**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-K**

 

**(Mark One)**

 

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

 

**For thefiscal year ended December 31, 2009**

 

**or**

 

**o****        ****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period from            to            **

 

**CommissionFile Number:  33-96358**

 

**KENTUCKYBANCSHARES, 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’stelephone number, 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 No x

 

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

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes x No o

 

Indicate by check mark whether theregistrant has submitted electronically and posted on its corporate Web site,if any, every Interactive Data File required to be submitted and postedpursuant to Rule 405 of Regulations S-T (§232.405 of this chapter) during thepreceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files). Yes o No o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment 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 markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o No x

 

Aggregate market value ofvoting stock held by non-affiliates as of June 30, 2009 was approximately$36.8 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, 2010:  2,743,561.

 

 

 

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**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”).

 

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

 

Kentucky Bank is a commercialbank 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), Sandy Hook (Elliott County), Versailles (Woodford County),Wilmore (Jessamine County) and Winchester (Clark County).  The deposits of Kentucky Bank are insured upto prescribed limits by the Deposit Insurance Fund (“DIF”) of the FederalDeposit Insurance Corporation (“FDIC”).

 

The Company had totalassets of $675.5 million, total deposits of $536.4 million and stockholders’equity of $61.1 million as of December 31, 2009.  The Company’s principal executive office islocated at 339 Main Street, Paris, Kentucky 40361, and the telephone number atthat 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 customer service.  Management continues to consider opportunitiesfor branch expansion and will also consider acquisition opportunities that helpadvance its strategic objectives.

 

Lending

 

Kentucky Bank is engagedin general full-service commercial and consumer banking.  A significant part of Kentucky Bank’s operatingactivities include originating loans, approximately 72% of which are secured byreal estate at December 31, 2009. Kentucky Bank makes commercial, agricultural and real estate loans toits commercial customers, with emphasis on small-to-medium-sized industrial,service and agricultural businesses.  Italso makes residential mortgage, installment and other loans to its individualand other non-commercial customers.

 

*LoanRates: *Kentucky Bank offers variable and fixed rateloans.  Loan rates on variable rate loans generally adjust upward ordownward based on changes in the loan’s index.  Rate adjustments onvariable rate loans are made from 1 day to 5 years.  Variable rateloans may contain provisions that cap the amount of interest rate increases ordecreases over the life of the loan.  Inaddition to the lifetime caps and floors on rate adjustments, loans secured byresidential real estate may contain provisions that limit annual increases at amaximum of 200 basis points.  There isusually no annual limit applied to loans secured by commercial real estate.

 

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*CreditRisk: *Commercial lending and real estate constructionlending, generally includes a higher degree of credit risk than other loans, suchas residential mortgage loans.  Commercial loans, like other loans,are evaluated at the time of approval to determine the adequacy of repaymentsources and collateral requirements.  Collateral requirements vary to somedegree among borrowers and depend on the borrower’s financial strength,the terms and amount of the loan, and collateral available to secure theloan.  Credit risk results from the decreased ability or willingnessto pay by a borrower.  Credit risk also results when a liquidation ofcollateral occurs and there is a shortfall in collateral value as compared to aloans outstanding balance.  For construction loans, inaccurateinitial estimates of a project’s costs and the property’s completed value couldweaken the 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 Kentucky Bank’s general market area.

 

*OtherProducts:** *Kentucky Bank offers its customers a variety of otherservices, including checking, savings, money market accounts, certificates ofdeposits, safe deposit facilities, a credit card and other consumer-orientedfinancial services.  Kentucky Bank hasInternet banking, including bill payment available to its customers atwww.kybank.com.  Through its WealthManagement Department, Kentucky Bank provides brokerage services, annuities,life and long term care insurance, personal trust and agency services(including management agency services).

 

Competition and MarketServed

 

*Competition:* The banking business is highlycompetitive.  Competition arises from anumber of sources, including other bank holding companies and commercial banks,consumer finance companies, thrift institutions, other financial institutionsand financial intermediaries.  Inaddition to commercial banks, savings and loan associations, savings banks andcredit unions actively compete to provide a wide variety of bankingservices.  Mortgage banking firms,finance companies, insurance companies, brokerage companies, financialaffiliates of industrial companies and government agencies provide additionalcompetition for loans and for many other financial services.  Kentucky Bank also currently competes forinterest-bearing funds with a number of other financial intermediaries,including brokerage firms and mutual funds, which offer a diverse range ofinvestment alternatives.  Some of theCompany’s competitors are not subject to the same degree of regulatory reviewand restrictions that apply to the Company and its subsidiary bank.  In addition, the Company must compete withmuch larger financial institutions that have greater financial resources thanthe Company.

 

*MarketServed.*  The Company’s primary market areas consist ofBourbon, Clark, Elliott, Harrison, Jessamine, Rowan, Scott, Woodford andsurrounding counties in Kentucky.

 

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Supervision andRegulation

 

*GoverningRegulatory Institutions:*  As a bank holding company, theCompany is subject to the regulation and supervision of the Federal ReserveBoard.  The Company’s subsidiary issubject to supervision and regulation by applicable state and federal bankingagencies, including the Federal Reserve Board, the Federal Deposit InsuranceCorporation and the Kentucky Office of Financial Institutions.  Kentucky Bank is also subject to variousrequirements and restrictions under federal and state law, includingrequirements to maintain reserves against deposits, restrictions on the typesand amounts of loans that may be granted and the interest that may be chargedthereon, and limitations on the types of investments that may be made and the typesof services that may be offered.  Inaddition to the impact of regulation, Kentucky Bank is affected significantlyby the actions of the Federal Reserve Board as it attempts to control the moneysupply and credit availability in order to influence the economy.

 

*LawsProtecting Deposits: *There are a number of obligations andrestrictions imposed on bank holding companies and their depository institutionsubsidiaries by federal law and regulatory policy.  These obligations and restrictions aredesigned to reduce potential loss exposure to the depositors of such depositoryinstitutions and to the FDIC insured funds in the event the depositoryinstitution 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 is subject to several depositinsurance assessments, which are described below:

 

*FDICAssessments.*  The Company’s subsidiary bank is a member ofthe FDIC, and its deposits are insured by the FDIC’s Deposit Insurance Fund upto the amount permitted by law.  TheCompany’s subsidiary bank is thus subject to FDIC deposit insuranceassessments.  The FDIC utilizes arisk-based assessment system that imposes insurance premiums based upon a riskmatrix that takes into account a bank’s capital level and supervisoryrating.  Under the Federal DepositInsurance Reform Act of 2005, which became law in 2006, the Company received aone-time assessment credit of $434 thousand that can be applied against futurepremiums, subject to certain limitations. Based on the one-time assessment credit, the Company was not required topay any deposit insurance premiums in 2006 and unused credits from 2006resulted in the amount of deposit insurance premiums being zero 2007.  Lower credits remained to offset assessmentsfor 2008, which was the primary factor in higher deposit insurance netassessments of $175 thousand.

 

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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 0.40% to 1.15% within seven years.  Banks in the best risk category, whichinclude the Company’s subsidiary bank, will pay initial base rates ranging from12 to 16 basis points of assessable deposits beginning April 1, 2009, upfrom the initial base rate range of 12 to 14 basis points.  Additionally, the FDIC approved an interim rule imposinga special emergency assessment to all financial institutions of five basispoints as of June 30, 2009.  Thespecial assessment amounted to $296 thousand and was paid on September 30,2009.  The FDIC is also permitted toimpose an emergency special assessment after June 30, 2009 of up to 10 basispoints if necessary to maintain public confidence in federal depositinsurance.  On November 12, 2009,the FDIC adopted a final rule requiring insured depository institutions toprepay their estimated quarterly risk-based assessments for the fourth quarterof 2009, and for all of 2010, 2011, and 2012, on December 30, 2009, alongwith each institution’s risk-based deposit insurance assessment for the thirdquarter of 2009.  The prepaid amount willbe amortized over the prepayment period.  The Company’s prepayment was$3.1 million.

 

Financing Corporation (“FICO”)Assessments.  FICO assessment costs were$53 thousand in 2009 and $54 thousand for 2008. FICO is a mixed-ownership government corporation established by theCompetitive Equality Banking Act of 1987 possessing assessment powers inaddition to the FDIC.  The FDIC acts as acollection agent for FICO, whose sole purpose is to function as a financingvehicle for the now defunct Federal Savings & Loan InsuranceCorporation.

 

*TemporaryLiquidity Guarantee Program (“TLGP”).*  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. The TLGP consists of two separate programs implemented by the FDIC in October 2008.  This includes the Debt Guarantee Program (“DGP”)and the Transaction Account Guarantee Program (“TAGP”).  These programs were initially provided at nocost to participants during the first 30 days. Eligible institutions that do not “opt out” of either of these programsbecome participants by default and will incur the fees assessed for takingpart.

 

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 wassigned into law by the President on October 3, 2008 as a measure tostabilize and provide liquidity to the U.S. financial markets.  Under EESA, the Troubled Asset Relief Program(“TARP”) was created.  TARP granted theTreasury authority to, among other things, invest in financial institutions andpurchase troubled assets in an aggregate amount up to $700 billion.

 

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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: *There are various legal and regulatorylimits on the extent to which the Company’s subsidiary bank may pay dividendsor otherwise supply funds to the Company. In addition, federal and state regulatory agencies also have theauthority to prevent a bank or bank holding company from paying a dividend or engagingin any other activity that, in the opinion of the agency, would constitute anunsafe or unsound practice.  Dividendspaid by the subsidiary bank have provided substantially all of the Company’soperating funds, and this may reasonably be expected to continue for theforeseeable future.

 

Employees

 

At December 31,2009, the number of full time equivalent employees of the Company was 182.

 

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 mayobtain information on the operation of the Public Reference Room bycalling the SEC at 1-800-SEC-0330.  TheSEC maintains an Internet site that contains reports, proxy and informationstatements, and other information regarding issuers that file electronicallywith the SEC on its website at www.sec.gov.

 

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**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.

 

**Industry Risk**

 

Industry risk includesrisks that affect the entire banking service industry.

 

*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 and continued to weaken in 2009.  The United States is currently in arecession.  The housing market is indecline reflected by falling 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 financialinstitutions have failed.  Many financialinstitutions and institutional investors have tightened the availability ofcredit to borrowers and other financial institutions, which, in turn, resultsin more loan defaults and decreased business activity.  Consumer confidence regarding the economy islow and the financial markets reflect this lack of confidence.  Most of our customers are in the CentralKentucky area, and have been directly affected by this recession.  Local economic conditions have affected thedemand of customers for loans, the ability of some borrowers to repay theseloans and the value of the collateral securing these loans.  Loan growth is critical to ourprofitability.  We do not expectsignificant improvement in the economy in the near future, and future declinesin the economy will likely make 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 or federalor state legislation could have a substantial impact on our operations.  Additional legislation and regulations may beenacted or adopted in the future that could significantly affect our powers,authority and operations, which could have a material adverse effect on thefinancial condition and results of operations. For example, in response to the economic downturn and financial crisis,the U.S. government has enacted legislation by passing the Emergency EconomicStabilization Act of 2008 (“EESA”) followed by the American Recovery andReinvestment Act of 2009 (the “Recovery Act”). These Acts have enabled the U.S. Treasury, the FDIC and the FederalReserve Board to develop programs, such as the Capital Purchase Program, theFinancial Stability Plan and the foreclosure prevention program, to improvefunding to consumers, increase interbank lending and reduce homeforeclosures.  The U.S. governmentcontinues to closely evaluate the economy, the effect of its legislation andresulting 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.

 

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*Higher FDIC Deposit Insurance Premiums and Assessments CouldAdversely Affect Our Financial Condition.*   FDIC insurance premiums have increasedsubstantially in 2009 and the Company may have to pay significantly higher FDICpremiums in the future.  Marketdevelopments have significantly depleted the insurance fund of the FDIC andreduced the ratio of reserves to insured deposits.  The FDIC adopted a revised risk-based depositinsurance assessment schedule in February 2009, which raised regulardeposit insurance premiums.  In May 2009,the FDIC also implemented a five basis point special assessment of each insureddepository institution’s total assets minus Tier 1 capital as of June 30,2009, but no more than ten basis points times the institution’s assessment basefor the second quarter of 2009, collected by the FDIC on September 30,2009.  The Company paid $296 thousandrelated to this special assessment. Additional special assessments may be imposed by the FDIC for futurequarters at the same or higher levels which could affect results of operation.

 

Inaddition, the FDIC recently adopted a rule requiring insured depositoryinstitutions to prepay their estimated quarterly risk-based assessments for thefourth quarter of 2009 and for all of 2010, 2011 and 2012.  The prepaid assessments collected on December 30,2009 were $3.1 million, all of which was recorded as a prepaid expense as of December 30,2009.  As of December 31, 2009 andeach quarter thereafter, the Company recorded and will record an expense forits regular quarterly assessment for the quarter and an offsetting credit tothe prepaid assessment until the asset is exhausted.  These changes may cause the premiums chargedby the FDIC to increase and could significantly increase the Company’s noninterest expense in future periods.  Theprepayment of the Company’s FDIC assessments also may temporarily reduce theCompany’s liquidity.

 

*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.*

 

Manyother banks and financial institutions have substantially greater resources andlending limits, larger branch systems and a wider array of bankingservices.  Additionally, we encountercompetition from both de novo and smaller community banks entering the marketswe are currently in.  We also competewith other providers of 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.

 

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Managementmakes various assumptions and judgments about the collectability 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.

 

*Changes in market factors maynegatively affect the value of our investment assets. *Market risk focuses on the impact to earnings andcapital arising from changes in market factors (e.g., interest rates, marketliquidity, volatilities, etc.) that affect the value of tradedinstruments.  Market risk includes itemsreflected both on and off the balance sheet. Market risk focuses primarily on mark-to-market portfolios (e.g.,accounts revalued for financial statement presentation), including tradingaccounts and certain derivatives.

 

*Our inability to maintain appropriatelevels of liquidity may have a negative impact on our results of operations andfinancial 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.

 

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*Incorrectstrategic decisions may have a negative impact on our results of operations andfinancial condition. *Strategic risk is the risk to earningsand capital arising from adverse business decisions or improper implementationof those decisions.  Strategic riskfocuses on more than an analysis of the written strategic plan.  Its focus is on how plans, systems andimplementation affect franchise value. It also incorporates how management analyzes external factors thataffect the Company’s strategic direction.

 

*Adverse publicity may have anegative impact on our business. *Reputation risk is the risk to earningsand capital arising from negative public opinion.  This affects the ability to establish newrelationships or services or to continue servicing existing relationships.  Examiners will assess reputation risk byrecognizing the potential effect the public’s opinion could have on ourfranchise value.

 

**Operational Risk**

 

*An inability to processtransactions may have a negative impact 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.

 

**Item 1B.**** ****Unresolved Staff Comments**

 

None.

 

**Item2.  Properties**

 

The Company’s corporateheadquarters is located at 339 Main Street, Paris, KY 40631, which itowns.  The main banking office ofKentucky Bank is located at 401 Main Street, Paris, Kentucky 40361.  In addition, Kentucky Bank serves customerneeds at 13 other locations.  Alllocations offer a full range of banking services.  Kentucky Bank owns all of the properties atwhich it conducts its business.  TheCompany owns approximately 119,000 square feet of office space.

 

Note 6 to the Company’sconsolidated financial statements included in this report contains additionalinformation relating to amounts invested in premises and equipment.

