes between the time of the commitment to make a loan to a borrower ata stated rate and when the loan is sold. These derivatives are carried at fair value.  The Company did not have any mandatoryforward sales contracts at December 31, 2008 and 2007.

 

Fair Value of FinancialInstruments:  Fair values of financial instruments areestimated using relevant market information and other assumptions, as morefully disclosed in a separate note.  Fairvalue estimates involve uncertainties and matters of significant judgmentregarding interest rates, credit risk, prepayments, and other factors,especially in the absence of broad markets for particular items.  Changes in assumptions or in marketconditions could significantly affect the estimates.

 

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

 

Reclassifications: Some items in the prior year financial statements were reclassified toconform to the current presentation.

 

Adoption of New Accounting Standards:  In September 2006,the FASB issued SFAS No. 157, Fair Value Measurements (FAS 157).  This Statement defines fair value,establishes a framework for measuring fair value and expands disclosures aboutfair value measurements.  This Statementestablishes a fair value hierarchy about the assumptions used to measure fairvalue and clarifies assumptions about risk and the effect of a restriction onthe sale or use of an asset.  TheStatement is effective for fiscal years beginning after November 15, 2007.  The impact of adoption on January 1, 2008 was notmaterial.  In February 2008, theFASB issued Staff Position (FSP) 157-2, Effective Date of FASB Statement No. 157.  This FSP delays the effective date of FAS 157for all nonfinancial assets and nonfinancial liabilities, except those that arerecognized or disclosed at fair value on a recurring basis (at least annually)to fiscal years beginning after November 15, 2008, and interim periodswithin those fiscal years.  The impact ofadoption was not material.  In October 2008,the FASB issued Staff Position (FSP) 157-3, Determining the Fair Value of aFinancial Asset when the Market for That Asset Is Not Active. This FSPclarifies the application of FAS 157 in a market that is not active. The impactof adoption was not material.

 

InFebruary 2007, the FASB issued SFAS No. 159, The Fair Value Optionfor Financial Assets and Financial Liabilities. The Statement provides companies with an option to report selectedfinancial assets and liabilities at fair value and establishes presentation anddisclosure requirements designed to facilitate comparisons between companiesthat choose different measurement attributes for similar types of assets andliabilities.  The new Statement iseffective for the Company on January 1, 2008.  The Company did not elect the fair valueoption for any financial assets or financial liabilities as of January 1,2008.

 

45

----

 

Effect of Newly Issued But Not Yet EffectiveAccounting Standards:

 

In December 2007,the FASB issued FAS No. 141 (revised 2007), Business Combinations (“FAS141(R)”), which establishes principles and requirements for how an acquirerrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest in anacquiree, including the recognition and measurement of goodwill acquired in abusiness combination.  FAS No. 141(R) is effective for fiscalyears beginning on or after December 15, 2008.  Earlier adoption isprohibited.  The adoption of this standard did not have a material effecton the Corporation’s results of operations or financial position.

 

In December 2007,the FASB issued SFAS No. 160,*“NoncontrollingInterest in Consolidated Financial Statements, an amendment of ARB No. 51”*  (“SFAS No. 160”), which will change theaccounting and reporting for minority interests, which will be recharacterizedas noncontrolling interests and classified as a component of equity within theconsolidated balance sheets.  FAS No. 160 is effective as of thebeginning of the first fiscal year beginning on or after December 15,2008.  Earlier adoption is prohibited and the adoption of FAS No. 160did not have a significant impact on the Corporations’s results of operationsor financial position.

 

In March 2008, theFASB issued SFAS No. 161, “Disclosures about Derivative Instruments andHedging Activities, an amendment of SFAS No. 133”. FAS No. 161 amendsand expands the disclosure requirements of SFAS No. 133 for derivativeinstruments and hedging activities.  FAS No. 161requires qualitative disclosure about objectives and strategies for usingderivative and hedging instruments, quantitative disclosures about fair valueamounts of the instruments and gains and losses on such instruments, as well asdisclosures about credit-risk features in derivative agreements.  FAS No. 161 is effective for financialstatements issued for fiscal years and interim periods beginning after November 15,2008, with early application encouraged. The adoption of this standard did not have a material effect on theCorporation’s results of operations or financial position.

 

**NOTE 2 - RESTRICTIONS ON CASH ANDDUE FROM BANKS**

 

Included in cash and duefrom banks are certain non-interest bearing deposits that are held at theFederal Reserve or maintained in vault cash in accordance with average balancerequirements specified by the Federal Reserve Board of Governors.  The reserve requirement at December 31,2008 and 2007 was $545,000 and $369,000.

 

# **NOTE 3 - SECURITIES AVAILABLE FOR SALE**

# ** **

Year-end securities areas follows:

 
| ** **                 | ** ** | **Fair**   | ** **  | **Unrealized** | ** ** | **Unrealized** | ** ** |
|----------------------------|------------|------------|-------------|----------------|------------|----------------|------------|
| ** **                 | ** ** | **Value**  | ** **  | **Gains**      | ** ** | **Losses**     | ** ** |
| ** **                 | ** ** | ** ** | ** **  | ** **     | ** ** | ** **     | ** ** |
| 2008                       |       |       |        |           |       |           |       |
| U. S. government  agencies |       | $          | 19,350,434  |           | $          | 211,715        |       | $ | — |   |
| States and  municipals     |       | 63,970,625 |        | 1,061,559      |       | (2,181,346     | )          |
| Mortgage-backed            |       | 89,222,748 |        | 1,142,060      |       | (232,625       | )          |
| Equity  securities         |       | 289,959    |        | 19,959         |       | —         |       |
|                       |       |       |        |           |       |           |       |
| Total                      |       | $          | 172,833,766 |           | $          | 2,435,293      |       | $ | (2,413,971 | ) |
|                       |       |       |        |           |       |           |       |
| 2007                       |       |       |        |           |       |           |       |
| U. S. government  agencies |       | $          | 36,020,468  |           | $          | 495,539        |       | $ | (10,085 | ) |
| States and  municipals     |       | 59,361,045 |        | 691,258        |       | (661,819       | )          |
| Mortgage-backed            |       | 52,077,818 |        | 218,221        |       | (610,211       | )          |
| Equity  securities         |       | 290,215    |        | 20,215         |       | —         |       |
|                       |       |       |        |           |       |           |       |
| Total                      |       | $          | 147,749,546 |           | $          | 1,425,233      |       | $ | (1,282,115 | ) |

 

46

----

 

Thefair value of securities at December 31, 2008, by contractual maturity,are shown below.  Expected maturitieswill differ from contractual maturities because borrowers may have the right tocall or prepay obligations with or without call or prepayment penalties.  Securities not due at a single maturity areshown separately.

 
| ** **                              | ** ** | **Fair**   | ** **  |
|-----------------------------------------|------------|------------|-------------|
| ** **                              | ** ** | **Value**  | ** **  |
| ** **                              | ** ** | ** ** | ** **  |
| Due in one year  or less                |       | $          | 3,584,092   |   |
| Due after one  year through five years  |       | 13,892,263 |        |
| Due after five  years through ten years |       | 25,904,102 |        |
| Due after ten  years                    |       | 39,940,602 |        |
|                                    |       | 83,321,059 |        |
| Mortgage-backed                         |       | 89,222,748 |        |
| Equity                                  |       | 289,959    |        |
|                                    |       |       |        |
| Total                                   |       | $          | 172,833,766 |   |

 

Proceeds from sales ofsecurities during 2008, 2007 and 2006 were $40,241,628, $19,323,795 and$42,207,571.  Gross gains of $697,374,$180,005 and $452,218 and gross losses of $39,337, $143,449 and $417,959, wererealized on those sales, respectively. The tax provision related to these realized gains and losses was$223,733, $12,429 and $11,648, respectively.

 

Securities with anapproximate carrying value of $141,245,000 and $112,499,000 at December 31,2008 and 2007, were pledged to secure public deposits, trust funds, securitiessold under agreements to repurchase and for other purposes as required or permittedby law.

 

Securities withunrealized losses at year end 2008 and 2007 not recognized in income are asfollows:

 

2008

 
| ** **                              | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**  | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|------------|------------|
| ** **                              | ** ** | **Fair**                               | ** ** | **Unrealized**                       | ** ** | **Fair**   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **Description of Securities** | ** ** | **Value**                              | ** ** | **Loss**                             | ** ** | **Value**  | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
| ** **                              | ** ** | ** **                             | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| States and  municipals                  |       | $                                      | 13,054,613 |                                 | $          | (587,065   | )          | $ | 23,023,662 |   | $ | (1,594,281 | ) | $ | 36,078,275 |   | $ | (2,181,346 | ) |
| Mortgage-backed                         |       | 30,903,300                             |       | (165,135                             | )          | 1,564,430  |       | (67,490 | ) | 32,467,730 |   | (232,625 | ) |
|                                    |       |                                   |       |                                 |       |       |       |   |   |   |   |   |   |
| Total  temporarily impaired             |       | $                                      | 43,957,913 |                                 | $          | (752,200   | )          | $ | 24,588,092 |   | $ | (1,661,771 | ) | $ | 68,546,005 |   | $ | (2,413,971 | ) |

 

2007

 
| ** **                              | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**  | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|------------|------------|
| ** **                              | ** ** | **Fair**                               | ** ** | **Unrealized**                       | ** ** | **Fair**   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **Description of Securities** | ** ** | **Value**                              | ** ** | **Loss**                             | ** ** | **Value**  | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
| ** **                              | ** ** | ** **                             | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| U.S. Government  securities             |       | $                                      | 21,947,522 |                                 | $          | (10,085    | )          | $ | — |   | $ | — |   | $ | 21,947,522 |   | $ | (10,085 | ) |
| States and  municipals                  |       | 21,940,792                             |       | (631,462                             | )          | 7,054,136  |       | (30,357 | ) | 28,994,928 |   | (661,819 | ) |
| Mortgage-backed                         |       | 2,595,724                              |       | (4,834                               | )          | 30,212,510 |       | (605,377 | ) | 32,808,234 |   | (610,211 | ) |
|                                    |       |                                   |       |                                 |       |       |       |   |   |   |   |   |   |
| Total  temporarily impaired             |       | $                                      | 46,484,038 |                                 | $          | (646,381   | )          | $ | 37,266,646 |   | $ | (635,734 | ) | $ | 83,750,684 |   | $ | (1,282,115 | ) |

 

47

----

 

The Company evaluatessecurities for other than temporary impairment at least on a quarterly basis,and more frequently when economic or market concerns warrant suchevaluation.  Consideration is given tothe length of time and the extent to which the fair value has been less thancost, the financial condition and near-term prospects of the issuer, and theintent and ability of the Company to retain its investment in the issuer for aperiod of time sufficient to allow for any anticipated recovery in fairvalue.  In analyzing an issuer’sfinancial condition, the Company may consider whether the securities are issuedby the federal government or its agencies, whether downgrades by bond ratingagencies have occurred, and the results of reviews of the issuer’s financialcondition.