 

**KentuckyBank Banking Offices**

 

401 Main Street, Paris,Kentucky 40361

2021 South Main Street,Paris, KY 40361

24 West Lexington Avenue,Winchester, KY 40391

1975 By Pass Road,Winchester, KY 40391

Main and JaneStreet, Sandy Hook, KY 41171

939 US Hwy 27 South,Cynthiana, KY 41031

920 North Main Street,Nicholasville, KY 40356

108 East Main Street,Wilmore, KY 40390

400 West First Street,Morehead, KY 40351

1500 Flemingsburg Road,Morehead, KY 40351

260 Blossom Park Drive,Georgetown, KY 40324

103 West Showalter Drive,Georgetown, KY 40324

520 Marsailles Road,Versailles, KY 40383

 

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**Item3.  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.  Further, wemaintain liability insurance to cover some, but not all, of the potentialliabilities normally incident to the ordinary course of our businesses as wellas other insurance coverages customary in our business, with coverage limits aswe deem prudent.

 

**PART II**

 

**Item5.  Market for Common Equity and RelatedStockholder Matters**

 

**MarketInformation**

 

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 following table setsforth the high and low closing sales prices of the Common Stock from the OTCBulletin Board and the dividends declared thereon, for the periods indicatedbelow:

 
| ** ** | ** ** | ** ** | ** ** | **High**   | ** ** | **Low**    | ** ** | **Dividend** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|--------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **   | ** ** |
| 2009       |       | Quarter 4  |       | $          | 17.90      |       | $          | 15.50        |       | $ | .20 |   |
|       |       | Quarter 3  |       | 18.00      |       | 15.20      |       | .20          |       |
|       |       | Quarter 2  |       | 17.95      |       | 15.50      |       | .20          |       |
|       |       | Quarter 1  |       | 19.50      |       | 16.50      |       | .20          |       |
| 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          |       |

 

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

 

**Holders**

 

As of December 31,2009 the Company had 2,739,511 shares of Common Stock outstanding andapproximately 529 holders of record of its Common Stock.

 

**Purchasesof Equity Securities by the Issuer and Affiliates Pruchasers**

 

The table below lists issuer purchases of equitysecurities.

 
| ** **         | ** ** | **(a)**             | ** ** | ** **          | ** ** | **(c) Total Number**          | ** ** | **(d) Maximum Number**               | ** **    |
|--------------------|------------|---------------------|------------|---------------------|------------|-----------------------------------------|------------|------------------------------------------------|---------------|
| ** **         | ** ** | **Total**           | ** ** | **(b)**             | ** ** | **of Shares (or Units)** | ** ** | **(or Approximate Dollar**           | ** **    |
| ** **         | ** ** | **Number of**  | ** ** | **Average**         | ** ** | **Purchased as Part**         | ** ** | **Value) of Shares (or**        | ** **    |
| ** **         | ** ** | **Shares (or** | ** ** | **Price Paid** | ** ** | **of Publicly**                    | ** ** | **Units) that May Yet Be** | ** **    |
| ** **         | ** ** | **Units)**          | ** ** | **Per Share**  | ** ** | **Announced Plans**                | ** ** | **Purchased Under the**              | ** **    |
| **Period**         | ** ** | **Purchased**       | ** ** | **(or Unit)**  | ** ** | **Or Programs**                    | ** ** | **Plans or Programs**                | ** **    |
|               |       |                |       |                |       |                                    |       |                                           |          |
| 10/1/09 - 10/31/09 |       | 1,000               |       | $                   | 15.75      |                                    | 1,000      |                                           | 32,199 shares |   |
|               |       |                |       |                |       |                                    |       |                                           |          |
| 11/1/09 - 11/30/09 |       | —              |       | —              |       | —                                  |       | 32,199 shares                                  |          |
|               |       |                |       |                |       |                                    |       |                                           |          |
| 12/1/09 - 12/31/09 |       | —              |       | —              |       | —                                  |       | 32,199 shares                                  |          |
|               |       |                |       |                |       |                                    |       |                                           |          |
| Total              |       | 1,000               |       |                |       | 1,000                                   |       | 32,199 shares                                  |          |
|                    |            |                     |            |                     |            |                                         |            |                                                |               |  |

 

11

----

 

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 the purchase of 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, 2009, 267,801 shares have been purchased, with the most recent share repurchase under the Board-approved stock repurchase program having occurred on October 5, 2009.

 

**Securities Authorized for Issuance under Equity Compensation Plans**

 

The following table setsforth certain information regarding Company compensations plans under whichequity securities of the company are authorized for issuance.

 
| ** **                                                 | ** ** | ** **                         | ** ** | ** **                        | ** ** | **No. of securities**           | ** ** |
|------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|-------------------------------------------|------------|
| ** **                                                 | ** ** | ** **                         | ** ** | ** **                        | ** ** | **remaining available**              | ** ** |
| ** **                                                 | ** ** | **Number of securities** | ** ** | ** **                        | ** ** | **for future issuance**         | ** ** |
| ** **                                                 | ** ** | **to be issued**         | ** ** | **Weighted average**         | ** ** | **under equity**                     | ** ** |
| ** **                                                 | ** ** | **upon exercise of**     | ** ** | **exercise price of**   | ** ** | **compensation plans**               | ** ** |
| ** **                                                 | ** ** | **outstanding options,**      | ** ** | **outstanding options**      | ** ** | **(excluding securities**            | ** ** |
| **Plan category**                                     | ** ** | **warrants and rights**  | ** ** | **warrants and rights** | ** ** | **reflected in column 1)** | ** ** |
|                                                       |       |                               |       |                              |       |                                      |       |
| ***Plans Approved******By Stockholders:***                 |       |                               |       |                              |       |                                      |       |
|                                                       |       |                               |       |                              |       |                                      |       |
| 1993 Nonemployee Directors Stock Ownership Incentive  Plan |       | 6,600                              |       | $                                 | 29.83      |                                      | —     |   |
|                                                       |       |                               |       |                              |       |                                      |       |
| 1999 Employee Stock Option Plan                            |       | 29,650                             |       | 29.33                             |       | —                                    |       |
|                                                       |       |                               |       |                              |       |                                      |       |
| 2005 Restricted Stock Grant Plan                           |       | —                             |       | —                            |       | 33,847                                    |       |
|                                                       |       |                               |       |                              |       |                                      |       |
| 2009 Stock Award Plan                                      |       | —                             |       | —                            |       | 150,000                                   |       |
|                                                            |            |                                    |            |                                   |            |                                           |            |  |

 

12

----

 

**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 through2009.  This comparison assumes $100 invested on December 31,2004 in (a) our common stock, (b) SIC Code 6022 State CommercialBanks <$100 million, and (c) the Russell Microcap Index.

 

**COMPARISON OF 5 YEAR CUMULATIVETOTAL RETURN***

Among Kentucky BancsharesInc, The Russell MicroCap Index

And SIC Code 6022 StateCommercial Banks <$100mil

 

 

----

*$100 invested on12/31/04 in stock or index, including reinvestment of dividends. Fiscal yearending December 31.

 

13

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## **Item6.  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)**            | ** ** | **2009**                                                                    | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                 |       |                                                                        |       |   |   |   |   |   |   |   |   |
| CONDENSED  STATEMENT OF INCOME:                                      |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Total Interest  Income                                               |       | $                                                                           | 31,929     |   | $ | 35,129 |   | $ | 39,219 |   | $ | 35,593 |   | $ | 28,897 |   |
| Total Interest  Expense                                              |       | 12,509                                                                      |       | 15,359 |   | 19,034 |   | 16,718 |   | 11,766 |   |
| Net Interest  Income                                                 |       | 19,420                                                                      |       | 19,770 |   | 20,185 |   | 18,875 |   | 17,131 |   |
| Provision for  Losses                                                |       | 3,450                                                                       |       | 3,700 |   | 1,000 |   | 475 |   | 508 |   |
| Net Interest  Income After Provision for Losses                      |       | 15,970                                                                      |       | 16,070 |   | 19,185 |   | 18,400 |   | 16,623 |   |
| Noninterest  Income                                                  |       | 10,214                                                                      |       | 8,354 |   | 7,936 |   | 7,236 |   | 6,495 |   |
| Noninterest  Expense                                                 |       | 21,152                                                                      |       | 20,027 |   | 18,131 |   | 16,682 |   | 15,220 |   |
| Income Before  Income Tax Expense                                    |       | 5,032                                                                       |       | 4,397 |   | 8,990 |   | 8,954 |   | 7,898 |   |
| Income Tax  Expense                                                  |       | 184                                                                         |       | 684 |   | 2,404 |   | 2,468 |   | 2,078 |   |
| Net Income                                                           |       | 4,848                                                                       |       | 3,713 |   | 6,586 |   | 6,486 |   | 5,820 |   |
|                                                                 |       |                                                                        |       |   |   |   |   |   |   |   |   |
| SHARE DATA:                                                          |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Basic Earnings  per Share (EPS)                                      |       | $                                                                           | 1.77       |   | $ | 1.34 |   | $ | 2.31 |   | $ | 2.35 |   | $ | 2.17 |   |
| Diluted EPS                                                          |       | 1.77                                                                        |       | 1.33 |   | 2.30 |   | 2.34 |   | 2.16 |   |
| Cash Dividends  Declared                                             |       | 0.80                                                                        |       | 1.12 |   | 1.08 |   | 1.00 |   | 0.92 |   |
| Book Value                                                           |       | 22.25                                                                       |       | 20.77 |   | 20.65 |   | 19.59 |   | 17.45 |   |
| Average Common  Shares-Basic                                         |       | 2,737                                                                       |       | 2,778 |   | 2,852 |   | 2,762 |   | 2,677 |   |
| Average Common  Shares-Diluted                                       |       | 2,737                                                                       |       | 2,782 |   | 2,862 |   | 2,774 |   | 2,692 |   |
|                                                                 |       |                                                                        |       |   |   |   |   |   |   |   |   |
| SELECTED BALANCE  SHEET DATA:                                        |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Loans, including  loans held for sale                                |       | $                                                                           | 417,818    |   | $ | 418,812 |   | $ | 412,509 |   | $ | 439,159 |   | $ | 366,602 |   |
| Investment  Securities                                               |       | 168,411                                                                     |       | 172,834 |   | 147,750 |   | 127,891 |   | 160,652 |   |
| Total Assets                                                         |       | 675,231                                                                     |       | 678,775 |   | 630,939 |   | 629,542 |   | 572,750 |   |
| Deposits                                                             |       | 536,446                                                                     |       | 520,808 |   | 486,005 |   | 468,808 |   | 431,631 |   |
| Securities sold  under agreements to repurchase and other borrowings |       | 8,226                                                                       |       | 10,717 |   | 6,735 |   | 11,327 |   | 16,838 |   |
| Federal Home  Loan Bank advances                                     |       | 56,096                                                                      |       | 77,301 |   | 63,993 |   | 80,030 |   | 66,749 |   |
| Stockholders’  Equity                                           |       | 60,966                                                                      |       | 57,041 |   | 58,844 |   | 55,281 |   | 46,546 |   |
|                                                                 |       |                                                                        |       |   |   |   |   |   |   |   |   |
| PERFORMANCE RATIOS:                                                  |       |                                                                        |       |   |   |   |   |   |   |   |   |
| (Average  Balances)                                                  |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Return on Assets                                                     |       | 0.72                                                                        | %          | 0.58 | % | 1.04 | % | 1.09 | % | 1.08 | % |
| Return on  Stockholders’ Equity                                 |       | 8.10                                                                        | %          | 6.45 | % | 11.59 | % | 12.82 | % | 12.69 | % |
| Net Interest  Margin (1)                                             |       | 3.36                                                                        | %          | 3.49 | % | 3.56 | % | 3.48 | % | 3.50 | % |
| Equity to Assets  (annual average)                                   |       | 8.92                                                                        | %          | 8.96 | % | 8.97 | % | 8.48 | % | 8.50 | % |
|                                                                 |       |                                                                        |       |   |   |   |   |   |   |   |   |
| SELECTED  STATISTICAL DATA:                                          |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Dividend Payout  Ratio                                               |       | 45.28                                                                       | %          | 84.05 | % | 46.89 | % | 42.68 | % | 42.30 | % |
| Number of  Employees (at period end)                                 |       | 182                                                                         |       | 214 |   | 204 |   | 203 |   | 172 |   |
|                                                                 |       |                                                                        |       |   |   |   |   |   |   |   |   |
| ALLOWANCE COVERAGE  RATIOS:                                          |       |                                                                        |       |   |   |   |   |   |   |   |   |
| Allowance to  Total Loans                                            |       | 1.79                                                                        | %          | 1.29 | % | 1.17 | % | 1.12 | % | 1.16 | % |
| Net Charge-offs  as a Percentage of Average Loans                    |       | 0.31                                                                        | %          | 0.75 | % | 0.26 | % | 0.14 | % | 0.10 | % |

 

----

(1)  Taxequivalent

 

14

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**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.  When necessary,reclassifications have been made to prior years’ data throughout the followingdiscussion and analysis for purposes of comparability with 2009 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

 

This discussion contains forward-lookingstatements under the Private Securities Litigation Reform Act of 1995 thatinvolve risks and uncertainties. Although the Company believes that the assumptions underlying theforward-looking statements contained herein are reasonable, any of theassumptions could be inaccurate, and therefore, there can be no assurance thatthe forward-looking statements included herein will prove to be accurate.  Factors that could cause actual results todiffer from the results discussed in the forward-looking statements include,but are not limited to:  economicconditions (both generally and more specifically in the markets, including thetobacco market and the thoroughbred horse industry, in which the Company andits bank operate); competition for the Company’s customers from other providersof financial and mortgage services; government legislation, regulation andmonetary policy (which changes from time to time and over which the Company hasno control); changes in interest rates (both generally and more specificallymortgage interest rates); material unforeseen changes in the liquidity, resultsof operations, or financial condition of the Company’s customers; and otherrisks detailed in the Company’s filings with the Securities and ExchangeCommission, all of which are difficult to predict and many of which are beyondthe control of the Company.  The Companyundertakes no obligation to republish revised forward-looking statements toreflect events or circumstances after the date hereof or to reflect theoccurrence of unanticipated events.

 

15

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Overview

 

Net income for the yearended December 31, 2009 was $4.8 million, or $1.77 per common sharecompared to $3.7 million, or $1.34 for 2008 and $6.6 million, or $2.31 for2007.  Earnings per share assumingdilution were $1.84, $1.33 and $2.30 for 2009, 2008 and 2007, respectively.  For 2009, net income increased $1.1 million,or 30.6%.  Net interest income decreased$350 thousand, the loan loss provision decreased $250 thousand, total otherincome increased $1.9 million, while total other expenses increased $1.1million.

 

For 2008, net incomedecreased $2.9 million, or 43.6%.  Netinterest income decreased $415 thousand, the loan loss provision increased $2.7million, total other income increased $418 thousand, while total other expensesincreased $1.9 million.

 

Return on average equitywas 8.1% in 2009 compared to 6.5% in 2008 and 11.6% in 2007.  Return on average assets was 0.72% in 2009compared to 0.58% in 2008 and 1.04% in 2007.

 

Non-performing loans as apercentage of loans (including held for sale) were 3.42%, 1.73% and 1.57% as ofDecember 31, 2009, 2008 and 2007, respectively.

 

RESULTS OF OPERATIONS

 

Net Interest Income

 

Net interest income, theCompany’s largest source of revenue, on a tax equivalent basis decreased from$20.9 million in 2007 to $20.7 million in both 2008 and 2009.  The taxable equivalent adjustment (nontaxableinterest income on state and municipal obligations net of the relatednon-deductible portion of interest expense) is based on our Federal income taxrate of 34%.

 

Average earning assetsand interest bearing liabilities both increased from 2008 to 2009.  Average earning assets increased $23 million,or 4%.  Investment securities increased$28 million primarily due to lower level of loan demand.  Loans increased $4 million as a result of theeconomy and slower demand during 2009. Average interest bearing liabilities increased $21 million, or 4% duringthis same period.  This change wasprimarily from the increase in time deposits. The Company continues to actively pursue quality loans and fund theseprimarily with 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, and leveled out during 2009.  As a result of this, the tax equivalent yieldon earning assets decreased from 6.07% in 2008 to 5.38% in 2009.

 

The volume rate analysisfor 2009 that follows indicates that $4.5 million of the decrease in interestincome is attributable to the decrease in rates, while the change in volumecontributed to an increase of $1.3 million in interest income.  The rate decrease also caused a decrease inthe cost of interest bearing liabilities. The average rate of these liabilities decreased from 3.15% in 2008 to2.46% in 2009.  Based on the volume rateanalysis that follows, the lower level of interest rates contributed to adecrease of $3.5 million to interest expense, while the change in volume wasresponsible for a $602 thousand increase in interest expense.  As a result, the 2009 net interest incomedecrease is attributed to decreases in rates.

 

16

----

 

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 volume contributedto 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.

 

In addition to thenegative impact on net interest income that may result from the decreasing rateenvironment that began in 2007 and continued into 2009, competitive pressureson interest rates will continue and are likely to result in continued downwardpressure on net interest margins.

 

The accompanying analysis of changes in netinterest income in the following table shows the relationships of the volumeand rate portions of these changes in 2009 and 2008.  Changes in interest income and expenses dueto both rate and volume are allocated on a pro rata basis.

 

**Changes in Interest Income andExpense**

 
| ** **                                                              | ** ** | **2009 vs. 2008** | ** ** | **2008 vs. 2007** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                              | ** ** | **Increase**                | ** ** | **(Decrease)**              | ** ** | **Due to Change in** | ** ** | **Increase** | ** ** | **(Decrease)** | ** ** | **Due to Change in** | ** ** |
| ** **                                                              | ** ** | **Volume**                  | ** ** | **Rate**                    | ** ** | **Net Change** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Net Change** | ** ** |
| INTEREST INCOME                                                         |       |                        |       |                        |       |   |   |   |   |   |   |   |   |
| Loans                                                                   |       | $                           | 265        |                        | $          | (2,796 | ) | $ | (2,531 | ) | $ | (1,023 | ) | $ | (3,294 | ) | $ | (4,317 | ) |
| Investment  Securities                                                  |       | 1,185                       |       | (1,515                      | )          | (330 | ) | 1,068 |   | (152 | ) | 916 |   |
| Federal Funds  Sold and Securities Purchased under Agreements to Resell |       | (121                        | )          | (213                        | )          | (334 | ) | (108 | ) | (576 | ) | (684 | ) |
| Deposits with  Banks                                                    |       | 1                           |       | (6                          | )          | (5 | ) | 10 |   | (15 | ) | (5 | ) |
| Total Interest  Income                                                  |       | 1,330                       |       | (4,530                      | )          | (3,200 | ) | (53 | ) | (4,037 | ) | (4,090 | ) |
| INTEREST EXPENSE                                                        |       |                        |       |                        |       |   |   |   |   |   |   |   |   |
| Deposits                                                                |       |                        |       |                        |       |   |   |   |   |   |   |   |   |
| Demand                                                                  |       | 40                          |       | (830                        | )          | (790 | ) | (202 | ) | (1,864 | ) | (2,066 | ) |
| Savings                                                                 |       | 9                           |       | (85                         | )          | (76 | ) | 79 |   | (61 | ) | 18 |   |
| Negotiable  Certificates of Deposit and Other Time Deposits             |       | 986                         |       | (2,267                      | )          | (1,281 | ) | (71 | ) | (1,624 | ) | (1,695 | ) |
| Securities sold  under agreements to repurchase and other borrowings    |       | —                      |       | (302                        | )          | (302 | ) | 117 |   | (220 | ) | (103 | ) |
| Federal Home  Loan Bank advances                                        |       | (433                        | )          | 32                          |       | (401 | ) | 181 |   | (10 | ) | 171 |   |
| Total Interest  Expense                                                 |       | 602                         |       | (3,452                      | )          | (2,850 | ) | 104 |   | (3,779 | ) | (3,675 | ) |
| Net Interest  Income                                                    |       | $                           | 728        |                        | $          | (1,078 | ) | $ | (350 | ) | $ | (157 | ) | $ | (258 | ) | $ | (415 | ) |

 

17

----

 

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

 
| ** **                                                                             | ** ** | **2009**    | ** ** | **2008**     | ** ** | **2007**    | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------|------------|--------------|------------|-------------|------------|
| ** **                                                                             | ** ** | **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                                           |       | 107,658     |       | 3,641        |       | 3.38        | %          | 88,272 |   | 4,348 |   | 4.93 | % | 74,648 |   | 3,727 |   | 4.99 | % |
| State and Municipal obligations                                                        |       | 72,307      |       | 2,994        |       | 4.14        |       | 63,463 |   | 2,581 |   | 4.07 |   | 52,674 |   | 2,134 |   | 4.05 |   |
| Other Securities                                                                       |       | 6,982       |       | 322          |       | 4.61        |       | 6,796 |   | 358 |   | 5.27 |   | 8,046 |   | 510 |   | 6.34 |   |
| Total Securities Available for Sale                                                    |       | 186,947     |       | 6,957        |       | 3.72        |       | 158,531 |   | 7,287 |   | 4.60 |   | 135,368 |   | 6,371 |   | 4.71 |   |
| Tax Equivalent Adjustment                                                              |       |        |       | 1,307        |       | 0.70        |       |   |   | 944 |   | 0.60 |   |   |   | 715 |   | 0.53 |   |
| Tax Equivalent Total                                                                   |       |        |       | 8,264        |       | 4.42        |       |   |   | 8,231 |   | 5.19 |   |   |   | 7,086 |   | 5.23 |   |
| Federal Funds Sold and Agreements to  Repurchase                                       |       | 8,678       |       | 12           |       | 0.14        |       | 18,324 |   | 346 |   | 1.89 |   | 20,735 |   | 1,030 |   | 4.97 |   |
| Interest-Bearing Deposits with Banks                                                   |       | 882         |       | 9            |       | 1.02        |       | 799 |   | 14 |   | 1.75 |   | 432 |   | 19 |   | 4.40 |   |
| Loans, Net of Deferred Loan Fees (2)                                                   |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                                                                             |       | 47,395      |       | 2,696        |       | 5.69        |       | 45,309 |   | 2,852 |   | 6.29 |   | 46,508 |   | 3,731 |   | 8.02 |   |
| Real Estate Mortgage                                                                   |       | 360,752     |       | 21,220       |       | 5.88        |       | 358,067 |   | 23,442 |   | 6.55 |   | 370,699 |   | 26,802 |   | 7.23 |   |
| Installment                                                                            |       | 12,563      |       | 1,035        |       | 8.24        |       | 13,292 |   | 1,187 |   | 8.93 |   | 13,677 |   | 1,265 |   | 9.25 |   |
| Total Loans                                                                            |       | 420,710     |       | 24,951       |       | 5.93        |       | 416,668 |   | 27,481 |   | 6.60 |   | 430,884 |   | 31,798 |   | 7.38 |   |
| Total Interest-Earning Assets                                                          |       | 617,217     |       | 33,236       |       | 5.38        |       | 594,322 |   | 36,072 |   | 6.07 |   | 587,419 |   | 39,933 |   | 6.80 |   |
| Allowance for Loan Losses                                                              |       | (6,064      | )          |         |       |        |       | (5,123 | ) |   |   |   |   | (4,935 | ) |   |   |   |   |
| Cash and Due From Banks                                                                |       | 12,585      |       |         |       |        |       | 13,387 |   |   |   |   |   | 13,642 |   |   |   |   |   |
| Premises and Equipment                                                                 |       | 17,754      |       |         |       |        |       | 17,196 |   |   |   |   |   | 15,246 |   |   |   |   |   |
| Other Assets                                                                           |       | 29,374      |       |         |       |        |       | 22,729 |   |   |   |   |   | 21,934 |   |   |   |   |   |
| Total Assets                                                                           |       | 670,866     |       |         |       |        |       | 642,511 |   |   |   |   |   | 633,306 |   |   |   |   |   |
|                                                                                   |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES                                                                            |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-Bearing Deposits                                                              |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Negotiable Order of Withdrawal (“NOW”) and  Money Market Investment Accounts |       | 113,576     |       | 464          |       | 0.41        |       | 110,022 |   | 1,254 |   | 1.14 |   | 117,610 |   | 3,320 |   | 2.82 |   |
| Savings                                                                                |       | 39,888      |       | 322          |       | 0.81        |       | 38,962 |   | 398 |   | 1.02 |   | 31,722 |   | 380 |   | 1.20 |   |
| Certificates of Deposit and Other  Deposits                                            |       | 269,435     |       | 8,448        |       | 3.14        |       | 242,884 |   | 9,729 |   | 4.01 |   | 244,408 |   | 11,424 |   | 4.67 |   |
| Total Interest-Bearing Deposits                                                        |       | 422,899     |       | 9,234        |       | 2.18        |       | 391,868 |   | 11,381 |   | 2.90 |   | 393,740 |   | 15,124 |   | 3.84 |   |
| Securities sold under agreements to repurchase  and other borrowings                   |       | 21,354      |       | 596          |       | 2.79        |       | 21,346 |   | 898 |   | 4.21 |   | 18,935 |   | 1,001 |   | 5.29 |   |
| Federal Home Loan Bank advances                                                        |       | 64,142      |       | 2,679        |       | 4.18        |       | 74,508 |   | 3,080 |   | 4.13 |   | 70,132 |   | 2,909 |   | 4.15 |   |
| Total Interest-Bearing Liabilities                                                     |       | 508,395     |       | 12,509       |       | 2.46        |       | 487,722 |   | 15,359 |   | 3.15 |   | 482,807 |   | 19,034 |   | 3.94 |   |
| Noninterest-Bearing Earning Demand  Deposits                                           |       | 96,171      |       |         |       |        |       | 91,244 |   |   |   |   |   | 86,951 |   |   |   |   |   |
| Other Liabilities                                                                      |       | 6,438       |       |         |       |        |       | 5,983 |   |   |   |   |   | 6,745 |   |   |   |   |   |
| Total Liabilities                                                                      |       | 611,004     |       |         |       |        |       | 584,949 |   |   |   |   |   | 576,503 |   |   |   |   |   |
| STOCKHOLDERS’ EQUITY                                                              |       | 59,862      |       |         |       |        |       | 57,562 |   |   |   |   |   | 56,803 |   |   |   |   |   |
| Total Liabilities and Stockholders’  Equity                                       |       | 670,866     |       |         |       |        |       | 642,511 |   |   |   |   |   | 633,306 |   |   |   |   |   |
| Average Equity to Average Total Assets                                                 |       | 8.92        | %          |         |       |        |       | 8.96 | % |   |   |   |   | 8.97 | % |   |   |   |   |
| Net Interest Income                                                                    |       |        |       | 19,420       |       |        |       |   |   | 19,769 |   |   |   |   |   | 20,184 |   |   |   |
| Net Interest Income (tax equivalent) (3)                                               |       |        |       | 20,727       |       |        |       |   |   | 20,713 |   |   |   |   |   | 20,899 |   |   |   |
| Net Interest Spread (tax equivalent) (3)                                               |       |        |       |         |       | 2.92        |       |   |   | 2.92 |   |   |   |   |   | 2.86 |   |   |   |
| Net Interest Margin (tax equivalent) (3)                                               |       |        |       |         |       | 3.36        |       |   |   | 3.49 |   |   |   |   |   | 3.56 |   |   |   |

 

----

(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.

 

18

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Noninterest Income andExpenses

 

Noninterest income was$10.2 million in 2009 compared to $8.4 million in 2008 and $7.9 million in2007.  In 2009, increases in securitiesgains and gains on sold mortgage loans account for the majority of the increase.  In 2008, increases in securities gainsaccount for the majority of the increase. However, for both 2008 and 2009 these increases were offset by decreasesin service charges and loan service fee income.

 

Securities gains were$1.6 million in 2009, $658 thousand in 2008 and $37 thousand in 2007.  These are primarily attributable to declininginterest rates and the related inverse relationship of interest rates andmarket values.  Some securities gainswere taken in 2009 and 2008 and used to offset additions to the loan lossreserve and costs related to the pension plan termination.

 

Gains on loans sold were$1.2 million, $411 thousand and $432 thousand in 2009, 2008 and 2007,respectively.  Loans held for sale aregenerally sold after closing to the Federal Home Loan MortgageCorporation.  During 2009, the loanservice fee income increased $290 thousand, compared to a decrease of $187thousand in 2008, which was largely due to a write down of $213 thousand ofmortgage servicing rights.  Proceeds fromthe sale of loans were $52 million, $19 million and $16 million in 2009, 2008and 2007, respectively.  The volume ofloan originations is inverse to rate changes. The volume of loan originations during 2009 was $52 million, $19 millionin 2008, and $16 million in 2007.

 

Other noninterest incomeexcluding security net gains and gain on sale of mortgage loans was $7.4million in 2009, $7.3 million in 2008 and $7.5 million in 2007.  Service charge income, and more particularlyoverdraft income, is the largest contributor to these numbers.  Overdraft income was $4.2 million in 2009,$4.3 million in 2008 and $4.6 million in 2007. The decreases in 2009 and 2008 are primarily attributable to the slowereconomy.  Other income was $1.4 millionin 2007, $1.6 million in 2008 and $1.5 million in 2009.  The decrease in 2009 is primarilyattributable to a $101 thousand decrease in brokerage income and a $63 thousandloss on the sale of premises, and the increase in 2008 is primarily attributableto a $153 thousand increase in interchange income.

 

Noninterest expenseincreased $1.1 million in 2009 to $21.2 million, and increased $1.9 million in2008 to $20.0 million from $18.1 million in 2007.  The increases in salaries and benefits from$10.6 million in 2007 to $11.1 million in 2008 and to $11.3 million in 2009 areattributable to normal salary and benefit increases.  Bonus compensation was $381 thousand higherin 2009 compared to 2008 and $481 thousand lower in 2008 compared to 2007.  The 2009 increase is mainly a result of asuccessful bank wide incentive program that incorporated individual goals whilethe 2008 decrease was mainly the result of a decline in net income.  Occupancy expense increased $178 thousand in2008 to $2.7 million and decreased $92 thousand, or 3.3% in 2009 to $2.6million.  The largest expense,depreciation, increased $113 thousand to $1.1 million in 2008, and decreased$128 thousand to $1.0 million in 2009. Other noninterest expense increased from $5.0 million in 2007 to $6.2million in 2008 and increased to $7.2 million in 2009.  Additional pension plan costs due to its December 31,2008 termination were $563 thousand in 2008. Costs associated with terminating the pension plan as of December 31,2008 that were incurred and expensed in 2009 were $874 thousand.  FDIC insurance increased $870 thousand in2009 compared to 2008.  Legal andprofessional fees increased $119 thousand from 2008 to 2009, mainly fromadditional loan collection efforts. Check card processing fees increased $71 thousand from 2008 to 2009.   Amortization of core deposits related to thePeoples acquisition was $164 thousand in 2009, compared to $169 thousand in2008.  See Note 7 in the notes to 

 

19

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consolidated financialstatements included as Exhibit 13 for more detail of the goodwill andintangible assets.