 

At December 31, 2008, three mortgage-backedsecurities have unrealized losses with aggregate depreciation of 0.7% fromtheir amortized cost basis, and eighty nine states and municipals haveunrealized losses with aggregate depreciation of 5.7% from their amortized costbasis.  Management believes the declines in fair value from these andother securities are largely due to changes in interest rates.  Asmanagement has the ability to hold debt securities until maturity, or for theforeseeable future, no declines are deemed to be other than temporary.

 

**NOTE 4 - LOANS**

 

Loans at year-end were asfollows:

 
| ** **                | ** ** | **2008**    | ** **  | **2007**    | ** ** |
|---------------------------|------------|-------------|-------------|-------------|------------|
|                      |       |        |        |        |       |
| Commercial                |       | $           | 21,505,019  |        | $          | 22,924,130 |   |
| Real estate  construction |       | 16,818,668  |        | 26,172,120  |       |
| Real estate  mortgage     |       | 286,845,709 |        | 270,494,250 |       |
| Agricultural              |       | 80,778,758  |        | 80,774,195  |       |
| Consumer                  |       | 17,643,301  |        | 15,420,647  |       |
| Other                     |       | 685,062     |        | 1,602,706   |       |
|                      |       |        |        |        |       |
|                      |       | $           | 424,276,517 |        | $          | 417,388,048 |   |

 

Activity in the allowancefor loan losses was as follows:

 
| ** **                  | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-----------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Beginning  balance          |       | $          | 4,878,732  |       | $          | 4,991,277  |       | $ | 4,309,403 |   |
| Allowance from  acquisition |       | —     |       | —     |       | 775,913    |       |
| Charge-offs                 |       | (3,395,734 | )          | (1,268,568 | )          | (642,664   | )          |
| Recoveries                  |       | 281,866    |       | 156,023    |       | 73,625     |       |
| Provision for  loan losses  |       | 3,700,000  |       | 1,000,000  |       | 475,000    |       |
|                        |       |       |       |       |       |       |       |
| Ending balance              |       | $          | 5,464,864  |       | $          | 4,878,732  |       | $ | 4,991,277 |   |

 

Impaired loans totaled$5,131,000 and $2,093,000 at December 31, 2008 and 2007. The averagerecorded investment in impaired loans during 2008, 2007 and 2006 was$3,263,000, $1,379,000 and $3,463,000. The total allowance for loan losses related to these loans was $320,000and $692,000 at December 31, 2008 and 2007. Interest income on impairedloans of $88,000, $121,000 and $62,000 was recognized for cash paymentsreceived in 2008, 2007 and 2006.

 

48

----

 

Nonperforming loans wereas follows:

 
| ** **                                    | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-----------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans past due  over 90 days still on accrual |       | $          | 779,000    |       | $          | 195,000 |   |
| Nonaccrual loans                              |       | 6,562,000  |       | 6,358,000  |       |
|                                               |            |            |            |            |            |  |  |

 

Nonaccrual loans secured by real estate make up 97% ofthe total nonaccruals. Management does not see further material loss related tothese loans.

 

Nonperforming loansinclude impaired loans and smaller balance homogeneous loans, such asresidential mortgage and consumer loans, that are collectively evaluated forimpairment.

 

Certain directors andexecutive officers of the Company and companies in which they have beneficialownership were loan customers of the Bank during 2008 and 2007.  An analysis of the activity with respect toall director and executive officer loans is as follows:

 
| ** **                                           | ** ** | **2008**   | ** ** |
|------------------------------------------------------|------------|------------|------------|
| ** **                                           | ** ** | ** ** | ** ** |
| Balance,  beginning of year                          |       | $          | 4,179,000  |   |
| New loans                                            |       | 1,020,000  |       |
| Effect of  changes in composition of related parties |       | —     |       |
| Repayments                                           |       | (1,230,000 | )          |
|                                                 |       |       |       |
| Balance, end of  year                                |       | $          | 3,969,000  |   |

 

LoanServicing

 

Mortgage loans servicedfor others are not included in the accompanying consolidated balancesheets.  The unpaid principal balances ofmortgage loans serviced for others were approximately $112,553,000 and$110,175,000 at December 31, 2008 and 2007.  Custodial escrow balances maintained inconnection with the foregoing loan servicing, and included in demand deposits,were approximately $605,000 and $388,000 at December 31, 2008 and 2007.

 

Activity for mortgageservicing rights and the related valuation allowance follows:

 
| ** **                         | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                               |       |     |       |     |       |     |       |
| Servicing  Rights:                 |       |     |       |     |       |     |       |
| Beginning  balance                 |       | $        | 696,826    |     | $          | 745,834  |       | $ | 801,501 |   |
| Additions                          |       | 185,362  |       | 165,059  |       | 179,507  |       |
| Amortization                       |       | (203,917 | )          | (214,067 | )          | (265,174 | )          |
| Change in  valuation allowance     |       | (213,000 | )          | —   |       | —   |       |
|                               |       |     |       |     |       |     |       |
| Ending balance                     |       | $        | 465,271    |     | $          | 696,826  |       | $ | 745,834 |   |
|                               |       |     |       |     |       |     |       |
| Valuation  Allowance:              |       |     |       |     |       |     |       |
| Beginning  balance                 |       | $        | —     |     | $          | —   |       | $ | — |   |
| Additions  expensed                |       | 213,000  |       | —   |       | —   |       |
| Reductions  credited to operations |       | —   |       | —   |       | —   |       |
|                               |       |     |       |     |       |     |       |
| Ending balance                     |       | $        | 213,000    |     | $          | —   |       | $ | — |   |

 

The fair value ofservicing rights was $539,000 and $1,107,000 at year-end 2008 and 2007.  Fair value at year-end 2008 was determinedusing a discount rate of 12.0%, prepayment speeds ranging from 14.1% to 40.5%,depending on the stratification of the specific right, and default ratesranging from 0.1% to 0.9%.  Fair value atyear-end 2007 was determined using a discount rate of 10.0%, prepayment speedsranging from 8.0% to 15.0%, depending on the stratification of the specificright, and default rates ranging from 0.1% to 0.9%.

 

49

----

 

The weighted average amortization period is 6.2years.  Estimated amortization expensefor each of the next five years is:

 
| 2009 |   | $      | 117,000 |   |
|------|--------|--------|---------|--------|
| 2010 |   | 92,000 |    |
| 2011 |   | 73,000 |    |
| 2012 |   | 57,000 |    |
| 2013 |   | 43,000 |    |

 

# **NOTE5 - PREMISES AND EQUIPMENT**

# ** **

Year-end premises andequipment were as follows:

 
| ** **                     | ** ** | **2008**    | ** ** | **2007**    | ** ** |
|--------------------------------|------------|-------------|------------|-------------|------------|
| ** **                     | ** ** | ** **  | ** ** | ** **  | ** ** |
| Land and  buildings            |       | $           | 18,789,227 |        | $          | 17,243,311 |   |
| Furniture and  equipment       |       | 13,030,204  |       | 11,958,611  |       |
| Construction  projects         |       | 1,249,305   |       | 1,163,406   |       |
|                           |       | 33,068,736  |       | 30,365,328  |       |
| Less accumulated  depreciation |       | (15,194,030 | )          | (14,042,014 | )          |
|                           |       |        |       |        |       |
|                           |       | $           | 17,874,706 |        | $          | 16,323,314 |   |

 

Depreciation expense was$1,154,156, $1,041,368 and $956,221 in 2008, 2007, and 2006.

 

# **NOTE6 — GOODWILL AND INTANGIBLE ASSETS**

# ** **

Thechange in balance for goodwill during the year is as follows:

 
| ** **         | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|--------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Beginning of  year |       | $          | 13,116,710 |       | $          | 13,116,710 |       | $ | 9,110,524 |   |
| Acquired  goodwill |       | —     |       | —     |       | 4,006,186  |       |
| Impairment         |       | —     |       | —     |       | —     |       |
|               |       |       |       |       |       |       |       |
| End of year        |       | $          | 13,116,710 |       | $          | 13,116,710 |       | $ | 13,116,710 |   |

 

Goodwillis not amortized but instead evaluated periodically for impairment.

 

Acquiredintangible assets were as follows at year-end:

 
| ** **                    | ** ** | **2008**     | ** ** | **2007**         | ** ** |
|-------------------------------|------------|--------------|------------|------------------|------------|
| ** **                    | ** ** | **Gross**    | ** ** | ** **       | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **Carrying** | ** ** | **Accumulated**  | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                    | ** ** | **Amount**   | ** ** | **Amortization** | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Amortized  intangible assets: |       |         |       |             |       |   |   |   |   |
| Core deposit  intangibles     |       | $            | 2,530,102  |             | $          | 1,007,425 |   | $ | 2,530,102 |   | $ | 742,689 |   |
|                               |            |              |            |                  |            |  |  |  |  |  |  |  |  |

 

Coredeposit intangibles of $1,477,000 were acquired during 2006 in the Peoplesacquisition, as further described in Note 16 — Business Combination.

 

Aggregate amortization expense was $264,736,$270,736 and $184,736 for 2008, 2007 and 2006.

 

Estimatedamortization expense for each of the next five years:

 
| 2009 |   | $       | 259,736 |   |
|------|--------|---------|---------|--------|
| 2010 |   | 253,736 |    |
| 2011 |   | 243,736 |    |
| 2012 |   | 233,736 |    |
| 2013 |   | 214,973 |    |

 

50

----

 

**NOTE 7 - DEPOSITS**

 

At December 31,2008, the scheduled maturities of time deposits are as follows:

 
| 2009 |   | $           | 124,066,035 |   |
|------|--------|-------------|-------------|--------|
| 2010 |   | 109,795,660 |        |
| 2011 |   | 38,740,988  |        |
| 2012 |   | 2,687,217   |        |
| 2013 |   | 987,582     |        |

 

Certaindirectors and executive officers of the Company and companies in which theyhave beneficial ownership are deposit customers of the Bank. The amount ofthese deposits was approximately $2,212,000 and $2,632,000 at December 31,2008 and 2007.

 

# **NOTE8 - REPURCHASE AGREEMENTS AND OTHER BORROWINGS**

# ** **

Securities sold underagreements to repurchase are secured by U.S. Government securities with acarrying amount of $12,667,471 and $15,179,740 at year-end 2008 and 2007.

 

Repurchase agreements generallymature within one year from the transaction date and range in maturities from 1day to 5 years. The securities underlying the agreements are maintained in athird-party custodian’s account under a written custodial agreement.  Information concerning repurchase agreementsfor 2008, 2007 and 2006 is summarized as follows:

 
| ** **                                  | ** ** | **2008** | ** ** | **2007** | ** ** | **2006**   | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|------------|------------|
| Average daily  balance during the year      |       | $        | 9,685,901  |     | $          | 10,415,241 |       | $ | 15,660,750 |   |
| Average interest  rate during the year      |       | 2.97     | %          | 4.18     | %          | 3.79       | %          |
| Maximum  month-end balance during the year  |       | $        | 13,125,185 |     | $          | 16,072,679 |       | $ | 18,372,446 |   |
| Weighted average  interest rate at year end |       | 3.09     | %          | 4.72     | %          | 3.83       | %          |

 

Promissory note payableof $3,100,000 at December 31, 2008, has $200,000 principal due eachquarter, and matures June 30, 2009, interest payable quarterly at prime,and is secured by 100% of the common stock of the bank.

 

**NOTE 9 - FEDERAL HOME LOAN BANKADVANCES**

 

At year-end, advancesfrom the Federal Home Loan Bank were as follows:

 
| ** **                                                                            | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Maturities  January 2009 through March 2030, fixed rates from 0.52% to 3.13%     |       | $          | 18,444,808 |       | $          | 14,298,815 |   |
| Maturities  February 2009 through February 2026, fixed rates from 3.58% to 4.58% |       | 42,595,628 |       | 28,158,277 |       |
| Maturities  March 2009 through January 2026, fixed rates from 4.77% to 7.23%     |       | 16,260,495 |       | 21,536,380 |       |
|                                                                                  |       |       |       |       |       |
| Total                                                                                 |       | $          | 77,300,931 |       | $          | 63,993,472 |   |

 

Advances are paid eitheron a monthly basis or at maturity.  Alladvances require a prepayment penalty and certain advances are callable by theFHLB at various call dates throughout the term of the advance.  Advances are secured by the FHLB stock andsubstantially all first mortgage residential loans.

 

51

----

 

Scheduled principalpayments due on advances during the years subsequent to December 31, 2008are as follows:

 
| 2009       |   | $          | 32,167,356 |   |
|------------|--------|------------|------------|--------|
| 2010       |   | 12,738,925 |       |
| 2011       |   | 7,756,297  |       |
| 2012       |   | 12,746,553 |       |
| 2013       |   | 6,227,748  |       |
| Thereafter |   | 5,664,052  |       |
|       |   |       |       |
|       |   | $          | 77,300,931 |   |

 

# **NOTE10 — SUBORDINATED DEBENTURES**

# ** **

InAugust 2003, the Company formed Kentucky Bancshares, Statutory Trust I (“Trust”).  The Trust issued $217,000 of commonsecurities to the Company and $7,000,000 of trust preferred securities as partof a pooled offering of such securities. The Company issued $7,217,000 subordinated debentures to the Trust inexchange for the proceeds of the offering, which debentures represent the soleasset of the Trust.  The debentures payinterest quarterly at 7.06% for the first 5 years.  Starting September 2008, the rateconverted to three-month LIBOR plus 3.00 adjusted quarterly.  The Company may redeem the subordinateddebentures, in whole or in part, beginning September 2008 at a price of100% of face value.  The subordinateddebentures must be redeemed no later than 2033.

 

Inaccordance with FASB Interpretation No. 46, the Trust is not consolidatedwith the Company.  Accordingly, theCompany does not report the securities issued by the Trust as liabilities, andinstead reports as liabilities the subordinated debentures issued by theCompany and held by the Trust, as these are no longer eliminated inconsolidation.

 

**NOTE 11 - INCOME TAXES**

 

Income tax expense was asfollows:

 
| ** ** | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current    |       | $          | 1,234,414  |       | $          | 2,457,421  |       | $ | 2,476,648 |   |
| Deferred   |       | (550,340   | )          | (53,289    | )          | (8,838     | )          |
|       |       |       |       |       |       |       |       |
|       |       | $          | 684,074    |       | $          | 2,404,132  |       | $ | 2,467,810 |   |

 

Year-end deferred taxassets and liabilities were due to the following.  No valuation allowance for the realization ofdeferred tax assets is considered necessary.

 
| ** **                        | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-----------------------------------|------------|------------|------------|------------|------------|
| ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deferred tax  assets              |       |       |       |       |       |
| Allowance for  loan losses        |       | $          | 1,883,554  |       | $          | 1,684,269 |   |
| Pension plan  cost                |       | 524,547    |       | 149,512    |       |
| Adjustment for  SFAS No. 158 |       | —     |       | 351,439    |       |
| Other                             |       | 125,668    |       | 130,599    |       |
|                              |       |       |       |       |       |
| Deferred tax  liabilities         |       |       |       |       |       |
| Unrealized gain  on securities    |       | (7,249     | )          | (48,660    | )          |
| Bank premises  and equipment      |       | (843,316   | )          | (724,892   | )          |
| FHLB stock                        |       | (1,343,242 | )          | (1,254,026 | )          |
| Mortgage  servicing rights        |       | (158,192   | )          | (236,921   | )          |
| Core deposit  intangibles         |       | (440,106   | )          | (464,599   | )          |
| Other                             |       | (200,943   | )          | (286,312   | )          |
|                              |       |       |       |       |       |
| Net deferred tax  liability       |       | $          | (459,279   | )          | $          | (699,591 | ) |

 

52

----

 

Effectivetax rates differ from federal statutory rates applied to financial statementincome due to the following:

 
| ** **                                                                  | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| U. S. federal  income tax rate                                              |       | 34.0       | %          | 34.0       | %          | 34.0       | %          |
| Changes from the  statutory rate                                            |       |       |       |       |       |       |       |
| Tax-exempt  investment income                                               |       | (21.4      | )          | (9.2       | )          | (7.8       | )          |
| Non-deductible  interest expense related to carrying tax-exempt investments |       | 2.5        |       | 1.3        |       | 1.1        |       |
| Other                                                                       |       | 0.5        |       | 0.6        |       | 0.3        |       |
|                                                                        |       |       |       |       |       |       |       |
|                                                                        |       | 15.6       | %          | 26.7       | %          | 27.6       | %          |

 

Federal income tax lawsprovided the Federal Savings Bank, acquired by the Company in 2003, withadditional bad debt deductions through 1987, totaling $1.3 million.  Accounting standards do not require adeferred tax liability to be recorded on this amount, which otherwise wouldtotal a $441,000 liability at December 31, 2008.  The Company’s acquisition of First FederalSavings Bank did not require the recapture of the bad debt reserve.  However, if Kentucky Bank was liquidated orotherwise ceased to be a bank, or if tax laws were to change, the $441,000would be recorded as expense.

 

Unrecognized TaxBenefits

 

The Company doesnot have any beginning and ending unrecognized tax benefits. The Company doesnot expect the total amount of unrecognized tax benefits to significantlyincrease or decrease in the next twelve months.

 

There were nointerest and penalties recorded in the income statement or accrued for theyears ended December 31, 2008 and December 31, 2007 related tounrecognized tax benefits.

 

The Company andits subsidiary file a consolidated U.S. Corporation income tax return and acorporate income tax return in the state of Kentucky.  The Company is no longer subject toexamination by taxing authorities for years before 2005.