 

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

 
| ** **                                                  | ** ** | **For the Year Ended December 31  (in thousands)** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **2009**                                                                         | ** ** | **2008** | ** ** | **2007** | ** ** |
| NON-INTEREST INCOME                                         |       |                                                                             |       |   |   |   |   |
| Service Charges                                             |       | $                                                                                | 5,212      |   | $ | 5,332 |   | $ | 5,495 |   |
| Loan Service Fee Income (Loss), net                         |       | 160                                                                              |       | (130 | ) | 58 |   |
| Trust Department Income                                     |       | 520                                                                              |       | 478 |   | 515 |   |
| Investment Securities Gains, net                            |       | 1,619                                                                            |       | 658 |   | 37 |   |
| Gains on Sale of Mortgage Loans                             |       | 1,205                                                                            |       | 411 |   | 432 |   |
| Other                                                       |       | 1,498                                                                            |       | 1,605 |   | 1,399 |   |
| Total Non-interest Income                                   |       | 10,214                                                                           |       | 8,354 |   | 7,936 |   |
|                                                        |       |                                                                             |       |   |   |   |   |
| NON-INTEREST EXPENSE                                        |       |                                                                             |       |   |   |   |   |
| Salaries and Employee Benefits                              |       | 11,289                                                                           |       | 11,082 |   | 10,594 |   |
| Occupancy Expenses                                          |       | 2,646                                                                            |       | 2,738 |   | 2,560 |   |
| Other                                                       |       | 7,217                                                                            |       | 6,207 |   | 4,977 |   |
| Total Non-interest Expense                                  |       | 21,152                                                                           |       | 20,027 |   | 18,131 |   |
|                                                        |       |                                                                             |       |   |   |   |   |
| Net Non-interest Expense as a Percentage  of Average Assets |       | 1.63                                                                             | %          | 1.82 | % | 1.61 | % |
|                                                             |            |                                                                                  |            |  |  |  |  |  |  |  |

 

Income Taxes

 

The Company had incometax expense of $185 thousand in 2009 and $684 thousand in 2008 and $2.4 millionin 2007.  This represents an effectiveincome tax rate of 3.8% in 2009, 15.6% in 2008 and 26.7% in 2007.  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, and various tax credits in 2009.

 

Balance Sheet Review

 

Assets declined slightlyfrom $679 million at December 31, 2008 to $675 million at December 31,2009.  Securities decreased $4 millionand loans increased $1 million in 2009. Deposits grew $16 million and FHLB borrowings decreased $21million.  The gain in deposits of 3% isprimarily from normal growth and the addition of public money.  Assets at year-end 2008 totaled $679 millioncompared to $631 million in 2007.  Loansincreased $7 million in 2008.  Depositsgrew $35 million and FHLB borrowings decreased $13 million.  The gain in deposits of 7% is primarily fromnormal growth and the addition of public money.

 

Loans

 

Total loans (includingloans held for sale) were $426 million at December 31, 2009 compared to$424 million at the end of 2008 and $417 million in 2007.  The slight increase in 2009 is mainlyattributable to normal loan demand. Loans increased in 2008, and the increase in 2008 is primarilyattributable to normal loan demand.  Asof the end of 2009 and compared to the prior year-end, commercial loansincreased $400 thousand, real estate construction loans were flat, real estatemortgage loans (including loans held for sale) increased $800 thousand andinstallment loans increased $600 thousand. As of the end of 2008 and compared to the prior year-end, commercialloans decreased $1.4 million, real estate construction loans decreased $9.4million, real estate mortgage loans (including loans held for sale) increased$16.3 million and installment loans increased $2.2 million.

 

As of December 31,2009, the real estate mortgage portfolio comprised 68% of total loans similarto 68% in 2008.  Of this, 1-4 family 

 

20

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residential propertyrepresented 57% in 2009 and 54% in 2008. Agricultural loans comprised 19% in 2009 and 19% in 2008 of the loanportfolio.  Approximately 75% of theagricultural loans are secured by real estate in 2009 compared to 73% in2008.  The remainder of the agriculturalportfolio is used to purchase livestock, equipment and other capitalimprovements and for general operation of the farm.  Generally, a secured interest is obtained inthe capital assets, equipment, livestock or crops.  Automobile loans account for 30% in 2009 and29% in 2008 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)** | ** ** |
|----------------------------------------|------------|-----------------------------------------------|------------|
| ** **                             | ** ** | **2009**                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Commercial                             |       | $                                             | 21,933     |   | $ | 21,505 |   | $ | 22,924 |   | $ | 29,335 |   | $ | 27,302 |   |
| Real Estate Construction               |       | 16,865                                        |       | 16,819 |   | 26,172 |   | 29,034 |   | 29,822 |   |
| Real Estate Mortgage                   |       | 287,797                                       |       | 287,032 |   | 270,749 |   | 290,324 |   | 245,326 |   |
| Agricultural                           |       | 80,619                                        |       | 80,779 |   | 80,774 |   | 79,627 |   | 59,328 |   |
| Installment                            |       | 18,277                                        |       | 17,643 |   | 15,421 |   | 15,684 |   | 8,954 |   |
| Other                                  |       | 280                                           |       | 685 |   | 1,603 |   | 402 |   | 368 |   |
| Total Loans                            |       | 425,771                                       |       | 424,463 |   | 417,643 |   | 444,406 |   | 371,100 |   |
| Less Deferred Loan Fees                |       | 161                                           |       | 186 |   | 255 |   | 256 |   | 188 |   |
| Total Loans, Net of Deferred Loan Fees |       | 425,610                                       |       | 424,277 |   | 417,388 |   | 444,150 |   | 370,912 |   |
| Less loans held for sale               |       | 191                                           |       | — |   | — |   | — |   | — |   |
| Less Allowance For Loan Losses         |       | 7,601                                         |       | 5,465 |   | 4,879 |   | 4,991 |   | 4,310 |   |
| Net Loans                              |       | 417,818                                       |       | 418,812 |   | 412,509 |   | 439,159 |   | 366,602 |   |
|                                        |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

21

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Thefollowing table sets forth the maturity distribution and interest sensitivityof selected loan categories at December 31, 2009.  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 table is netted with realestate mortgage loans on the following table.

 

Loan Maturities and Interest Sensitivity

 
| ** **                             | ** ** | **December 31, 2009 (in thousands)** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                             | ** ** | **One Year**                                        | ** ** | **One Through** | ** ** | **Over** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | **or Less**                                         | ** ** | **Five Years** | ** ** | **Five Years** | ** ** | **Loans** | ** ** |
| Commercial                             |       | $                                                        | 6,525      |   | $ | 13,319 |   | $ | 2,089 |   | $ | 21,933 |   |
| Real Estate Construction               |       | 13,623                                                   |       | 3,242 |   | — |   | 16,865 |   |
| Real Estate Mortgage                   |       | 38,931                                                   |       | 72,865 |   | 175,648 |   | 287,444 |   |
| Agricultural                           |       | 10,546                                                   |       | 36,757 |   | 33,316 |   | 80,619 |   |
| Installment                            |       | 4,899                                                    |       | 8,528 |   | 4,850 |   | 18,277 |   |
| Other                                  |       | 280                                                      |       | — |   | — |   | 280 |   |
| Total Loans, Net of Deferred Loan Fees |       | 74,804                                                   |       | 134,711 |   | 215,903 |   | 425,418 |   |
| Fixed Rate Loans                       |       | 34,587                                                   |       | 84,528 |   | 32,503 |   | 151,618 |   |
| Floating Rate Loans                    |       | 40,217                                                   |       | 50,183 |   | 183,400 |   | 273,800 |   |
| Total Loans, Net of Deferred Loan Fees |       | 74,804                                                   |       | 134,711 |   | 215,903 |   | 425,418 |   |
|                                        |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |

 

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 increased from $16million in 2007 to $19 million in 2008, and increased to $52 million in2009.  Proceeds from the sale of loanswere $53 million, $19 million and $16 million for the years 2009, 2008 and2007, respectively.  Mortgage loans heldfor sale were $191 thousand at December 31, 2009 and zero at December 31,2008.  Loans are generally sold when theyare made.  The volume of loanoriginations is inverse to rate changes. Declining rates toward the end of 2007 and continued low rates into2009, along with consumer tax incentives, resulted in higher loan originationsstarting in the latter portion of 2007 and continued into 2009.  The effect of these changes was alsoreflected on the income statement.  As aresult, the gain on sale of mortgage loans was $1.2 million in 2009 compared to$411 thousand in 2008 and $432 thousand in 2007.

 

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 $822 thousand at December 31, 2009, $465 thousand at December 31,2008 and $697 thousand at December 31, 2007.  Amortization of mortgage servicing rights was$161 thousand (including $75 thousand in recovery of 2008 write downs), $417thousand (including $213 thousand in write downs)and $214 thousand for theyears ended December 31, 2009, 2008 and 2007, respectively.  See Note 4 in the notes to consolidatedfinancial statements included as Exhibit 13 for additional information.

 

22

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Deposits

 

For 2009, total depositsincreased $16 million to $536 million.  Noninterest bearing deposits increased $7 million, while time depositsof $100 thousand and over decreased $3 million, and other interest bearingdeposits increased $13 million.  Publicfunds totaled $101 million at the end of 2009 ($95 million were interestbearing).

 

Total deposits increasedto $521 million in 2008, up $35 million from 2007.  Noninterest bearing deposits increased $2million, time deposits of $100 thousand and over increased $30 million, andother interest bearing deposits increased $3 million.  Public funds totaled $55 million at the endof 2008 ($48 million were interest bearing), a decrease of $4 million from theend of 2007.

 

The table below providesinformation on the maturities of time deposits of $100,000 or more at December 31,2009:

 

Maturity of Time Deposits of $100,000 ofMore

 
| ** **                               | ** ** | **At December 31, 2009** | ** ** |
|------------------------------------------|------------|-----------------------------------------|------------|
| ** **                               | ** ** | **(in thousands)**                 | ** ** |
| Maturing 3 Months or Less                |       | $                                       | 11,902     |   |
| Maturing over 3 Months through 6 Months  |       | 7,188                                   |       |
| Maturing over 6 Months through 12 Months |       | 43,806                                  |       |
| Maturing over 12 Months                  |       | 42,140                                  |       |
| Total                                    |       | $                                       | 105,036    |   |

 

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, 2009, $56 million wasborrowed from FHLB, a decrease of $21 million from 2008.  During 2009, $32 million of FHLB borrowingwas paid, and advances were made for an additional $11 million.  The decrease in advances in 2009 is primarilya result of an increase in deposits and the slower loan growth.  In 2008, $51 million of FHLB advances werepaid and advances were made for and additional $64 million.  The following table depicts relevantinformation concerning our short term borrowings.

 

Short Term Borrowings

 
| ** **                      | ** ** | **As of and for the year ended** | ** ** |
|---------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                      | ** ** | **December 31 (in thousands)**                  | ** ** |
| ** **                      | ** ** | **2009**                                                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Federal Funds Purchased:        |       |                                                           |       |   |   |   |   |
| Balance at Year end             |       | $                                                              | —     |   | $ | — |   | $ | — |   |
| Average Balance During the Year |       | 2,094                                                          |       | 1,643 |   | 117 |   |
| Maximum Month End Balance       |       | 12,611                                                         |       | 10,853 |   | — |   |
| Year end rate                   |       | —                                                         |       | — |   | — |   |
| Average annual rate             |       | 0.45                                                           | %          | 2.25 | % | 5.24 | % |
| Repurchase Agreements:          |       |                                                           |       |   |   |   |   |
| Balance at Year end             |       | $                                                              | 4,807      |   | $ | 6,617 |   | $ | 5,977 |   |
| Average Balance During the Year |       | 8,576                                                          |       | 9,686 |   | 10,415 |   |
| Maximum Month End Balance       |       | 11,935                                                         |       | 13,125 |   | 16,073 |   |
| Year end rate                   |       | 1.33                                                           | %          | 3.09 | % | 4.72 | % |
| Average annual rate             |       | 2.43                                                           | %          | 2.97 | % | 4.18 | % |
| Other Borrowed Funds:           |       |                                                           |       |   |   |   |   |
| Balance at Year end             |       | $                                                              | 3,419      |   | $ | 4,100 |   | $ | 758 |   |
| Average Balance During the Year |       | 3,467                                                          |       | 2,800 |   | 1,186 |   |
| Maximum Month End Balance       |       | 3,901                                                          |       | 4,500 |   | 2,036 |   |
| Year end rate                   |       | 2.76                                                           | %          | 2.46 | % | 4.79 | % |
| Average annual rate             |       | 2.78                                                           | %          | 3.68 | % | 5.58 | % |

 

23

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ContractualObligations

 

TheBank has required future payments for time deposits and long-term debt. See Note 14 in the notes to consolidated financial statements included as Exhibit 13for further information on the defined benefit retirement plan.  The otherrequired payments under such commitments at December 31, 2009 are asfollows:

 
| ** **                       | ** ** | **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                   |       | $                                                                  | 56,095     |   | $ | 11,159 |   | $ | 22,788 |   | $ | 14,761 |   | $ | 7,387 |   |
| Subordinated  debentures         |       | 7,217                                                              |       | — |   | — |   | — |   | 7,217 |   |
| Time  deposits                   |       | 262,853                                                            |       | 172,778 |   | 83,852 |   | 5,580 |   | 643 |   |
|                                  |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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.

 

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)** | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2009**                                                           | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Non-accrual Loans                                                                       |       | $                                                                  | 12,038     |   | $ | 6,562 |   | $ | 6,358 |   | $ | 2,379 |   | $ | 774 |   |
| Accruing Loans which are Contractually  past due 90 days or more                        |       | 2,526                                                              |       | 779 |   | 195 |   | 253 |   | 206 |   |
| Restructured Loans                                                                      |       | —                                                             |       | — |   | — |   | — |   | — |   |
| Total Nonperforming Loans                                                               |       | 14,564                                                             |       | 7,341 |   | 6,553 |   | 2,632 |   | 980 |   |
| Other Real Estate                                                                       |       | 4,542                                                              |       | 1,840 |   | 768 |   | 411 |   | 141 |   |
| Total Nonperforming Assets                                                              |       | 19,106                                                             |       | 9,181 |   | 7,321 |   | 3,043 |   | 1,121 |   |
| Total Nonperforming Loans as a Percentage  of Loans (including loans held for sale) (1) |       | 3.42                                                               | %          | 1.73 | % | 1.57 | % | 0.59 | % | 0.26 | % |
| Total Nonperforming Assets as a  Percentage of Total Assets                             |       | 2.83                                                               | %          | 1.35 | % | 1.16 | % | 0.48 | % | 0.20 | % |
| Allowance to nonperforming assets                                                       |       | 0.40                                                               |       | 0.60 |   | 0.67 |   | 1.64 |   | 3.84 |   |
|                                                                                         |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)  Net of deferredloan fees

 

24

----

 

Total nonperformingassets at December 31, 2009 were $19.1 million compared to $9.2 million atDecember 31, 2008 and $7.3 million at December 31, 2007.  The increase from 2008 to 2009 is primarilyattributable to the increase in various loans being put on non-accrual andadditions to other real estate.  Theincrease from 2007 to 2008 is primarily attributable to an increase in otherreal estate.  Total nonperforming loanswere $14.6 million, $7.3 million, and $6.6 million at December 31, 2009,2008 and 2007, respectively.  Thenon-accrual loan increase from 2008 to 2009 is mainly attributable to fourloans ranging from $1.2 million to $3.4 million that total $7.8 million.  All other non-accrual loans are less than$500 thousand.  The increase in past dueloans 90 days or more is primarily from one borrower of $1.4 million.  All other loans in this category are lessthan $300 thousand.  These loans aresecured by real estate.  The increase inloans past due 90 days or more from 2007 to 2008 is primarily attributable to 3borrowers totaling $482 thousand and ranging from $147 thousand to $179thousand.  All are secured by realestate.  The amount of lost interest onour non-accrual loans was $600 thousand for 2009.  At December 31, 2009, loans currentlyperforming but which management believes require special attention were notsignificant.  The Company continues to followits long-standing policy of not engaging in international lending and notconcentrating lending activity in any one industry.