 

**NOTE 12 - EARNINGS PER SHARE**

 

The factors used in theearnings per share computation follow:

 
| ** **                                                                | ** ** | **2008**  | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|---------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Basic Earnings  Per Share                                                 |       |      |       |      |       |      |       |
| Net income                                                                |       | $         | 3,713,062  |      | $          | 6,585,952 |       | $ | 6,486,054 |   |
| Weighted average  common shares outstanding                               |       | 2,778,037 |       | 2,852,094 |       | 2,761,826 |       |
| Basic earnings  per share                                                 |       | $         | 1.34       |      | $          | 2.31      |       | $ | 2.35 |   |
|                                                                      |       |      |       |      |       |      |       |
| Diluted Earnings  Per Share                                               |       |      |       |      |       |      |       |
| Net income                                                                |       | $         | 3,713,062  |      | $          | 6,585,952 |       | $ | 6,486,054 |   |
| Weighted average  common shares outstanding                               |       | 2,778,037 |       | 2,852,094 |       | 2,761,826 |       |
| Add dilutive  effects of assumed exercise of stock options                |       | 4,040     |       | 10,292    |       | 11,736    |       |
| Weighted average  common and dilutive potential common shares outstanding |       | 2,782,077 |       | 2,862,386 |       | 2,773,562 |       |
| Diluted earnings  per share                                               |       | $         | 1.33       |      | $          | 2.30      |       | $ | 2.34 |   |

 

Stock options of 30,700shares common stock from 2008, 29,200 shares common stock from 2007 and 11,736shares common stock from 2006 were excluded from diluted earnings per sharebecause their impact was antidilutive.

 

53

----

 

**NOTE 13 - RETIREMENT PLANS**

 

The Company terminatedits defined pension plan as of December 31, 2008.  The plan covered substantially all of itsemployees.  The Company’s funding policywas to contribute annually the maximum amount that could be deducted forfederal income tax purposes.  Benefitswere based on one percent of employee average earnings for the previous fiveyears times years of credited service. Final distributions will be at the discretion of the employee.  Expense recognized in connection with thetermination of the plan was $562,607 in 2008.

 

Components of netperiodic pension cost and other amounts recognized in other comprehensiveincome:

 
| ** **                                                                    | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service cost                                                                  |       | $          | 518,241    |       | $          | 483,518    |       | $ | 472,140 |   |
| Interest cost                                                                 |       | 469,542    |       | 405,547    |       | 364,248    |       |
| Expected return  on plan assets                                               |       | (480,850   | )          | (439,253   | )          | (400,485   | )          |
| Amortization                                                                  |       | 33,506     |       | 34,592     |       | 41,249     |       |
|                                                                          |       |       |       |       |       |       |       |
| Net periodic  cost                                                            |       | $          | 540,439    |       | $          | 484,404    |       | $ | 477,152 |   |
|                                                                          |       |       |       |       |       |       |       |
| Net loss (gain)                                                               |       | (1,000,135 | )          | (210,941   | )          | —     |       |
| Prior service  cost (credit)                                                  |       | —     |       | —     |       | —     |       |
| Amortization of  net (gain) loss                                              |       | (33,506    | )          | (34,592    | )          | —     |       |
| Total recognized  in other comprehensive income                               |       | (1,033,641 | )          | (245,533   | )          | —     |       |
|                                                                          |       |       |       |       |       |       |       |
| Total recognized  in net periodic benefit cost and other comprehensive income |       | $          | (493,202   | )          | $          | 238,871    |       | $ | 477,152 |   |

 

As of December 31,2008, the date of termination, the projected benefit obligation was $6,749,694and the fair value of the plan assets was $5,206,908. The difference of$1,542,786 is recognized in other liabilities on the consolidated balancesheet.

 

The Company also has aqualified profit sharing plan which covers substantially all employees andincludes a 401(k) provision.  Profitsharing contributions, excluding the 401(k) provision, are at the discretionof the Company’s Board of Directors. Expense recognized in connection with the plan was $408,491, $434,203and $369,847 in 2008, 2007 and 2006.

 

**NOTE 14 - STOCK BASEDCOMPENSATION**

 

The Company has two sharebased compensation plans as described below. Total compensation cost that has been charged against income for thoseplans was $135,327, $96,178, and $59,375 for 2008, 2007 and 2006.  The total income tax benefit was $1,446,$3,611, and $911.

 

Stock Option Plan

 

The Company grantscertain officers and key employees stock option awards which vest and becomefully exercisable at the end of five years and provides for issue of up to220,000 options.  The Company also grantscertain directors stock option awards which vest and become fully exercisable immediatelyand provides for issue of up to 20,000 options. The exercise price of each option, which has a ten year life, was equalto the market price of the Company’s stock on the date of grant.

 

54

----

 

 

The fair value ofeach option award is estimated on the date of grant using a closed form optionvaluation (Black-Scholes) model that uses the assumptions noted in the tablebelow.  Expected volatilities are basedon historical volatilities of the Company’s common stock.  The Company uses historical data to estimateoption exercise and post-vesting termination behavior.  The expected term of options granted is basedon historical data and represents the period of time that options granted areexpected to be outstanding, which takes into account that the options are nottransferable.  The risk-free interestrate for the expected term of the option is based on the U.S. Treasury yieldcurve in effect at the time of the grant.

 

The fair value ofoptions granted was determined using the following weighted-average assumptionsas of grant date.

 
| ** **                       | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                             |       |     |       |     |       |     |       |
| Fair value of  options granted   |       | $        | 2.38       |     | $          | 4.22     |       | $ | 3.14 |   |
| Risk-free  interest rate         |       | 2.96     | %          | 4.51     | %          | 4.59     | %          |
| Expected term                    |       | 8 years  |       | 8 years  |       | 8 years  |       |
| Expected stock  price volatility |       | 11.05    | %          | 12.69    | %          | 7.99     | %          |
| Dividend yield                   |       | 3.61     | %          | 3.48     | %          | 3.39     | %          |
|                                  |            |          |            |          |            |          |            |  |  |  |

 

Summary of activity inthe stock option plan for 2008 follows:

 
| ** **                      | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** **  | ** **    | ** ** |
|---------------------------------|------------|------------|------------|--------------|------------|-----------------|-------------|---------------|------------|
| ** **                      | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**     | ** **  | ** **    | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**   | ** **  | **Aggregate** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** **  | **Intrinsic** | ** ** |
| ** **                      | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Term**        | ** **  | **Value**     | ** ** |
| ** **                      | ** ** | ** ** | ** ** | ** **   | ** ** | ** **      | ** **  | ** **    | ** ** |
| Outstanding,  beginning of year |       | 58,774     |       | $            | 27.80      |            |        |          |       |   |
| Granted                         |       | 800        |       | 31.00        |       |            |        |          |       |
| Forfeited or  expired           |       | (2,700     | )          | 28.68        |       |            |        |          |       |
| Exercised                       |       | (6,705     | )          | 22.12        |       |            |        |          |       |
| Outstanding, end  of year       |       | 50,169     |       | $            | 28.57      |            | 54.6 months |          | $          | — |   |
| Vested and  expected to vest    |       | 50,169     |       | $            | 28.57      |            | 54.6 months |          | $          | — |   |
| Exercisable, end  of year       |       | 43,309     |       | $            | 28.28      |            | 51.8 months |          | $          | — |   |

 

Options outstanding atyear-end 2008 were as follows:

 
| ** **                       | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                       | ** ** | ** **      | ** ** | **Weighted**    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                       | ** ** | ** **      | ** ** | **Average**     | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                       | ** ** | ** **      | ** ** | **Remaining**   | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                       | ** ** | ** **      | ** ** | **Contractual** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| **Range of Exercise Prices**     | ** ** | **Options**     | ** ** | **Life**        | ** ** | **Price** | ** ** | **Options** | ** ** | **Price** | ** ** |
|                             |       |            |       |            |       |   |   |   |   |   |   |
| From $20.50 to $20.63  per share |       | 5,890           |       | 0.5             |       | 20.62 |   | 5,890 |   | 20.62 |   |
| From $23.50 to  $28.00 per share |       | 13,679          |       | 41.5            |       | 25.47 |   | 13,679 |   | 25.47 |   |
| From $29.50 to  $31.00 per share |       | 21,050          |       | 75.7            |       | 30.38 |   | 14,190 |   | 30.38 |   |
| From $33.90 to  $34.00 per share |       | 9,550           |       | 60.3            |       | 33.91 |   | 9,550 |   | 33.91 |   |
|                             |       | 50,169          |       |            |       |   |   | 43,309 |   |   |   |

 

Informationrelated to the stock option plan during each year follows:

 
| ** **                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                            |       |     |       |     |       |     |       |
| Intrinsic value  of options exercised           |       | $        | 59,700     |     | $          | 141,258  |       | $ | 119,419 |   |
| Cash received  from option exercises            |       | 14,666   |       | 172,504  |       | 117,286  |       |
| Tax benefit  realized from option exercises     |       | 2,163    |       | 2,883    |       | 455      |       |
| Total fair value  of options granted            |       | 1,904    |       | 3,376    |       | 4,082    |       |
|                                            |       |     |       |     |       |     |       |
| Options  exercised through net share settlement |       | 6,100    |       | 400      |       | 600      |       |
|                                                 |            |          |            |          |            |          |            |  |  |  |

 

55

----

 

As ofDecember 31, 2008, there was $17,982 of total unrecognized compensationcost related to nonvested stock options granted under the Plan.  The cost is expected to be recognized over aweighted-average period of 5 years.

 

Stock Grant Plan

 

On February 15,2005, the Company’s Board of Directors adopted a restricted stock grantplan.  Total shares issuable under theplan are 50,000.  There were 4,025 sharesissued during 2008 and 5,605 shares issued during 2007, and 644 shares wereforfeited during 2007.

 

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

 
| ** **                           | ** ** | ** ** | ** ** | **Weighted-Average** | ** ** |
|--------------------------------------|------------|------------|------------|----------------------|------------|
| ** **                           | ** ** | ** ** | ** ** | **Grant-Date**       | ** ** |
| **Nonvested Shares**            | ** ** | **Shares** | ** ** | **Fair Value**  | ** ** |
|                                 |       |       |       |                 |       |
| Nonvested at  January 1, 2008   |       | 8,037      |       | $                    | 243,474    |   |
| Granted                              |       | 4,025      |       | 124,775              |       |
| Vested                               |       | (1,744     | )          | (52,690              | )          |
| Forfeited                            |       | (312       | )          | (9,536               | )          |
|                                 |       |       |       |                 |       |
| Nonvested at  December 31, 2008 |       | 10,006     |       | $                    | 306,023    |   |

 

As of December 31,2008, there was $251,288 of total unrecognized compensation cost related tononvested shares granted under the Plan. The cost is expected to be recognized over a weighted-average period of5 years.  The total fair value of sharesvested during the years ended December 31, 2008, 2007 and 2006 was$53,784, $23,839 and $0.

 

**NOTE 15 - BUSINESS COMBINATION**

 

On July 7, 2006, theCompany acquired 100% of the outstanding shares of Peoples Bancorp of SandyHook, Inc., parent of Peoples Bank of Sandy Hook.  Operating results of Peoples are included inthe consolidated financial statements since the date of acquisition.

 

The purchase price of $14million was 40 percent stock and 60 percent cash.  At the acquisition date, Peoples had$96,380,000 in total assets, $50,925,000 in loans and $72,279,000 in deposits.

 

**NOTE 16 - LIMITATION ON BANK DIVIDENDS**

 

The Company’s principalsource of funds is dividends received from the Bank. Banking regulations limitthe amount of dividends that may be paid by the Bank without prior approval ofregulatory agencies.  Under theseregulations, the amount of dividends that may be paid in any calendar year islimited to the current year’s net profits, as defined, combined with theretained net profits of the preceding two years.  During 2009 the Bank could, without priorapproval, declare dividends on any 2009 net profits retained to the date of thedividend declaration plus $3,022,000.

 

**NOTE 17 - FAIR VALUE**

 

Statement157 establishes a fair value hierarchy which requires an entity to maximize theuse of observable inputs and minimize the use of unobservable inputs when measuringfair value.  The standard describes threelevels of inputs that may be used to measure fair value:

 

Level1: Quoted prices (unadjusted) for identical assets or liabilities in activemarkets that the entity has the ability to access as of the measurement date.

 

56

----

 

Level2: Significant other observable inputs other than Level 1 prices such as quotedprices for similar assets or liabilities; quoted prices in markets that are notactive; or other inputs that are observable or can be corroborated byobservable market data.

 

Level3: Significant unobservable inputs that reflect a reporting entity’s ownassumptions about the assumptions that market participants would use in pricingan asset or liability.

 

Thefair values of securities available for sale are determined by obtaining quotedprices on nationally recognized securities exchanges (Level 1 inputs) or matrixpricing, which is a mathematical technique widely used in the industry to valuedebt securities without relying exclusively on quoted prices for the specificsecurities but rather by relying on the securities’ relationship to otherbenchmark quoted securities (Level 2 inputs).

 

Thefair value of servicing rights is based on a valuation model that calculatesthe present value of estimated net servicing income.  The valuation model incorporates assumptionsthat market participants would use in estimating future net servicing income.  The Company is able to compare the valuationmodel inputs and results to widely available published industry data forreasonableness (Level 2 inputs).

 

The fairvalue of impaired loans with specific allocations of the allowance for loanlosses is generally based on recent real estate appraisals.  These appraisals may utilize a singlevaluation approach or a combination of approaches including comparable salesand the income approach.  Adjustments areroutinely made in the appraisal process by the appraisers to adjust fordifferences between the comparable sales and income data available. Suchadjustments are typically significant and result in a Level 3 classification ofthe inputs for determining fair value.

 

Assets and LiabilitiesMeasured on a Recurring Basis

 

For this disclosure, theCompany only has available for sale investment securities that meet therequirement.

 

Available for saleinvestment securities are the Company’s only balance sheet item that meet thedisclosure requirements for instruments measured at fair value on a recurringbasis.  Disclosures are as follows in thetable below.

 

(In thousands)

 
| ** **                     | ** ** | **Fair  Value Measurements at December 31, 2008 Using** | ** ** |
|--------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                     | ** ** | ** **                                                   | ** ** | **Quoted Prices** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | ** **                                                   | ** ** | **In Active** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | ** **                                                   | ** ** | **Markets for** | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                     | ** ** | ** **                                                   | ** ** | **Identical** | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                     | ** ** | **Fair Value**                                          | ** ** | **Assets** | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| **Description**                | ** ** | **12/31/08**                                                 | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
|                           |       |                                                         |       |   |   |   |   |   |   |
| Available for  Sale Securities |       | $                                                            | 172,834    |   | $ | 290 |   | $ | 172,544 |   | $ | — |   |
|                                |            |                                                              |            |  |  |  |  |  |  |  |  |  |  |

 

Assetsand Liabilities Measured on a Non-Recurring Basis

 

Servicingrights, which are carried at lower of cost or fair value, were written down tofair value of $465,000, resulting in a valuation allowance of $213,000. Acharge of $213,000 was included in earnings for the period.

 

Impaired loans in theamount of $5.1 million have been written down to their estimated fair value of$4.8 million at December 31, 2008. Impaired loans are measured at fair value based on the underlyingcollateral and are considered level 3 inputs.

 

57

----

 

Fair Value of FinancialInstruments

 

The fair values of theCompany’s financial instruments at December 31, 2008 and 2007 are asfollows:

 
| ** **                                                           | ** ** | **2008**                | ** ** | **2007**            | ** ** |
|----------------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                                           | ** ** | **Carrying**            | ** ** | ** **          | ** ** | **Carrying** | ** ** | ** ** | ** ** |
| ** **                                                           | ** ** | **Amount**              | ** ** | **Fair Value** | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| ** **                                                           | ** ** | **(In Thousands)** | ** ** |
| Financial assets                                                     |       |                    |       |                |       |   |   |   |   |
| Cash and cash  equivalents                                           |       | $                       | 37,106     |                | $          | 37,106 |   | $ | 25,807 |   | $ | 25,807 |   |
| Securities                                                           |       | 172,834                 |       | 172,834             |       | 147,750 |   | 147,750 |   |
| Loans, net                                                           |       | 418,812                 |       | 418,635             |       | 412,509 |   | 409,134 |   |
| FHLB stock                                                           |       | 6,731                   |       | 6,731               |       | 6,468 |   | 6,468 |   |
| Interest  receivable                                                 |       | 5,156                   |       | 5,156               |       | 5,220 |   | 5,220 |   |
| Financial liabilities                                                |       |                    |       |                |       |   |   |   |   |
| Deposits                                                             |       | $                       | 520,808    |                | $          | 528,949 |   | $ | 486,005 |   | $ | 489,276 |   |
| Securities sold  under agreements to repurchase and other borrowings |       | 10,717                  |       | 10,983              |       | 6,735 |   | 6,843 |   |
| FHLB advances                                                        |       | 77,301                  |       | 79,665              |       | 63,993 |   | 63,643 |   |
| Subordinated  debentures                                             |       | 7,217                   |       | 4,253               |       | 7,217 |   | 7,098 |   |
| Interest payable                                                     |       | 2,874                   |       | 2,874               |       | 4,984 |   | 4,984 |   |

 

The methods andassumptions used to estimate fair value are described as follows:  Carrying amount is the estimated fair valuefor cash and cash equivalents, short-term borrowings, Federal Home Loan Bankstock, accrued interest receivable and payable, demand deposits, short-termdebt, and variable rate loans or deposits that reprice frequently andfully.  For fixed rate loans or depositsand for variable rate loans or deposits with infrequent repricing or repricinglimits, fair value is based on discounted cash flows using current market ratesapplied to the estimated life and credit risk. Fair value of debt is based on current rates for similar financing.  The fair value of commitments to extendcredit and standby letters of credit is not considered material.

 

**NOTE 18 - OFF-BALANCE SHEETACTIVITIES AND COMMITMENTS**

 

Some financialinstruments, such as loan commitments, credit lines, letters of credit, andoverdraft protection, are issued to meet customer financing needs. These areagreements to provide credit or to support the credit of others, as long asconditions established in the contract are met, and usually have expirationdates.  Commitments may expire withoutbeing used.  Off-balance sheet risk tocredit loss exists up to the face amount of these instruments, althoughmaterial losses are not anticipated.  Thesame credit policies are used to make such commitments as are used for loans,including obtaining collateral at exercise of the commitment.

 

Financial instrumentswith off-balance sheet risk were as follows at year-end:

 
| ** **                 | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|----------------------------|------------|------------|------------|------------|------------|
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unused lines of  credit    |       | $          | 64,791,109 |       | $          | 65,298,282 |   |
| Commitments to  make loans |       | 5,214,000  |       | 1,871,000  |       |
| Letters of  credit         |       | 794,066    |       | 907,335    |       |
|                            |            |            |            |            |            |  |  |

 

Unused lines of creditare substantially all at variable rates. Commitments to make loans are generally made for a period of 60 days orless and are primarily fixed at current market rates ranging from 4.38% to6.14% with maturities ranging from 15 to 30 years and are intended to be sold.

 

58

----

 

**NOTE 19 - CONTINGENT LIABILITIES**

 

The Bank is a defendantin legal actions arising from normal business activities.  Management believes these actions are withoutmerit or that the ultimate liability, if any, resulting from them will notmaterially affect the Company’s consolidated financial position or results ofoperations.