 

Impaired loans as of December 31,2009 were $33.5 million compared to $5.1 million in 2008 and $2.1 million in2007.  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.

 

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 $4.1 million, $320 thousand and $692 thousand on December 31,2009, 2008 and 2007, respectively.

 

25

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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)** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2009**                                                | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Balance at Beginning of Year                                               |       | $                                                       | 5,465      |   | $ | 4,879 |   | $ | 4,991 |   | $ | 4,310 |   | $ | 4,163 |   |
| Balance of Allowance for Loan Losses of  Acquired Bank at Acquisition Date |       | —                                                  |       | — |   | — |   | 775 |   | — |   |
| Amounts Charged-off:                                                       |       |                                                    |       |   |   |   |   |   |   |   |   |
| Commercial                                                                 |       | 340                                                     |       | 114 |   | 131 |   | 15 |   | 146 |   |
| Real Estate Construction                                                   |       | 39                                                      |       | 637 |   | 374 |   | 28 |   | — |   |
| Real Estate Mortgage                                                       |       | 807                                                     |       | 1,981 |   | 289 |   | 232 |   | 134 |   |
| Agricultural                                                               |       | 22                                                      |       | 101 |   | 25 |   | 3 |   | 21 |   |
| Consumer                                                                   |       | 621                                                     |       | 563 |   | 449 |   | 365 |   | 225 |   |
| Total Charged-off Loans                                                    |       | 1,829                                                   |       | 3,396 |   | 1,268 |   | 643 |   | 526 |   |
| Recoveries on Amounts Previously  Charged-off:                             |       |                                                    |       |   |   |   |   |   |   |   |   |
| Commercial                                                                 |       | 6                                                       |       | 6 |   | 24 |   | 2 |   | 3 |   |
| Real Estate Construction                                                   |       | 35                                                      |       | 27 |   | 19 |   | — |   | — |   |
| Real Estate Mortgage                                                       |       | 408                                                     |       | 165 |   | 10 |   | 2 |   | 11 |   |
| Agricultural                                                               |       | —                                                  |       | 30 |   | 64 |   | 21 |   | 16 |   |
| Consumer                                                                   |       | 65                                                      |       | 54 |   | 39 |   | 49 |   | 135 |   |
| Total Recoveries                                                           |       | 514                                                     |       | 282 |   | 156 |   | 74 |   | 165 |   |
| Net Charge-offs                                                            |       | 1,315                                                   |       | 3,114 |   | 1,112 |   | 569 |   | 361 |   |
| Provision for Loan Losses                                                  |       | 3,450                                                   |       | 3,700 |   | 1,000 |   | 475 |   | 508 |   |
| Balance at End of Year                                                     |       | 7,600                                                   |       | 5,465 |   | 4,879 |   | 4,991 |   | 4,310 |   |
| Total Loans (1)                                                            |       |                                                    |       |   |   |   |   |   |   |   |   |
| Average                                                                    |       | 420,710                                                 |       | 416,668 |   | 430,884 |   | 408,131 |   | 361,732 |   |
| At December 31                                                        |       | 425,610                                                 |       | 424,277 |   | 417,388 |   | 444,150 |   | 370,912 |   |
| As a Percentage of Average Loans (1):                                      |       |                                                    |       |   |   |   |   |   |   |   |   |
| Net Charge-offs                                                            |       | 0.31                                                    | %          | 0.75 | % | 0.26 | % | 0.14 | % | 0.10 | % |
| Provision for Loan Losses                                                  |       | 0.82                                                    | %          | 0.89 | % | 0.23 | % | 0.12 | % | 0.14 | % |
| Allowance as a Percentage of Year-end  Loans (1)                           |       | 1.79                                                    | %          | 1.29 | % | 1.17 | % | 1.12 | % | 1.16 | % |
| Beginning Allowance as a Multiple of Net  Charge-offs                      |       | 4.2                                                     |       | 1.6 |   | 4.5 |   | 7.6 |   | 11.5 |   |
| Ending Allowance as a Multiple of  Nonperforming Assets                    |       | 0.40                                                    |       | 0.60 |   | 0.67 |   | 1.64 |   | 3.84 |   |
|                                                                            |            |                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

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

 

Loans are typicallycharged-off after being 120 days delinquent. Limited exceptions for not charging-off a loan would be well documentedand approved by the appropriate responsible party or committee.  The provision for loan losses for 2009 was$3.5 million compared to $3.7 million in 2008 and $1.0 million in 2007.  Net charge-offs were $1.3 million in 2009,$3.1 million in 2008 and $1.1 million in 2007. Net charge-offs to average loans were 0.31%, 0.75% and 0.26% in 2009,2008 and 2007, respectively.  The loanloss provision decreased $250 thousand from 2008 to 2009 and increased $2.7million from 2007 to 2008.  The provisionfor 2009 is lower than 2008 due to the $3.1 million in net charge-offs in2008.  In evaluating the allowance forloan losses, management considers the composition of the loan portfolio, thehistorical loan loss experience, the overall quality of the loans and anassessment of current economic conditions. The decline in the economy over the past couple of years has resulted inmore loan losses, higher loan loss provisions and declining loan qualitynumbers in 2008 and 2009, compared to prior years.  At December 31, 2009, the allowance forloan losses was 1.79% of loans outstanding compared to 1.29% at year-end 2008and 1.17% at year-end 2007.  Managementbelieves the allowance for loan losses at the end of 2009 is adequate to coverprobable incurred credit losses within the portfolio. 

 

26

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The following tables setsforth an allocation for the allowance for loan losses and loans bycategory.  In making the allocation,management evaluates the risk in each category, current economic conditions andcharge-off experience.  An allocation forthe allowance for loan losses is an estimate of the portion of the allowancethat will be used to cover future charge-offs in each loan category, but itdoes not preclude any portion of the allowance allocated to one type of loanbeing used to absorb losses of another loan type.

 

Allowance for Loan Losses

 
| ** **               | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
|                     |       |     |       |     |       |     |       |     |       |     |       |
| Commercial               |       | $        | 645        |     | $          | 529      |       | $        | 537        |     | $          | 594 |   | $ | 507 |   |
| Real Estate Construction |       | 819      |       | 623      |       | 633      |       | 638      |       | 566      |       |
| Real Estate Mortgage     |       | 3,762    |       | 2,211    |       | 1,827    |       | 1,806    |       | 1,785    |       |
| Agricultural             |       | 1,437    |       | 1,259    |       | 1,180    |       | 1,241    |       | 1,023    |       |
| Consumer                 |       | 937      |       | 843      |       | 702      |       | 712      |       | 428      |       |
| Total                    |       | 7,600    |       | 5,465    |       | 4,879    |       | 4,991    |       | 4,309    |       |
|                          |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |

 

Loans

 
|                     |       |        |       |           |       |        |       |           |       |        |       |           |       |        |       |           |       |        |       |           |       |   |   |   |   |   |
|--------------------------|------------|-------------|------------|----------------|------------|-------------|------------|----------------|------------|-------------|------------|----------------|------------|-------------|------------|----------------|------------|-------------|------------|----------------|------------|--------|--------|--------|--------|--------|
| ** **               | ** ** | **2009**    | ** ** | **2008**       | ** ** | **2007**    | ** ** | **2006**       | ** ** | **2005**    | ** ** |
| ** **               | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
|                     |       |        |       |           |       |        |       |           |       |        |       |           |       |        |       |           |       |        |       |           |       |
| Commercial               |       | $           | 21,933     |           | 5.15       | %           | $          | 21,505         |       | 5.07        | %          | $              | 22,924     |        | 5.49       | %              | $          | 29,335      |       | 6.60           | %          | $      | 27,302 |   | 7.36   | %      |
| Real Estate Construction |       | 16,865      |       | 3.96           | %          | 16,819      |       | 3.96           | %          | 26,172      |       | 6.27           | %          | 29,034      |       | 6.54           | %          | 29,822      |       | 8.04           | %          |
| Real Estate Mortgage     |       | 287,636     |       | 67.58          | %          | 286,846     |       | 67.61          | %          | 270,494     |       | 64.81          | %          | 290,068     |       | 65.31          | %          | 245,138     |       | 66.09          | %          |
| Agricultural             |       | 80,619      |       | 18.94          | %          | 80,779      |       | 19.04          | %          | 80,774      |       | 19.35          | %          | 79,627      |       | 17.93          | %          | 59,328      |       | 16.00          | %          |
| Consumer                 |       | 18,277      |       | 4.29           | %          | 17,643      |       | 4.16           | %          | 15,421      |       | 3.69           | %          | 15,684      |       | 3.53           | %          | 8,954       |       | 2.41           | %          |
| Other                    |       | 280         |       | 0.07           | %          | 685         |       | 0.16           | %          | 1,603       |       | 0.38           | %          | 402         |       | 0.09           | %          | 368         |       | 0.10           | %          |
| Total, Net (1)           |       | 425,610     |       | 100.00         | %          | 424,277     |       | 100.00         | %          | 417,388     |       | 100.00         | %          | 444,150     |       | 100.00         | %          | 370,912     |       | 100.00         | %          |
|                     |       |        |       |           |       |        |       |           |       |        |       |           |       |        |       |           |       |        |       |           |       |   |   |   |   |   |
|                          |            |             |            |                |            |             |            |                |            |             |            |                |            |             |            |                |            |             |            |                |            |        |        |        |        |        |  |  |  |  |  |  |  |

 

----

(1) Including loans held 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:

 
| ** **                 | ** ** | **2009**  | ** ** | **2008**  | ** ** |
|----------------------------|------------|-----------|------------|-----------|------------|
|                       |       |      |       |      |       |
| Unused  lines of credit    |       | $         | 70,171,230 |      | $          | 64,791,109 |   |
| Commitments  to make loans |       | 2,961,000 |       | 5,214,000 |       |
| Letters  of credit         |       | 836,797   |       | 794,066   |       |
|                            |            |           |            |           |            |  |  |

 

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 the followingtable, the Company’s Tier I capital (as defined by the Federal Reserve Boardunder the Board’s risk-based guidelines) at December 31, 2009 decreased$2.2 million to $52.2 million.  During2008, the Company purchased 114,148 shares of its stock for $3.1 million.  These repurchases partially offset the $3.7million in net income for 2008. Stockholders’ equity, excluding accumulated other comprehensive income,was $59.6 million at December 31, 2009. Included in Tier I capital is $7 million of trust preferred securitiesissued in August 2003.  Thedisallowed amount of stockholders’ equity is mainly attributable to thegoodwill and core deposit intangible, resulting from the Peoples acquisition in2006 and the Kentucky First acquisition in 2003.  The Company’s risk-based capital and leverageratios, as shown in the following table, exceeded the levels required to beconsidered “well capitalized”.  Theleverage ratio compares Tier I capital to total average assets less disallowedamounts of goodwill.

 
| ** **                             | ** ** | **At December 31  (dollars in thousands)** | ** ** |
|----------------------------------------|------------|-------------------------------------------------|------------|
| ** **                             | ** ** | **2009**                                        | ** ** | **2008** | ** ** | **Change** | ** ** |
| Stockholders’ Equity (1)          |       | $                                               | 59,630     |   | $ | 57,026 |   | 2,604 |   |
| Trust Preferred Securities             |       | 7,000                                           |       | 7,000 |   | — |   |
| Less Disallowed Amount                 |       | 14,037                                          |       | 14,640 |   | (603 | ) |
| Tier I Capital                         |       | 52,593                                          |       | 49,386 |   | 3,207 |   |
| Allowance for Loan Losses              |       | 5,795                                           |       | 5,503 |   | 292 |   |
| Other                                  |       | 10                                              |       | 9 |   | 1 |   |
| Tier II Capital                        |       | 5,805                                           |       | 5,512 |   | 293 |   |
| Total Capital                          |       | 58,398                                          |       | 54,898 |   | 3,500 |   |
| Total Risk Weighted Assets             |       | 461,855                                         |       | 445,422 |   | 16,433 |   |
| Ratios:                                |       |                                            |       |   |   |   |   |
| Tier I Capital to Risk-weighted Assets |       | 11.4                                            | %          | 11.1 | % | 0.3 | % |
| Total Capital to Risk-weighted Assets  |       | 12.6                                            | %          | 12.3 | % | 0.3 | % |
| Leverage                               |       | 8.0                                             | %          | 8.3 | % | -0.3 | % |
|                                        |            |                                                 |            |  |  |  |  |  |  |

 

----

(1)  Excluding accumulated othercomprehensive 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 31,2009, 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, decreased from $172.8 million at December 31,2008 to $168.4 million at December 31, 2009.   Federal funds sold totaled $22.0 million at December 31,2009 and $20.7 million at December 31, 2008.

 

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, 2009 and2008, 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 31,2009.

 

29

----

 

Investment Securities atmarket value

 

Investment Securities (Held to maturity atamortized cost, available for sale at market value)

 
| ** **                        | ** ** | **At  December (in thousands)** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **2009**                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| Available for Sale                |       |                                 |       |   |   |   |   |
| U.S. government agencies          |       | $                                    | 44,733     |   | $ | 19,350 |   | $ | 36,021 |   |
| States and political subdivisions |       | 80,123                               |       | 63,971 |   | 59,361 |   |
| Mortgage-backed                   |       |                                 |       |   |   |   |   |
| Fixed -                           |       |                                 |       |   |   |   |   |
| GNMA, FNMA, FHLMC Passthroughs    |       | 37,325                               |       | 76,028 |   | 40,261 |   |
| GNMA, FNMA, FHLMC CMO’s      |       | 5,938                                |       | 13,195 |   | 11,817 |   |
| Total mortgage-backed             |       | 43,263                               |       | 89,223 |   | 52,078 |   |
| Other                             |       | 292                                  |       | 290 |   | 290 |   |
| Total                             |       | 168,411                              |       | 172,834 |   | 147,750 |   |
|                                   |            |                                      |            |  |  |  |  |  |  |  |

 

Maturity Distribution ofSecurities

 
| ** **                        | ** ** | **December 31,  2009 (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          |       | $                                          | 2,999      |           | $          | 22,923        |       | $ | 18,811 |   | $ | — |   | $ | — |   | $ | 44,733 |   |
| States and political subdivisions |       | 1,018                                      |       | 5,384          |       | 19,945        |       | 53,776 |   | — |   | 80,123 |   |
| Mortgage-backed                   |       | —                                     |       | —         |       | —        |       | — |   | 43,263 |   | 43,263 |   |
| Equity Securities                 |       | —                                     |       | —         |       | —        |       | — |   | 292 |   | 292 |   |
| Total                             |       | 4,017                                      |       | 28,307         |       | 38,756        |       | 53,776 |   | 43,555 |   | 168,411 |   |
| Percent of Total                  |       | 2.4                                        | %          | 16.8           | %          | 23.0          | %          | 31.9 | % | 25.9 | % | 100.0 | % |
| Weighted Average Yield (1)        |       | 1.19                                       | %          | 2.87           | %          | 4.98          | %          | 5.91 | % | 4.56 | % | 4.72 | % |
|                                   |            |                                            |            |                |            |               |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)     Tax Equivalent 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 marketrisk is reviewed on a regular basis by the Asset/Liability Committee.