 

**NOTE 20 - CAPITAL REQUIREMENTS**

 

The Company and the Bankare subject to various regulatory capital requirements administered by thefederal banking agencies.  Failure tomeet minimum capital requirements can initiate certain mandatory and possibleadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on the Company’s financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Company and the Bankmust meet specific capital guidelines that involve quantitative measures of theCompany’s and the Bank’s assets, liabilities, and certain off-balance sheetitems as calculated under regulatory accounting practices.  The Company and Bank capital amounts andclassifications are also subject to qualitative judgments by regulators aboutcomponents, risk weightings, and other factors.

 

Quantitative measuresestablished by regulation to ensure capital adequacy require the Company andthe Bank to maintain minimum amounts and ratios (set forth in the following table)of Total and Tier I capital (as defined in the regulations) to risk-weightedassets (as defined), and of Tier I capital to average assets (as defined).  Management believes, as of December 31,2008 and 2007, that the Company and the Bank meet all capital adequacyrequirements to which they are subject.

 

The most recentnotification from the Federal Deposit Insurance Corporation categorized theBank as well capitalized under the regulatory framework for prompt correctiveaction.  To be categorized as wellcapitalized, the Bank must maintain minimum Total risk-based, Tier I risk-basedand Tier I leverage ratios as set forth in the following table.  There are no conditions or events since thatnotification that management believes have changed the institution’s category.

 

The Company’s and theBank’s actual amounts and ratios are presented in the table below:

 
| ** **                                | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **To Be Well** | ** ** |
|-------------------------------------------|------------|--------------------------------------|------------|----------------------------|------------|----------------------------|------------|----------------|------------|--------------------------|------------|
| ** **                                | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Capitalized**          | ** ** |
| ** **                                | ** ** | ** **                           | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Under Prompt**    | ** ** |
| ** **                                | ** ** | ** **                           | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Corrective** | ** ** |
| ** **                                | ** ** | **Actual**                           | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| ** **                                | ** ** | **Amount**                           | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**      | ** ** | **Amount**               | ** ** | **Ratio** | ** ** |
| ** **                                | ** ** | **(Dollars in Thousands)** | ** ** |
| 2008                                      |       |                                 |       |                       |       |                       |       |           |       |                     |       |   |   |
| Consolidated                              |       |                                 |       |                       |       |                       |       |           |       |                     |       |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       | $                                    | 59,913     |                       | 13.5       | %                          | $          | 35,618         |       | 8                        | %          | $ | 44,522 |   | N/A |   |
| Tier I Capital  (to Risk-Weighted Assets) |       | 54,364                               |       | 12.2                       |       | 17,809                     |       | 4              |       | 26,713                   |       | N/A |   |
| Tier I Capital  (to Average Assets)       |       | 54,364                               |       | 8.3                        |       | 26,073                     |       | 4              |       | 32,591                   |       | N/A |   |
| Bank Only                                 |       |                                 |       |                       |       |                       |       |           |       |                     |       |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       | $                                    | 62,615     |                       | 14.1       | %                          | $          | 35,593         |       | 8                        | %          | $ | 44,491 |   | 10 | % |
| Tier I Capital  (to Risk-Weighted Assets) |       | 57,066                               |       | 12.8                       |       | 17,796                     |       | 4              |       | 26,695                   |       | 6 |   |
| Tier I Capital  (to Average Assets)       |       | 57,066                               |       | 8.8                        |       | 26,063                     |       | 4              |       | 32,578                   |       | 5 |   |
| 2007                                      |       |                                 |       |                       |       |                       |       |           |       |                     |       |   |   |
| Consolidated                              |       |                                 |       |                       |       |                       |       |           |       |                     |       |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       | $                                    | 56,491     |                       | 13.6       | %                          | $          | 33,134         |       | 8                        | %          | $ | 41,417 |   | N/A |   |
| Tier I Capital  (to Risk-Weighted Assets) |       | 51,528                               |       | 12.4                       |       | 16,567                     |       | 4              |       | 24,850                   |       | N/A |   |
| Tier I Capital  (to Average Assets)       |       | 51,528                               |       | 8.4                        |       | 24,493                     |       | 4              |       | 30,616                   |       | N/A |   |
| Bank Only                                 |       |                                 |       |                       |       |                       |       |           |       |                     |       |   |   |
| Total Capital  (to Risk-Weighted Assets)  |       | $                                    | 56,350     |                       | 13.6       | %                          | $          | 33,130         |       | 8                        | %          | $ | 41,413 |   | 10 | % |
| Tier I Capital  (to Risk-Weighted Assets) |       | 51,387                               |       | 12.4                       |       | 16,565                     |       | 4              |       | 24,848                   |       | 6 |   |
| Tier I Capital  (to Average Assets)       |       | 51,387                               |       | 8.4                        |       | 24,491                     |       | 4              |       | 30,614                   |       | 5 |   |

 

59

----

 

**NOTE 21 - PARENT COMPANYFINANCIAL STATEMENTS**

 

Condensed BalanceSheets

December 31

 
| ** **                                           | ** ** | **2008**                | ** ** | **2007**   | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|------------|------------|
| ** **                                           | ** ** | **(In Thousands)** | ** ** |
| **ASSETS**                                           | ** ** | ** **              | ** ** | ** ** | ** ** |
| Cash on deposit  with subsidiary                     |       | $                       | 104        |       | $          | 175 |   |
| Investment in  subsidiary                            |       | 66,742                  |       | 65,703     |       |
| Securities  available for sale                       |       | 20                      |       | 20         |       |
| Other assets                                         |       | 507                     |       | 482        |       |
|                                                 |       |                    |       |       |       |
| **Total  assets**                                    |       | $                       | 67,373     |       | $          | 66,380 |   |
|                                                 |       |                    |       |       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**       | ** ** | ** **              | ** ** | ** ** | ** ** |
| Liabilities                                          |       |                    |       |       |       |
| Subordinated  debentures                             |       | $                       | 7,217      |       | $          | 7,217 |   |
| Notes payable                                        |       | 3,100                   |       | 300        |       |
| Other  liabilities                                   |       | 15                      |       | 19         |       |
| Stockholders’  equity                           | ** ** | ** **              | ** ** | ** ** | ** ** |
| Preferred stock                                      |       | —                  |       | —     |       |
| Common stock                                         |       | 12,053                  |       | 12,517     |       |
| Additional  paid-in capital                          |       | 291                     |       | 156        |       |
| Retained  earnings                                   |       | 44,683                  |       | 46,759     |       |
| Accumulated  other comprehensive income (loss)       |       | 14                      |       | (588       | )          |
|                                                 |       |                    |       |       |       |
| **Total liabilities  and stockholders’ equity** |       | $                       | 67,373     |       | $          | 66,380 |   |

 

60

----

 

CondensedStatements of Income and Comprehensive Income Years Ended December 31

 
| ** **                                                                   | ** ** | **2008**                | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                                                   | ** ** | **(In Thousands)** | ** ** |
| Income                                                                       |       |                    |       |     |       |     |       |
| Dividends from  subsidiary                                                   |       | $                       | 3,900      |     | $          | 4,300    |       | $ | 9,800 |   |
| Securities gains  (losses), net                                              |       | —                  |       | —   |       | 409      |       |
| Interest income                                                              |       | —                  |       | 1        |       | 16       |       |
| Total income                                                                 |       | 3,900                   |       | 4,301    |       | 10,225   |       |
|                                                                         |       |                    |       |     |       |     |       |
| Expenses                                                                     |       |                    |       |     |       |     |       |
| Interest expense                                                             |       | 563                     |       | 531      |       | 577      |       |
| Other expenses                                                               |       | 179                     |       | 128      |       | 250      |       |
| Total expenses                                                               |       | 742                     |       | 659      |       | 827      |       |
|                                                                         |       |                    |       |     |       |     |       |
| Income before  income taxes and equity in undistributed income of subsidiary |       | 3,158                   |       | 3,642    |       | 9,398    |       |
|                                                                         |       |                    |       |     |       |     |       |
| Applicable  income tax (expense) benefits                                    |       | 253                     |       | 224      |       | 166      |       |
|                                                                         |       |                    |       |     |       |     |       |
| Income before  equity in undistributed income of subsidiary                  |       | 3,411                   |       | 3,866    |       | 9,564    |       |
|                                                                         |       |                    |       |     |       |     |       |
| Equity in  undistributed income of subsidiary                                |       | 302                     |       | 2,720    |       | (3,078   | )          |
|                                                                         |       |                    |       |     |       |     |       |
| Net income                                                                   |       | 3,713                   |       | 6,586    |       | 6,486    |       |
|                                                                         |       |                    |       |     |       |     |       |
| Other  comprehensive income (loss), net of tax:                              |       |                    |       |     |       |     |       |
| Unrealized gains  (losses) on securities arising during the period           |       | 354                     |       | 589      |       | 486      |       |
| Reclassification  of realized amount                                         |       | (434                    | )          | (24      | )          | (23      | )          |
|                                                                         |       |                    |       |     |       |     |       |
| Net change in  unrealized gain (loss) on securities                          |       | (80                     | )          | 565      |       | 463      |       |
|                                                                         |       |                    |       |     |       |     |       |
| Comprehensive  income                                                        |       | $                       | 3,633      |     | $          | 7,151    |       | $ | 6,949 |   |

 

61

----

 