 

Managementconsiders interest rate risk to be the most significant market risk.  Interest rate risk is thepotential of economic losses due to future interest rate changes.  These economic losses can be reflected as aloss of future net interest income and/or a loss of current fair marketvalues.  The objective is to measure theeffect on net interest income and to adjust the balance sheet to minimize the inherentrisk while at the same time maximize income.

 

30

----

 

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, 2009 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 31,2009 for a declining rates is not relevant. The projected net interest income report summarizing the Company’sinterest rate sensitivity as of December 31, 2009 and December 31,2008 is as follows:

 

ProjectedNet Interest Income (December 31, 2009)

 
| ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | **Level**  | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **Rate Change:**                 | ** ** | **-300**   | ** ** | **-100**   | ** ** | **Rates**  | ** ** | **+100**   | ** ** | **+300**   | ** ** |
| ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Year One (1/10 - 12/10)               |       |       |       |       |       |       |       |       |       |       |       |
| Net interest income                   |       | 21,669     |       | 22,656     |       | 23,505     |       | 24,273     |       | 24,867     |       |
|                                  |       |       |       |       |       |       |       |       |       |       |       |
| Net interest income dollar change     |       | (1,836     | )          | (849       | )          | —     |       | 768        |       | 1,362      |       |
|                                  |       |       |       |       |       |       |       |       |       |       |       |
| Net interest income percentage change |       | -7.8       | %          | -3.6       | %          | N/A        |       | 3.3        | %          | 5.8        | %          |
|                                  |       |       |       |       |       |       |       |       |       |       |       |
| Limitation on % Change                |       | >-18.0  | %          | >-6.0   | %          | N/A        |       | >-4.0   | %          | >-10.0  | %          |

 

Projected Net Interest Income (December 31,2008)

 
| ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | **Level**  | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **Rate Change:**                      | ** ** | **-300**   | ** ** | **-100**   | ** ** | **Rates**  | ** ** | **+100**   | ** ** | **+300**   | ** ** |
| ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Year One (1/09 - 12/09)               |       |       |       |       |       |       |       |       |       |       |       |
| 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  | %          |

 

The numbers in 2009 showless fluctuation when compared to 2008. In 2009, year one reflected an increase in net interest income of 3.3%compared to 5.6% projected increase from 2008 with a 100 basis pointincrease.  The 300 basis point increasein rates reflected a 5.8% increase in net interest income in 2009 compared to a9.7% increase in 2008.  The 100 pointdecrease in rates reflected a 3.6% decrease in net interest income in 2009compared to a 6.0% decrease in 2008.  Therisk is less in 2009 due to the current status of existing interest rates andtheir effect on rate sensitive assets and rate sensitive liabilities.  Based on the model, a 300 basis pointdecrease in rates would decrease 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 

 

31

----

 

ismeasured with the use of interest rate sensitivity analysis to determine thechange in net interest income in the event of hypothetical changes in interestrates, while interest rate sensitivity gap analysis is used to determine therepricing characteristics of the Company’s assets and liabilities.  If estimated changes to net interest incomeare not within the limits established by the Board, the Board may directmanagement to adjust the Company’s asset and liability mix to bring interestrate 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 maturingwithin one year along with cash and cash equivalents totaled $38.4 million at December 31,2009.  Additionally, securitiesavailable-for-sale with maturities greater than one year totaled $164.4 millionat December 31, 2009.  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, 2009 these balancestotaled $105.0 million, approximately 20% 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 $47 million from the FHLB at December 31, 2009.

 

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 many financialinstitutions, significant financing activities include deposit gathering, andthe use of short-term borrowings, such as federal funds purchased andsecurities sold under repurchase agreements along with long-term debt.  The Company’s primary investing activitiesinclude purchasing investment securities and loan originations.  Management believes there is sufficient cashflow from operations to meet investing and liquidity needs related toreasonable borrower, depositor and creditor needs in the present economicenvironment.

 

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.

 

32

----

 

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** | ** ** |
|---------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                  | ** ** | **2009**             | ** ** | **2008** | ** ** | **2007** | ** ** |
| Average Loans (including loans held for  sale)/Average Deposits                             |       | 81.1                 | %          | 86.2 | % | 89.6 | % |
| Average Securities sold under agreements  to repurchase and other borrowings/Average Assets |       | 3.2                  | %          | 3.3 | % | 3.0 | % |

 

Thischart shows that the loan to deposit ratio decreased in 2009 and 2008.  The decrease in the ratio in 2009 compared to2008 is mainly attributable to an increase in deposits.  The decrease in the ratio in 2008 compared to2007 is also mainly attributable to an increase in deposits.

 

**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’s2009 Annual Report to Stockholders included as Exhibit 13, and areincorporated herein by reference.  Noother portion of the 2009 Annual Report to Stockholders is to be deemed “filed”as part of this filing.

 

33

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM

 

Audit Committee

Kentucky Bancshares, Inc.

Paris, Kentucky

 

We have audited theaccompanying consolidated balance sheets of Kentucky Bancshares, Inc. asof December 31, 2009 and 2008, and the related consolidated statements ofincome, comprehensive income, changes in stockholders’ equity, and cash flowsfor each of the three years in the period ended December 31, 2009.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  The Company is not required to have, nor werewe engaged to perform, an audit of its internal control over financialreporting.  Our audit includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for 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, 2009and 2008, and the results of its operations and its cash flows for each of thethree years in the period ended December 31, 2009, in conformity with U.S.generally accepted accounting principles.

 

 

/s/Crowe Horwath LLP

Crowe Horwath LLP

Lexington, Kentucky

March 29, 2010

 

34

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KENTUCKY BANCSHARES, INC.

Paris, Kentucky

 

CONSOLIDATED FINANCIALSTATEMENTS

December 31, 2009,2008 and 2007

 

35

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CONSOLIDATEDBALANCE SHEETS

December 31

 
| ** **                                                                                                                         | ** ** | **2009**    | ** **  | **2008**    | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
| **ASSETS**                                                                                                                         |       |        |        |        |       |
| Cash and due  from banks                                                                                                           |       | $           | 12,387,128  |        | $          | 16,410,988 |   |
| Federal  funds sold                                                                                                                |       | 22,034,005  |        | 20,695,000  |       |
| Cash  and cash equivalents                                                                                                         |       | 34,421,133  |        | 37,105,988  |       |
| Securities  available for sale                                                                                                     |       | 168,411,026 |        | 172,833,766 |       |
| Mortgage  loans held for sale                                                                                                      |       | 191,000     |        | —      |       |
| Loans                                                                                                                              |       | 425,418,387 |        | 424,276,517 |       |
| Allowance  for loan losses                                                                                                         |       | (7,600,594  | )           | (5,464,864  | )          |
| Net  loans                                                                                                                         |       | 417,817,793 |        | 418,811,653 |       |
|                                                                                                                               |       |        |        |        |       |
| Federal  Home Loan Bank stock                                                                                                      |       | 6,730,600   |        | 6,730,600   |       |
| Real  estate owned, net                                                                                                            |       | 4,541,762   |        | 1,839,984   |       |
| Bank  premises and equipment, net                                                                                                  |       | 17,609,800  |        | 17,874,706  |       |
| Interest  receivable                                                                                                               |       | 4,620,755   |        | 5,155,727   |       |
| Mortgage  servicing rights                                                                                                         |       | 822,446     |        | 465,271     |       |
| Goodwill                                                                                                                           |       | 13,116,710  |        | 13,116,710  |       |
| Other  intangible assets                                                                                                           |       | 1,262,941   |        | 1,522,677   |       |
| Other  assets                                                                                                                      |       | 5,685,230   |        | 3,318,146   |       |
|                                                                                                                               |       |        |        |        |       |
| **Total assets**                                                                                                                   |       | $           | 675,231,196 |        | $          | 678,775,228 |   |
| ** **                                                                                                                         |       |        |        |        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                      |       |        |        |        |       |
| Deposits                                                                                                                           |       |        |        |        |       |
| Non-interest  bearing                                                                                                              |       | $           | 97,005,532  |        | $          | 90,479,772 |   |
| Time  deposits, $100,000 and over                                                                                                  |       | 105,036,220 |        | 108,465,600 |       |
| Other  interest bearing                                                                                                            |       | 334,404,746 |        | 321,862,857 |       |
| Total  deposits                                                                                                                    |       | 536,446,498 |        | 520,808,229 |       |
| Repurchase  agreements and other borrowings                                                                                        |       | 8,225,579   |        | 10,717,277  |       |
| Federal  Home Loan Bank advances                                                                                                   |       | 56,095,638  |        | 77,300,931  |       |
| Subordinated  debentures                                                                                                           |       | 7,217,000   |        | 7,217,000   |       |
| Interest  payable                                                                                                                  |       | 2,122,476   |        | 2,874,192   |       |
| Other  liabilities                                                                                                                 |       | 4,158,430   |        | 2,817,043   |       |
| Total  liabilities                                                                                                                 |       | 614,265,621 |        | 621,734,672 |       |
|                                                                                                                               |       |        |        |        |       |
| Stockholders’  equity                                                                                                         |       |        |        |        |       |
| Preferred  stock, 300,000 shares authorized and unissued                                                                           |       | —      |        | —      |       |
| Common  stock, no par value; 10,000,000 shares authorized; 2,739,511 and 2,745,729  shares issued and outstanding in 2009 and 2008 |       | 12,416,487  |        | 12,343,958  |       |
| Retained  earnings                                                                                                                 |       | 47,213,455  |        | 44,682,526  |       |
| Accumulated  other comprehensive income                                                                                            |       | 1,335,633   |        | 14,072      |       |
| Total  stockholders’ equity                                                                                                   |       | 60,965,575  |        | 57,040,556  |       |
|                                                                                                                               |       |        |        |        |       |
| **Total liabilities and stockholders’ equity**                                                                                |       | $           | 675,231,196 |        | $          | 678,775,228 |   |

 

See accompanyingnotes.

 

36

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CONSOLIDATED STATEMENTS OFINCOME

Years Ended December 31

 
| ** **                                           | ** ** | **2009**   | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Interest  income                                     |       |       |       |       |       |       |       |
| Loans,  including fees                               |       | $          | 24,951,383 |       | $          | 27,481,123 |       | $ | 31,798,307 |   |
| Securities                                           |       |       |       |       |       |       |       |
| Taxable                                              |       | 3,651,419  |       | 4,360,377  |       | 3,810,348  |       |
| Tax  exempt                                          |       | 2,994,620  |       | 2,580,740  |       | 2,134,600  |       |
| Other                                                |       | 331,380    |       | 706,621    |       | 1,475,831  |       |
|                                                 |       | 31,928,802 |       | 35,128,861 |       | 39,219,086 |       |
| Interest  expense                                    |       |       |       |       |       |       |       |
| Deposits                                             |       | 9,233,716  |       | 11,381,410 |       | 15,124,114 |       |
| Repurchase  agreements and other borrowings          |       | 317,093    |       | 428,192    |       | 506,835    |       |
| Federal  Home Loan Bank advances                     |       | 2,678,788  |       | 3,079,895  |       | 2,908,818  |       |
| Subordinated  debentures                             |       | 279,381    |       | 469,651    |       | 494,338    |       |
|                                                 |       | 12,508,978 |       | 15,359,148 |       | 19,034,105 |       |
|                                                 |       |       |       |       |       |       |       |
| Net  interest income                                 |       | 19,419,824 |       | 19,769,713 |       | 20,184,981 |       |
| Provision  for loan losses                           |       | 3,450,000  |       | 3,700,000  |       | 1,000,000  |       |
| Net  interest income after provision for loan losses |       | 15,969,824 |       | 16,069,713 |       | 19,184,981 |       |
|                                                 |       |       |       |       |       |       |       |
| Other  income                                        |       |       |       |       |       |       |       |
| Service  charges                                     |       | 5,211,548  |       | 5,332,172  |       | 5,495,499  |       |
| Loan  service fee income (loss), net                 |       | 160,478    |       | (129,505   | )          | 57,867     |       |
| Trust  department income                             |       | 519,834    |       | 477,891    |       | 515,149    |       |
| Securities  gains, net                               |       | 1,619,312  |       | 658,037    |       | 36,556     |       |
| Gain  on sale of mortgage loans                      |       | 1,205,383  |       | 410,539    |       | 432,314    |       |
| Other                                                |       | 1,497,497  |       | 1,605,349  |       | 1,398,673  |       |
|                                                 |       | 10,214,052 |       | 8,354,483  |       | 7,936,058  |       |
|                                                 |       |       |       |       |       |       |       |
| Other  expenses                                      |       |       |       |       |       |       |       |
| Salaries  and employee benefits                      |       | 11,289,478 |       | 11,082,600 |       | 10,593,544 |       |
| Occupancy  expenses                                  |       | 2,645,669  |       | 2,737,648  |       | 2,560,353  |       |
| Amortization                                         |       | 259,736    |       | 264,736    |       | 270,736    |       |
| Advertising  and marketing                           |       | 443,604    |       | 521,105    |       | 545,648    |       |
| Taxes  other than payroll, property and income       |       | 591,369    |       | 705,789    |       | 683,443    |       |
| Other                                                |       | 5,921,727  |       | 4,715,182  |       | 3,477,231  |       |
|                                                 |       | 21,151,583 |       | 20,027,060 |       | 18,130,955 |       |
|                                                 |       |       |       |       |       |       |       |
| Income  before income taxes                          |       | 5,032,293  |       | 4,397,136  |       | 8,990,084  |       |
| Provision  for income taxes                          |       | 184,554    |       | 684,074    |       | 2,404,132  |       |
|                                                 |       |       |       |       |       |       |       |
| Net  income                                          |       | $          | 4,847,739  |       | $          | 3,713,062  |       | $ | 6,585,952 |   |
|                                                 |       |       |       |       |       |       |       |
| Earnings  per share:                                 |       |       |       |       |       |       |       |
| Basic                                                |       | $          | 1.77       |       | $          | 1.34       |       | $ | 2.31 |   |
| Diluted                                              |       | 1.77       |       | 1.33       |       | 2.30       |       |

 

See accompanyingnotes.

 

37

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CONSOLIDATEDSTATEMENTS OF COMPREHENSIVE INCOME

Years Ended December 31

 
| ** **                                                         | ** ** | **2009**   | ** ** | **2008**  | ** ** | **2007**  | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|-----------|------------|-----------|------------|
|                                                               |       |       |       |      |       |      |       |
| Net  income                                                        |       | $          | 4,847,739  |      | $          | 3,713,062 |       | $ | 6,585,952 |   |
|                                                               |       |       |       |      |       |      |       |
| Other  comprehensive income (loss)                                 |       |       |       |      |       |      |       |
| Unrealized  gains (losses) on securities arising during the period |       | 3,621,677  |       | 536,241   |       | 892,171   |       |
| Reclassification  of realized amount                               |       | (1,619,312 | )          | (658,037  | )          | (36,556   | )          |
| Net  change in unrealized gain (loss) on securities                |       | 2,002,365  |       | (121,796  | )          | 855,615   |       |
| Less:   Tax impact                                       |       | 680,804    |       | (41,411   | )          | 290,909   |       |
|                                                               |       |       |       |      |       |      |       |
| 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    |       |
|                                                               |       |       |       |      |       |      |       |
| Other  comprehensive income                                        |       | 1,321,561  |       | 601,818   |       | 726,758   |       |
|                                                               |       |       |       |      |       |      |       |
| Comprehensive  income                                              |       | $          | 6,169,300  |      | $          | 4,314,880 |       | $ | 7,312,710 |   |

 

See accompanyingnotes.

 

38

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CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

Years Ended December 31,2009, 2008 and 2007

 
| ** **                                                                                                                 | ** ** | ** **            | ** ** | ** **   | ** **     | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** **   |
|----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------|----------------|-------------------|------------|------------------------|------------|------------|--------------|
| ** **                                                                                                                 | ** ** | ** **            | ** ** | ** **   | ** **     | ** **        | ** ** | **Other**              | ** ** | **Total**  | ** **   |
| ** **                                                                                                                 | ** ** | **Common Stock** | ** ** | **Retained** | ** **     | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                                                 | ** ** | **Shares**            | ** ** | **Amount**   | ** **     | **Earnings**      | ** ** | **Income**             | ** ** | **Equity** | ** **   |
|                                                                                                                       |       |                  |       |         |           |              |       |                   |       |       |         |
| Balances,  January 1, 2007                                                                                            |       | 2,864,586             |       | $            | 12,533,414     |              | $          | 44,061,889             |       | $          | (1,314,504   | ) | $ | 55,280,799 |   |
|                                                                                                                       |       |                  |       |         |           |              |       |                   |       |       |         |
| Common  stock issued including tax benefit, net (including 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 (including 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 - $1.08 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 |   |
|                                                                                                                       |       |                  |       |         |           |              |       |                   |       |       |         |
| Common  stock issued including tax benefit, net (including stock grants of 4,150  shares and employee gifts of 104 shares) |       | 4,254                 |       | 1,670        |           | —            |       | —                 |       | 1,670      |         |
| Stock  compensation expense                                                                                                |       | —                |       | 115,020      |           | —            |       | —                 |       | 115,020    |         |
| Common  stock purchased                                                                                                    |       | (10,472               | )          | (44,161      | )              | (121,945          | )          | —                 |       | (166,106   | )            |
| Net  change in unrealized gain (loss) on securities available for sale, net of tax                                         |       | —                |       | —       |           | —            |       | 1,321,561              |       | 1,321,561  |         |
| Net  income                                                                                                                |       | —                |       | —       |           | 4,847,739         |       | —                 |       | 4,847,739  |         |
| Dividends  declared - $0.80 per share                                                                                      |       | —                |       | —       |           | (2,194,865        | )          | —                 |       | (2,194,865 | )            |
| **Balances, December 31, 2009**                                                                                       |       | 2,739,511             |       | $            | 12,416,487     |              | $          | 47,213,455             |       | $          | 1,335,633    |   | $ | 60,965,575 |   |

 

See accompanyingnotes.

 

39

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CONSOLIDATEDSTATEMENTS OF CASH FLOWS

Years Ended December 31

 
| ** **                                                                                     | ** ** | **2009**     | ** ** | **2008**     | ** ** | **2007**     | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------|------------|--------------|------------|--------------|------------|
|                                                                                           |       |         |       |         |       |         |       |
| **Cash flows from operating activities**                                                       |       |         |       |         |       |         |       |
| Net  income                                                                                    |       | $            | 4,847,739  |         | $          | 3,713,062    |       | $ | 6,585,952 |   |
| Adjustments  to reconcile net income to net cash from operating activities                     |       |         |       |         |       |         |       |
| Depreciation  and amortization                                                                 |       | 1,519,465    |       | 1,850,726    |       | 1,499,855    |       |
| Provision  for loan losses                                                                     |       | 3,450,000    |       | 3,700,000    |       | 1,000,000    |       |
| Securities  amortization (accretion), net                                                      |       | 1,405,638    |       | (193,918     | )          | (178,289     | )          |
| Securities  (gains) losses, net                                                                |       | (1,619,312   | )          | (658,037     | )          | (36,556      | )          |
| Originations  of loans held for sale                                                           |       | (51,932,502  | )          | (18,605,081  | )          | (16,061,200  | )          |
| Proceeds  from sale of loans                                                                   |       | 52,946,885   |       | 19,015,620   |       | 16,493,514   |       |
| Gain  on sale of mortgage loans                                                                |       | (1,205,383   | )          | (410,539     | )          | (432,314     | )          |
| Stock  based compensation expense                                                              |       | 115,020      |       | 135,327      |       | 96,178       |       |
| Federal  Home Loan Bank stock dividends                                                        |       | —       |       | (262,400     | )          | —       |       |
| Losses  (gain) on sale of fixed assets                                                         |       | 62,510       |       | 4,538        |       | (2,672       | )          |
| Losses  (gain) on other real estate                                                            |       | (17,124      | )          | 94,213       |       | 8,352        |       |
| Changes  in:                                                                                   |       |         |       |         |       |         |       |
| Interest  receivable                                                                           |       | 534,972      |       | 64,087       |       | 434,055      |       |
| Other  assets                                                                                  |       | (2,884,848   | )          | (3,010,386   | )          | 42,068       |       |
| Interest  payable                                                                              |       | (751,716     | )          | (2,109,357   | )          | 1,300,764    |       |
| Other  liabilities                                                                             |       | 660,584      |       | 379,782      |       | (164,587     | )          |
| **Net cash from operating activities**                                                         |       | 7,131,928    |       | 3,707,637    |       | 10,585,120   |       |
| ** **                                                                                     |       |         |       |         |       |         |       |
| **Cash flows from investing activities**                                                       |       |         |       |         |       |         |       |
| Purchases  of securities                                                                       |       | (123,735,135 | )          | (126,927,213 | )          | (100,874,783 | )          |
| Proceeds  from sales of securities                                                             |       | 68,100,558   |       | 40,241,628   |       | 19,323,795   |       |
| Proceeds  from principal payments and maturities of securities                                 |       | 62,273,355   |       | 62,331,524   |       | 62,762,514   |       |
| Net  change in loans                                                                           |       | (6,640,283   | )          | (11,447,364  | )          | 24,602,312   |       |
| Purchases  of bank premises and equipment                                                      |       | (824,108     | )          | (2,715,086   | )          | (3,037,632   | )          |
| Proceeds  from sale of other real estate                                                       |       | 1,499,489    |       | 278,815      |       | 681,994      |       |
| Proceeds  from sale of bank premises and Equipment                                             |       | —       |       | 5,000        |       | 2,672        |       |
| **Net cash from investing activities**                                                         |       | 673,876      |       | (38,232,696  | )          | 3,460,872    |       |
|                                                                                           |       |         |       |         |       |         |       |
| **Cash flows from financing activities**                                                       |       |         |       |         |       |         |       |
| Net  change in deposits                                                                        |       | 15,638,269   |       | 34,803,011   |       | 17,197,299   |       |
| Net  change in repurchase agreements and other borrowings                                      |       | (2,291,698   | )          | 1,182,647    |       | (3,892,283   | )          |
| Advances  from Federal Home Loan Bank                                                          |       | 11,000,000   |       | 64,000,000   |       | —       |       |
| Payments  on Federal Home Loan Bank advances                                                   |       | (32,277,929  | )          | (50,707,458  | )          | (16,010,495  | )          |
| Proceeds  from note payable                                                                    |       | 2,900,000    |       | 5,500,000    |       | —       |       |
| Payments  on note payable                                                                      |       | (3,100,000   | )          | (2,700,000   | )          | (700,000     | )          |
| Proceeds  from issuance of common stock, including options and grants, including tax  benefits |       | 1,670        |       | 16,829       |       | 175,387      |       |
| Purchase  of common stock                                                                      |       | (166,106     | )          | (3,149,681   | )          | (933,077     | )          |
| Dividends  paid                                                                                |       | (2,194,865   | )          | (3,120,897   | )          | (3,087,899   | )          |
| **Net cash from financing activities**                                                         |       | (10,490,659  | )          | 45,824,451   |       | (7,251,068   | )          |
|                                                                                                |            |              |            |              |            |              |            |  |  |  |

 

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CONSOLIDATEDSTATEMENTS OF CASH FLOWS

Years Ended December 31

 
| ** **                                               | ** ** | **2009**   | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|----------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                     |       |       |       |       |       |       |       |
| Net  change in cash and cash equivalents                 |       | $          | (2,684,855 | )          | $          | 11,299,392 |       | $ | 6,794,924 |   |
|                                                     |       |       |       |       |       |       |       |
| Cash  and cash equivalents at beginning of year          |       | 37,105,988 |       | 25,806,596 |       | 19,011,672 |       |
|                                                     |       |       |       |       |       |       |       |
| **Cash and cash equivalents at end of year**             |       | $          | 34,421,133 |       | $          | 37,105,988 |       | $ | 25,806,596 |   |
|                                                     |       |       |       |       |       |       |       |
| Supplemental  disclosures of cash flow information       |       |       |       |       |       |       |       |
| Cash  paid during the year for:                          |       |       |       |       |       |       |       |
| Interest  expense                                        |       | $          | 13,260,694 |       | $          | 17,468,505 |       | $ | 17,733,341 |   |
| Income  taxes                                            |       | 400,000    |       | 1,800,000  |       | 2,600,000  |       |
|                                                     |       |       |       |       |       |       |       |
| Supplemental  schedules of non-cash investing activities |       |       |       |       |       |       |       |
| Real  estate acquired through foreclosure                |       | $          | 4,184,143  |       | $          | 1,445,027  |       | $ | 1,047,485 |   |

 

See accompanying notes.

 

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# **NOTE1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

Basis of Presentation: The consolidated financial statements include the accounts of KentuckyBancshares, Inc. (the Company), its wholly-owned subsidiary, Kentucky Bank(the Bank), and the Bank’s wholly-owned subsidiary, KB Special Assets Unit,LLC.  Intercompany transactions andbalances have been eliminated in consolidation.

 

Nature of Operations: The Bank operates under a state bank charter and provides full bankingservices, including trust services, to customers located in Bourbon, Clark,Elliot, 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.

 

Management evaluatessecurities for other-than-temporary impairment (“OTTI”) at least on a quarterlybasis, and more frequently when economic or market conditions warrant such anevaluation.

 

Loans Held for Sale: Loans held for sale are valued at the lower of cost or fair value 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.

 

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 

 

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loans is discontinued atthe time the loan is 120 days delinquent, unless the loan is well-secured andin process of collection.  Past duestatus is based on the contractual terms of the loan.  In all cases, loans are placed on nonaccrualor charged-off at an earlier date if collection of principal or interest isconsidered doubtful.  Nonaccrual loansand loans past due 90 days still on accrual include both smaller balancehomogeneous loans that are collectively evaluated for impairment andindividually classified impaired loans.

 

When interest accrual isdiscontinued, interest income received on such loans is accounted for on thecash-basis or cost-recovery method, until qualifying for return toaccrual.  Loans are returned to accrualstatus when all the principal and interest amounts contractually due arebrought 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 counties.

 

Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probableincurred credit losses.  Loan losses arecharged against the allowance when management believes the uncollectibility ofa loan balance is confirmed.  Subsequentrecoveries, if any, are credited to the allowance.  Management estimates the allowance balancerequired using past loan loss experience, the nature and volume of theportfolio, information about specific borrower situations and estimatedcollateral values, economic conditions, and other factors.  Allocations of the allowance may be made forspecific loans, but the entire allowance is available for any loan that, inmanagement’s judgment, should be charged off.

 

The allowance consists ofspecific and general components.  Thespecific component relates to loans that are individually classified asimpaired or loans otherwise classified as substandard or doubtful.  The general component covers non-classifiedloans and is based on historical loss experience adjusted for current factors.

 

A loan is impaired when,based on current information and events, it is probable that the Company willbe unable to collect all amounts due according to the contractual terms of theloan agreement.  Loans,  for which the terms have been modified, andfor which the borrower is experiencing financial difficulties, are consideredtroubled debt restructurings and classified as impaired.

 

Commercial and commercialreal estate loans over $200 thousand are individually evaluated forimpairment.  If a loan is impaired, aportion of the allowance is allocated so that the loan is reported, net, at thepresent value of estimated future cash flows using the loan’s existing rate orat the fair value of collateral if repayment is expected solely from thecollateral. Large groups of smaller balance homogeneous loans, such as consumerand residential real estate loans, are collectively evaluated for impairment,and accordingly, they are not separately identified for impairmentdisclosures.  Troubled debt restructuringsare measured at the present value of estimated future cash flows using the loan’seffective rate at inception.

 

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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 the amortizationmethod which requires servicing rights to be amortized into non-interest incomein proportion to, and over the period of, the estimated future net servicingincome of the underlying loans.

 

Servicing assets areevaluated for impairment based upon the fair value of the rights as compared tocarrying amount.  Impairment isdetermined by stratifying rights into groupings based on predominant riskcharacteristics, 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 $321,067, $287,412 and$271,934 for the years ended December 31, 2009, 2008 and 2007.  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.

 

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Investments in LimitedPartnerships:  Investments in limited partnerships representthe Company’s investments in affordable housing projects for the primarypurpose of available tax benefits.  TheCompany is a limited partner in these investments and as such, the Company isnot involved in the management or operation of such investments.  These investments are accounted for using theequity method of accounting.  Under theequity method of accounting, the Company records its share of the partnership’searnings or losses in its income statement and adjusts the carrying amount ofthe investments on the balance sheet. These investments are evaluated for impairment when events indicate thecarrying amount may not be recoverable. The investment recorded at December 31, 2009 and 2008 was $1.9million and $0 and is included with other assets in the balance sheet.

 

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 carryingamounts and tax bases of assets and liabilities, computed using enacted taxrates.  A valuation allowance, if needed,reduces deferred tax assets to the amount expected to be realized.

 

The Company adoptedguidance issued by the FASB with respect to accounting for uncertainty inincome taxes as of January 1, 2007.  A tax position is recognized as a benefitonly if it is “more likely than not” that the tax position would be sustainedin a tax examination, with a tax examination being presumed to occur.  The amount recognized is the largest amountof tax benefit that is greater than 50% likely of being realized on examination.  For tax positions not meeting the “morelikely 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 resulting from business combinations prior to January 1,2009 represents the excess of the purchase price over the fair value of the netassets of businesses acquired.  Goodwillresulting from business combinations after January 1, 2009, is generallydetermined as the excess of the fair value of the consideration transferred,plus the fair value of any noncontrolling interests in the acquiree, over thefair value of the net assets acquired and liabilities assumed as of theacquisition date.  Goodwill andintangible assets acquired in a purchase business combination and determined tohave an indefinite useful life are not amortized, but tested for impairment atleast annually.  The Company has selectedDecember 31 as the date to perform the annual impairment test.  Intangible assets with definite useful livesare amortized over their estimated useful lives to their 

 

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estimated residualvalues. Goodwill is the only intangible asset with an indefinite life on ourbalance sheet.

 

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 of issuanceof 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.