CondensedStatements of Cash Flows Years Ended December 31

 
| ** **                                                                 | ** ** | **2008**                | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------|------------|------------|------------|------------|------------|
| ** **                                                                 | ** ** | **(In Thousands)** | ** ** |
| **Cash  flows from operating activities**                                  | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                 |       | $                       | 3,713      |       | $          | 6,586      |       | $ | 6,486 |   |
| Adjustments to  reconcile net income to net cash from operating activities |       |                    |       |       |       |       |       |
| Equity in  undistributed earnings of subsidiary                            |       | (302                    | )          | (2,720     | )          | 3,083      |       |
| Securities  (gains) losses, net                                            |       | —                  |       | —     |       | (409       | )          |
| Change in other  assets                                                    |       | (24                     | )          | (58        | )          | 43         |       |
| Change in other  liabilities                                               |       | (4                      | )          | (27        | )          | 18         |       |
| **Net  cash from operating activities**                                    |       | 3,383                   |       | 3,781      |       | 9,221      |       |
| ** **                                                                 |       |                    |       |       |       |       |       |
| **Cash  flows from investing activities**                                  | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from  sales of securities available for sale                      |       | —                  |       | —     |       | 664        |       |
| Acquisition of  Peoples Bancorp, Inc.                                 |       | —                  |       | —     |       | (8,080     | )          |
| **Net  cash from investing activities**                                    | ** ** | **—**              |       | —     |       | (7,416     | )          |
| ** **                                                                 | ** ** | ** **              |       |       |       |       |       |
| **Cash  flows from financing activities**                                  | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from  note payable                                                |       | 5,500                   |       | —     |       | 8,000      |       |
| Payments on note  payable                                                  |       | (2,700                  | )          | (700       | )          | (7,000     | )          |
| Dividends paid                                                             |       | (3,121                  | )          | (3,088     | )          | (2,768     | )          |
| Proceeds from  issuance of common stock                                    |       | 17                      |       | 175        |       | 118        |       |
| Purchase of  common stock                                                  |       | (3,150                  | )          | (933       | )          | (378       | )          |
| **Net  cash from financing activities**                                    |       | (3,454                  | )          | (4,546     | )          | (2,028     | )          |
| ** **                                                                 |       |                    |       |       |       |       |       |
| Net change in  cash                                                        |       | (71                     | )          | (765       | )          | (223       | )          |
|                                                                       |       |                    |       |       |       |       |       |
| Cash at  beginning of year                                                 |       | 175                     |       | 940        |       | 1,163      |       |
|                                                                       |       |                    |       |       |       |       |       |
| **Cash at  end of year**                                                   |       | $                       | 104        |       | $          | 175        |       | $ | 940 |   |

 

62

----

 

**NOTE 22 –QUARTERLY FINANCIAL DATA (UNAUDITED)**

 
| ** **     | ** ** | **Interest** | ** ** | **Net Interest** | ** ** | **Net**    | ** ** | **Earnings Per Share** | ** ** |
|----------------|------------|--------------|------------|-----------------------|------------|------------|------------|----------------------------------|------------|
| ** **     | ** ** | **Income**   | ** ** | **Income**            | ** ** | **Income** | ** ** | **Basic**                        | ** ** | **Fully Diluted** | ** ** |
| 2008           |       |         |       |                  |       |       |       |                             |       |   |   |
| First quarter  |       | $            | 9,253      |                  | $          | 4,896      |       | $                                | 1,193      |   | $ | 0.42 |   | $ | 0.42 |   |
| Second quarter |       | 8,675        |       | 5,038                 |       | 1,486      |       | 0.53                             |       | 0.53 |   |
| Third quarter  |       | 8,788        |       | 5,100                 |       | 1,356      |       | 0.49                             |       | 0.49 |   |
| Fourth quarter |       | 8,413        |       | 4,736                 |       | (322       | )          | (0.10                            | )          | (0.11 | ) |
|           |       |         |       |                  |       |       |       |                             |       |   |   |
| 2007           |       |         |       |                  |       |       |       |                             |       |   |   |
| First quarter  |       | $            | 9,806      |                  | $          | 4,972      |       | $                                | 1,562      |   | $ | 0.55 |   | $ | 0.54 |   |
| Second quarter |       | 10,034       |       | 5,147                 |       | 1,918      |       | 0.67                             |       | 0.67 |   |
| Third quarter  |       | 9,801        |       | 5,148                 |       | 1,670      |       | 0.58                             |       | 0.58 |   |
| Fourth quarter |       | 9,578        |       | 4,918                 |       | 1,436      |       | 0.51                             |       | 0.51 |   |

 

The Company recorded a$2.2 million addition to the allowance for loan losses and $563 thousandexpense related to the termination of the pension plan during the fourthquarter of 2008.

 

63

----

 

**Item 9.    Changes In and Disagreements with Accountantson Accounting and Financial Disclosure**

 

None

 

**Item 9A.    Controls and Procedures**

 

GeneralOverview of Internal Controls over Financial Reporting*. *Management of theCompany is responsible for establishing and maintaining effective internalcontrol over financial reporting as defined in Rules 13a-15(f) underthe Securities Exchange Act of 1934.  TheCompany’s internal control over financial reporting is designed to providereasonable assurance to the Company’s management and Board of Directorsregarding the reliability of financial reporting and the preparation and fairpresentation of published financial statements. All internal controls, however, have inherent limitations regardless ofhow well they have been designed.

 

Management’sAnnual Report on Internal Control over Financial Reporting. Management, with participation of the Company’s Chief ExecutiveOfficer and Chief Financial Officer, has evaluated the effectiveness of theCompany’s disclosure controls and procedures as of December 31, 2008.  Based on the evaluation, the Company’s ChiefExecutive Officer and Chief Financial Officer concluded, to the best of theirknowledge, that the Company’s disclosure controls and procedures were effectiveto ensure that information required to be disclosed by the Company in reportsthat the Company files or submits under the Securities Exchange Act of 1934 isrecorded, processed, summarized and reported within the time periods specifiedin SEC rules and forms.  In making this assessment, management usedthe criteria set forth by the Committee of Sponsoring Organizations of theTreadway Commission (COSO) in Internal Control – Integrated Framework.

 

No Changes in InternalControls over Financial Reporting During Most Recent Quarter*. *The Company’s ChiefExecutive Officer and Chief Financial Officer have also concluded that therewere no changes in the Company’s internal control over financial reporting orin other factors that occurred during the Company’s most recent fiscal quarterthat have materially affected, or are reasonably likely to materially affect,the Company’s internal control over financial reporting or any correctiveactions with regard to significant deficiencies and material weaknesses ininternal control over financial reporting.

 

64

----

 

GeneralDescription of Internal Control over Financial Reporting*.  *Internal control overfinancial reporting refers to a process designed by, or under the supervisionof, the Company’s Chief Executive Officer and Chief Financial Officer andeffected by the Company’s Board of Directors, management and other personnel,to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles and includes thosepolicies and procedures that:

 

(1)          Pertainto the maintenance of records that in reasonable detail accurately and fairlyreflect the transactions and dispositions of Company assets;

 

(2)          Providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that Company’s receipts and expenditures are beingmade only in accordance with the authorization of Company’s management andmembers of the Company’s Board of Directors; and

 

(3)          Providereasonable assurance regarding prevention or timely detection of unauthorizedacquisitions, uses or dispositions of Company assets that could have a materialeffect on the Company’s financial statements.

 

InherentLimitations in Internal Control over Financial Reporting*.  *Internal control overfinancial reporting cannot provide absolute assurance of achieving financialreporting objectives because of its inherent limitations.  Internalcontrol over financial reporting is a process that involves human diligence andcompliance and is subject to lapses in judgment and breakdowns resulting fromhuman failures.  Internal control over financial reporting also canbe circumvented or overridden by collusion or other improperactivities.  Because of such limitations, there is a risk thatmaterial misstatements may not be prevented or detected on a timely basis byinternal control over financial reporting.  However, these inherentlimitations are known features of the financial reporting process, and it ispossible to design into the process safeguards to reduce, though not eliminate,this risk.

 

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

 

Management’s ConclusionRegarding Internal Control over Financial Reporting*. *As a result of ourassessment of the Company’s internal control over financial reporting,management concluded that the Company’s internal control over financialreporting was effective as of December 31, 2008 to ensure that informationrequired to be disclosed by the Company in reports that it files or submitsunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in SEC rules and forms.

 

**Item 9B.    Other Information**

 

None

 

65

----

 

**PART III**

 

**Item 10.    Directors and Executive Officers of theRegistrant**

 

The information requiredby Item 10 is hereby incorporated by reference from the Company’s definitiveproxy statement in connection with its annual meeting of shareholders scheduledfor May 13, 2009, which will be filed with the Commission on or about April 10,2009, pursuant to Regulation 14A.

 

**Item 11.    Executive Compensation**

 

Set forth below isinformation about our executive officers who do not serve as Directors,including their business experience for at least the past five years and theirages as of March 12, 2009.

 
| **Name**            | ** ** | **Age**    | ** ** | **Position with the Company**                                                                            |
|---------------------|------------|------------|------------|----------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** ** | ** ** | ** **                                                                                               |
| Brenda S. Bragonier |       | 52         |       | Vice President, Director of Marketing and Human Resources since  1999.                                   |
| Gregory J. Dawson   |       | 48         |       | Vice President, Chief Financial Officer since 1989.                                                      |
| Norman J. Fryman    |       | 59         |       | Senior Vice President, Director of Sales and Service since 2004.                                         |
| Clark Nyberg        |       | 56         |       | Vice President, Director of Wealth Management since 2004.                                                |
| Martha Woodford     |       | 55         |       | Vice President, Director of Operations, since 2006. Assistant  Director of Operations from 2004 to 2006. |

 

**Item 12.    Security Ownership of Certain BeneficialOwners and Management**

 

The information requiredby Item 12 is hereby incorporated by reference from the Company’s definitiveproxy statement in connection with its annual meeting of shareholders scheduledfor May 13, 2009, which will be filed with the Commission on or about April 10,2009, pursuant to Regulation 14A.

 

**Item 13.    Certain Relationships and RelatedTransactions**

 

The information requiredby Items 13 is hereby incorporated by reference from the Company’s definitiveproxy statement in connection with its annual meeting of shareholders scheduledfor May 13, 2009, which will be filed with the Commission on or about April 10,2009, pursuant to Regulation 14A.

 

**Item 14.    PrincipalAccountant Fees and Services**

 

The information requiredby Item 14 is hereby incorporated by reference from the Company’s definitiveproxy statement in connection with its annual meeting of shareholders scheduledfor May 13, 2009, which will be filed with the Commission on or about April 10,2009, pursuant to Regulation 14A.

## ** **

66

----

## ** **

## **Part IV**

## ** **

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

 

(a)  (1)   Financial Statements

 

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

 

Report of IndependentRegistered Public Accounting Firm

Consolidated BalanceSheets

Consolidated Statementsof Income

Consolidated Statementsof Changes in Shareholders’ Equity

Consolidated Statementsof Cash Flow

Notes to ConsolidatedFinancial Statements

 

(a)  (2)   Financial Statement Schedules.

 

All financial statementschedules have been omitted as the required information is inapplicable or therequired information has been included in the Consolidated Financial statementsor notes thereto.

 

(a)  (3)   Exhibits

 

The following exhibitsare incorporated by reference herein or made a part of this Form 10-K:

 
| 2.1    |   | Agreement and Plan of  Merger with Peoples Bancorp of Sandy Hook is incorporated by reference to  Exhibit 2.1 of the Registrant’s Current Report on Form 8-K dated  February 24, 2006.                                            |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                  |
| 3.1    |   | Articles of  Incorporation of the Registrant are incorporated by reference to  Exhibit 3.1 of the Registrant’s Quarterly Report on Form 10-Q for  the quarterly period ending March 31, 2000.                                     |
|   |   |                                                                                                                                                                                                                                                  |
| 3.2    |   | Bylaws of the  Registrant are incorporated by reference to Exhibit 3.1 of the  Registrant’s Quarterly Report on Form 10-Q for the quarterly period  ending June 30, 2000.                                                         |
|   |   |                                                                                                                                                                                                                                                  |
| 3.3    |   | Articles of Amendment  to Amended and Restated Articles of Incorporation of the Registrant are  incorporated by reference to Exhibit 3.3 of the Registrant’s Annual  Report on Form 10-K for the period ending December 31, 2005. |
|   |   |                                                                                                                                                                                                                                                  |
| 10.1   |   | Kentucky  Bancshares, Inc. 1993 Employee Stock Ownership Incentive Plan is  incorporated by reference to Exhibit 10.2 of the Registrant’s  Registration Statement on Form S-4 (File No. 33-96358).                           |
|   |   |                                                                                                                                                                                                                                                  |
| 10.2   |   | Kentucky  Bancshares, Inc. 1993 Non-Employee Directors Stock Ownership Incentive  Plan is incorporated by reference to Exhibit 10.3 of the Registrant’s  Registration Statement on Form S-4 (File No. 33-96358).             |
|   |   |                                                                                                                                                                                                                                                  |
| 10.3   |   | Kentucky  Bancshares, Inc. 1999 Employee Stock Option Plan is incorporated by  reference to Exhibit 99.1 of the Registrant’s Form 10-K for the  fiscal year ended December 31, 1998.                                         |

 

67

----

 
| 10.4   |   | Schedule of 2006 Compensation  Arrangements for Named Executive Officers is incorporated by reference to the  Registrant’s Current Report on Form 8-K dated December 20, 2005.                    |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                             |
| 10.5   |   | 2005 Restricted Stock  Grant Plan, including form of Award Agreement, as incorporated by reference  to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K  dated February 15, 2005. |
|   |   |                                                                                                                                                                                                             |
| 11     |   | Computation of earnings  per share - See Note 12 in the notes to consolidated financial statements  included as Exhibit 13.                                                                                 |
|   |   |                                                                                                                                                                                                             |
| 21     |   | Subsidiaries of Registrant                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                             |
| 23     |   | Consent of Crowe  Horwath LLP                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                             |
| 31.1   |   | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as amended.                                                         |
|   |   |                                                                                                                                                                                                             |
| 31.2   |   | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as amended.                                                         |
|   |   |                                                                                                                                                                                                             |
| 32.1   |   | Certification of Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                   |
|   |   |                                                                                                                                                                                                             |
| 32.2   |   | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                   |

 

(b)   Exhibits

 See response to Item 15(a)(3).

 

(c)   Financial Statement Schedules

 See response to Item 15(a)(2).

 

68

----

 

SIGNATURES

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
| Kentucky  Bancshares, Inc.                                  |
|------------------------------------------------------------------|
| By:                                                              | /s/Louis Prichard |   |
| Louis Prichard,  President and Chief Executive Officer, Director |
| March 30, 2009                                              |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| /s/Louis Prichard                                                |   | March 30, 2009                        |
|------------------------------------------------------------------|--------|--------------------------------------------|
| Louis Prichard,  President and Chief Executive Officer, Director |   |                                       |
|                                                             |   |                                       |
| /s/Gregory J. Dawson                                             |   | March 27, 2009                        |
| Gregory J. Dawson,  Chief Financial and Accounting Officer       |   |                                       |
|                                                             |   |                                       |
| /s/Buckner Woodford                                              |   | March 27, 2009                        |
| Buckner Woodford,  Chairman of the Board, Director               |   |                                       |
|                                                             |   |                                       |
| /s/William Arvin                                                 |   | March 30, 2009                        |
| William Arvin, Director                                          |   |                                       |
|                                                             |   |                                       |
|                                                             |   | March     ,  2009 |
| B. Proctor Caudill,  Director                                    |   |                                       |
|                                                             |   |                                       |
| /s/Henry Hinkle                                                  |   | March 27, 2009                        |
| Henry Hinkle, Director                                           |   |                                       |
|                                                             |   |                                       |
| /s/Theodore Kuster                                               |   | March 27, 2009                        |
| Theodore Kuster,  Director                                       |   |                                       |
|                                                             |   |                                       |
| /s/Betty J. Long                                                 |   | March 27, 2009                        |
| Betty J. Long, Director                                          |   |                                       |
|                                                             |   |                                       |
| /s/Ted McClain                                                   |   | March 30, 2009                        |
| Ted McClain, Director                                            |   |                                       |
|                                                             |   |                                       |
| /s/Edwin S. Saunier                                              |   | March 30, 2009                        |
| Edwin S. Saunier,  Director                                      |   |                                       |
|                                                             |   |                                       |
| /s/Robert G. Thompson                                            |   | March 27, 2009                        |
| Robert G. Thompson,  Director                                    |   |                                       |
|                                                             |   |                                       |
| /s/Woodford Van Meter                                            |   | March 30, 2009                        |
| Woodford Van Meter,  Director                                    |   |                                       |

 

69

----

 

KentuckyBancshares, Inc.

Exhibit Index

 
| 2.1    |   | Agreement and Plan of  Merger with Peoples Bancorp of Sandy Hook is incorporated by reference to  Exhibit 2.1 of the Registrant’s Current Report on Form 8-K dated  February 24, 2006.                                            |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                  |
| 3.1    |   | Articles of  Incorporation of the Registrant are incorporated by reference to  Exhibit 3.1 of the Registrant’s Quarterly Report on Form 10-Q for  the quarterly period ending March 31, 2000.                                     |
|   |   |                                                                                                                                                                                                                                                  |
| 3.2    |   | Bylaws of the  Registrant are incorporated by reference to Exhibit 3.1 of the  Registrant’s Quarterly Report on Form 10-Q for the quarterly period  ending June 30, 2000.                                                         |
|   |   |                                                                                                                                                                                                                                                  |
| 3.3    |   | Articles of Amendment  to Amended and Restated Articles of Incorporation of the Registrant are  incorporated by reference to Exhibit 3.3 of the Registrant’s Annual  Report on Form 10-K for the period ending December 31, 2005. |
|   |   |                                                                                                                                                                                                                                                  |
| 10.1   |   | Kentucky  Bancshares, Inc. 1993 Employee Stock Ownership Incentive Plan is  incorporated by reference to Exhibit 10.2 of the Registrant’s  Registration Statement on Form S-4 (File No. 33-96358).                           |
|   |   |                                                                                                                                                                                                                                                  |
| 10.2   |   | Kentucky  Bancshares, Inc. 1993 Non-Employee Directors Stock Ownership Incentive  Plan is incorporated by reference to Exhibit 10.3 of the Registrant’s  Registration Statement on Form S-4 (File No. 33-96358).             |
|   |   |                                                                                                                                                                                                                                                  |
| 10.3   |   | Kentucky  Bancshares, Inc. 1999 Employee Stock Option Plan is incorporated by  reference to Exhibit 99.1 of the Registrant’s Form 10-K for the  fiscal year ended December 31, 1998.                                         |
|   |   |                                                                                                                                                                                                                                                  |
| 10.4   |   | hedule of 2006  Compensation Arrangements for Named Executive Officers is incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  December 20, 2005.                                                          |
|   |   |                                                                                                                                                                                                                                                  |
| 10.5   |   | 05 Restricted Stock  Grant Plan, including form of Award Agreement, as incorporated by reference  to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K  dated February 15, 2005.                                        |
|   |   |                                                                                                                                                                                                                                                  |
| 11     |   | Computation of earnings  per share - See Note 12 in the notes to consolidated financial statements  included as Exhibit 13.                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                  |
| 21     |   | Subsidiaries of  Registrant                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                  |
| 23     |   | Consent of Crowe  Horwath LLP                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                  |
| 31.1   |   | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as amended.                                                                                              |
|   |   |                                                                                                                                                                                                                                                  |
| 31.2   |   | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a) of the Securities Exchange Act, as amended.                                                                                              |
|   |   |                                                                                                                                                                                                                                                  |
| 32.1   |   | Certification of Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                        |
|   |   |                                                                                                                                                                                                                                                  |
| 32.2   |   | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                        |

 

70

----