 

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 Statement No. 157,Fair Value Measurements (ASC 820-10). This Statement defines fair value, establishes a framework for measuringfair value and expands disclosures about fair value measurements.  This Statement also establishes a fair valuehierarchy about the assumptions used to measure fair value and clarifiesassumptions about risk and the effect of a restriction on the sale or use of anasset.  The standard was effective forfiscal years beginning after November 15, 2007.  In February 2008, the FASB issued StaffPosition (FSP) No. 157-2,*EffectiveDate of FASB Statement No. 157,*which is currently FASB ASC 820-10.* *This FSP delayed theeffective date of FAS 157 for all nonfinancial assets and nonfinancialliabilities, except those that are recognized or disclosed at fair value on arecurring basis (at least annually) to fiscal years beginning after November 15,2008, and interim periods within those fiscal years.  The adoption of thisaccounting guidance did not have a material impact on the Company’sconsolidated financial position or results of operations.

 

In December 2007, the FASB issued Statement ofFinancial Accounting Standards No. 141 (revised 2007), *Business Combinations (*ASC 805).   ASC 805 establishes principles andrequirements for how an acquirer recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in an acquiree, including the recognition andmeasurement of goodwill acquired in a business combination.  ASC805 was effective for fiscal years beginning on or after December 15,2008.  The adoption of this accounting guidance did nothave a material impact on the Company’s consolidated financial position orresults of operations.

 

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In June 2009, the FASB issued Statement ofFinancial Accounting Standards No. 168, *TheFASB Accounting Standards Codification and the Hierarchy of Generally AcceptedAccounting Principles*, to replace Statement No. 162*, The Hierarchy of Generally Accepted AccountingPrinciples*, and to establish the *FASBAccounting Standards Codification*TM as the source of authoritative accountingprinciples recognized by the FASB to be applied by nongovernmental entities inthe preparation of financial statements in conformity with GAAP.  Rules and interpretive releases of theSecurities and Exchange Commission under authority of federal securities lawsare also sources of authoritative GAAP for SEC registrants.  The Codification was effective for financialstatements issued for periods after September 15, 2009.  The adoption of thisaccounting guidance did not have a material impact on the Company’sconsolidated financial position or results of operations.

 

In June 2008, the FASB issued FASB Staff PositionEITF 03-6-1—*Determining Whether InstrumentsGranted in Share-Based Payment Transactions Are Participating Securities (*ASC 260-10).  This FASB Staff Position(FSP) addresses whether instruments granted in share-based payment transactionsare participating securities prior to vesting and, therefore, included in theearnings allocation in computing earnings per share (EPS) under the two-classmethod.  ASC 260-10 provides that unvested share-based payment awards thatcontain non-forfeitable rights to dividends or dividend equivalents (whetherpaid or unpaid) are participating securities and shall be included in the computationof EPS pursuant to the two-class method.  This FSP was effective forfinancial statements issued for fiscal years beginning after December 15,2008, and interim periods within those years. All prior-period EPS data presented were to be adjusted retrospectively(including interim financial statements, summaries of earnings, and selectedfinancial data) to conform to the provisions of this FSP.  The adoption of thisaccounting guidance did not have a material impact on the Company’sconsolidated financial position or results of operations.

 

In April 2009, the FASB issued Staff Position No. 115-2and No. 124-2, *Recognition andPresentation of Other-Than-Temporary Impairments (ASC*320-10), whichamended existing guidance for determining whether impairment is other-than-temporaryfor debt securities.  This requires anentity to assess whether it intends to sell, or it is more likely than not thatit will be required to sell, a security in an unrealized loss position before recoveryof its amortized cost basis.  If eitherof these criteria is met, the entire difference between amortized cost and fairvalue is recognized as impairment through earnings.  For securities that do not meet theaforementioned criteria, the amount of impairment is split into two componentsas follows: 1) other-than-temporary impairment (OTTI) related to other factors,which is recognized in other comprehensive income and 2) OTTI related to creditloss, which must be recognized in the income statement.  The credit loss is determined as the differencebetween the present value of the cash flows expected to be collected and theamortized cost basis.   Additionally,disclosures about other-than-temporary impairments for debt and equitysecurities were expanded.  ASC 320-10 waseffective for interim and annual reporting periods ending June 15, 2009,with early adoption permitted for periods ending after March 15,2009.  The Company has not previouslyrecognized impairment charges, representing the non-credit portion.  The adoption of thisaccounting guidance did not have a material impact on the Company’sconsolidated financial position or results of operations.

 

In April 2009, the FASB issued Staff Position(FSP) No. 157-4, *Determining Fair ValueWhen the Volume and Level of Activity for the Asset and Liability HaveSignificantly Decreased and Identifying Transactions That Are Not Orderly*(ASC820-10).  This FSP emphasizes that theobjective of a fair value measurement does not change even when market activityfor the asset or liability has decreased significantly.  Fair value is the price that would bereceived for an asset sold or paid to transfer a liability in an orderlytransaction (that is, not a forced liquidation or distressed sale) betweenmarket participants at the measurement date under current marketconditions.  When observable transactionsor quoted prices are not considered orderly, then 

 

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little, if any, weight should be assigned to theindication of the asset or liability’s fair value.   Adjustments to those transactions or priceswould be needed to determine the appropriate fair value.  The FSP, which was applied prospectively, waseffective for interim and annual reporting periods ending after June 15,2009 with early adoption for periods ending after March 15, 2009.  The adoption of thisaccounting guidance did not have a material impact on the Company’sconsolidated financial position or results of operations.

 

In August 2009, the FASB issued AccountingStandards Update (“ASU”) No. 2009-05, *MeasuringLiabilities at Fair Value* (ASC 820). This Update provides amendmentsto ASC 820 for the fair value measurement of liabilities by clarifying that incircumstances in which a quoted price in an active market for the identicalliability is not available, a reporting entity is required to measure fairvalue using a valuation technique that uses the quoted price of the identicalliability when traded as an asset, quoted prices for similar liabilities orsimilar liabilities when traded as assets, or that is consistent with theprinciples of ASC 820.  The amendments inthis guidance also clarify that both a quoted price for the identical liabilityat the measurement date and the quoted price for the identical liability whentraded as an asset in an active market when no adjustments to the quoted priceof the asset are required for Level 1 fair value measurements.  The guidance was effective for the firstreporting period beginning after issuance. The adoption of this accounting guidance did not have a material impacton the Company’s consolidated financial position or results of operations.

 

Effect of Newly Issued But Not Yet EffectiveAccounting Standards:

 

In June 2009, the FASB issued Statement ofFinancial Accounting Standards No. 166*,Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140(*ASC 810).  The new accountingrequirement amends previous guidance relating to the transfers of financialassets and eliminates the concept of a qualifying special purpose entity. ThisStatement must be applied as of the beginning of each reporting entity’s firstannual reporting period that begins after November 15, 2009, for interimperiods within that first annual reporting period and for interim and annualreporting periods thereafter. This Statement must be applied to transfersoccurring on or after the effective date. Additionally, on and after theeffective date, the concept of a qualifying special-purpose entity is no longerrelevant for accounting purposes. Therefore, formerly qualifyingspecial-purpose entities should be evaluated for consolidation by reportingentities on and after the effective date in accordance with the applicableconsolidation guidance. Additionally, the disclosure provisions of thisStatement were also amended and apply to transfers that occurred both beforeand after the effective date of this Statement. The adoption of this guidance is not expected to have a material impacton its consolidated results of operations or financial position upon adoption.

 

**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 31,2009 and 2008 was $0 and $545,000.

 

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# **NOTE 3 - SECURITIES AVAILABLEFOR SALE**

 

The following tablesummarizes the amortized cost and fair value of the securities at December 31,2009 and 2008 and the corresponding amounts of gross unrealized gains andlosses recognized in accumulated other comprehensive income (loss) were asfollows:

 
| ** **                    | ** ** | ** **    | ** **  | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|-------------------------------|------------|---------------|-------------|----------------|------------|----------------|------------|------------|------------|
| ** **                    | ** ** | **Amortized** | ** **  | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
| ** **                    | ** ** | **Cost**      | ** **  | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
|                          |       |          |        |           |       |           |       |       |       |
| 2009                          |       |          |        |           |       |           |       |       |       |
| U. S. government agencies     |       | $             | 45,167,791  |           | $          | 12,613         |       | $          | (447,567   | ) | $ | 44,732,837 |   |
| States and municipals         |       | 78,794,022    |        | 1,691,036      |       | (362,241       | )          | 80,122,817 |       |
| Mortgage-backed - residential |       | 42,155,527    |        | 1,259,143      |       | (151,560       | )          | 43,263,110 |       |
| Equity securities             |       | 270,000       |        | 22,262         |       | —         |       | 292,262    |       |
|                          |       |          |        |           |       |           |       |       |       |
| Total                         |       | $             | 166,387,340 |           | $          | 2,985,054      |       | $          | (961,368   | ) | $ | 168,411,026 |   |
|                          |       |          |        |           |       |           |       |       |       |
| 2008                          |       |          |        |           |       |           |       |       |       |
| U. S. government agencies     |       | $             | 19,138,719  |           | $          | 211,715        |       | $          | —     |   | $ | 19,350,434 |   |
| States and municipals         |       | 65,090,412    |        | 1,061,559      |       | (2,181,346     | )          | 63,970,625 |       |
| Mortgage-backed - residential |       | 88,313,313    |        | 1,142,060      |       | (232,625       | )          | 89,222,748 |       |
| Equity securities             |       | 270,000       |        | 19,959         |       | —         |       | 289,959    |       |
|                          |       |          |        |           |       |           |       |       |       |
| Total                         |       | $             | 172,812,444 |           | $          | 2,435,293      |       | $          | (2,413,971 | ) | $ | 172,833,766 |   |

 

The amortized cost and fair value of securitiesat December 31, 2009, by contractual maturity, are shown below.  Expected maturities will differ fromcontractual maturities because borrowers may have the right to call or prepayobligations with or without call or prepayment penalties.  Securities not due at a single maturity areshown separately.

 
| ** **                             | ** ** | **Amortized** | ** **  | **Fair**    | ** ** |
|----------------------------------------|------------|---------------|-------------|-------------|------------|
| ** **                             | ** ** | **Cost**      | ** **  | **Value**   | ** ** |
|                                   |       |          |        |        |       |
| Due in one year or less                |       | $             | 3,907,545   |        | $          | 4,017,466 |   |
| Due after one year through five years  |       | 28,220,470    |        | 28,306,601  |       |
| Due after five years through ten years |       | 38,197,495    |        | 38,755,895  |       |
| Due after ten years                    |       | 53,636,303    |        | 53,775,692  |       |
|                                   |       | 123,961,813   |        | 124,855,654 |       |
| Mortgage-backed - residential          |       | 42,155,527    |        | 43,263,110  |       |
| Equity                                 |       | 270,000       |        | 292,262     |       |
|                                   |       |          |        |        |       |
| Total                                  |       | $             | 166,387,340 |        | $          | 168,411,026 |   |

 

Proceeds from sales ofsecurities during 2009, 2008 and 2007 were $68,100,558, $40,241,628 and$19,323,795.  Gross gains of $1,677,293,$697,374 and $180,005 and gross losses of $57,981, $39,337 and $143,449, wererealized on those sales, respectively. The tax provision related to these realized gains and losses was$550,566, $223,733 and $12,429, respectively.

 

Securities with anapproximate carrying value of $143,643,000 and $141,245,000 at December 31,2009 and 2008, were pledged to secure public deposits, trust funds, securitiessold under agreements to repurchase and for other purposes as required orpermitted by law.

 

49

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Securities withunrealized losses at year end 2009 and 2008 not recognized in income are asfollows:

 

2009

 
| ** **                              | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| ** **                              | ** ** | **Fair**                               | ** ** | **Unrealized**                       | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **Description of Securities** | ** ** | **Value**                              | ** ** | **Loss**                             | ** ** | **Value** | ** ** | **Loss** | ** ** | **Value** | ** ** | **Loss** | ** ** |
|                                    |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| U.S. Government agencies                |       | $                                      | 35,216,173 |                                 | $          | (447,567  | )          | $ | — |   | $ | — |   | $ | 35,216,173 |   | $ | (447,567 | ) |
| States and municipals                   |       | 25,125,820                             |       | (348,302                             | )          | 869,404   |       | (13,939 | ) | 25,995,224 |   | (362,241 | ) |
| Mortgage-backed -  residential          |       | 11,930,310                             |       | (151,560                             | )          | —    |       | — |   | 11,930,310 |   | (151,560 | ) |
|                                    |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| Total temporarily impaired              |       | $                                      | 72,272,303 |                                 | $          | (947,429  | )          | $ | 869 404 |   | $ | (13,939 | ) | $ | 73,141,707 |   | $ | (961,368 | ) |

 

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 -  residential          |       | 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 | ) |

 

The Company evaluatessecurities for other than temporary impairment at least on a quarterly basis,and more frequently when economic or market concerns warrant suchevaluation.  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.

 

Unrealized losses onsecurities have not been recognized into income because the issues are of highcredit quality, management does not intend to sell and it is more likely thannot that management would be required to sell the securities prior to theiranticipated recovery, and the decline in fair value is largely due to changesin interest rates.  The fair value isexpected to recover as the securities approach maturity.

 

At December 31, 2009,nine U.S. government agency securities have unrealized loss with aggregatedepreciation of 1.2% from their amortized cost, two mortgage-backed securitieshave unrealized losses with aggregate depreciation of 1.2% from their amortizedcost basis, and sixty one states and municipals have unrealized losses withaggregate depreciation of 1.4% from their amortized cost basis.  Management believes the declines in fair value from these andother securities are largely due to changes in interest rates.  TheCompany believes there is no other than temporary impairment and does not havethe intent to sell these securities and it is likely that it will not berequired to sell the securities before their anticipated recovery.

 

**NOTE 4 -LOANS**

 

Loans at year-end were asfollows:

 
| ** **               | ** ** | **2009**    | ** **        | **2008**    | ** ** |
|--------------------------|------------|-------------|-------------------|-------------|------------|
|                     |       |        |              |        |       |
| Commercial               |       | $           | 21,932,828        |        | $          | 21,505,019 |   |
| Real estate construction |       | 16,864,509  |              | 16,818,668  |       |
| Real estate mortgage     |       | 287,444,169 |              | 286,845,709 |       |
| Agricultural             |       | 80,619,328  |              | 80,778,758  |       |
| Consumer                 |       | 18,277,491  |              | 17,643,301  |       |
| Other                    |       | 280,062     |              | 685,062     |       |
|                     |       |        |              |        |       |
|                     |       | $           |  425,418,387 |        | $          | 424,276,517 |   |

 

50

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Activity in the allowancefor loan losses was as follows:

 
| ** **                | ** ** | **2009**   | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|---------------------------|------------|------------|------------|------------|------------|------------|------------|
|                      |       |       |       |       |       |       |       |
| Beginning balance         |       | $          | 5,464,864  |       | $          | 4,878,732  |       | $ | 4,991,277 |   |
| Charge-offs               |       | (1,828,613 | )          | (3,395,734 | )          | (1,268,568 | )          |
| Recoveries                |       | 514,343    |       | 281,866    |       | 156,023    |       |
| Provision for loan losses |       | 3,450,000  |       | 3,700,000  |       | 1,000,000  |       |
|                      |       |       |       |       |       |       |       |
| Ending balance            |       | $          | 7,600,594  |       | $          | 5,464,864  |       | $ | 4,878,732 |   |

 

Individually impairedloans were as follows:

 
| ** **                                                  | ** ** | **2009**   | ** ** | **2008**  | ** ** |
|-------------------------------------------------------------|------------|------------|------------|-----------|------------|
|                                                        |       |       |       |      |       |
| Year-end loans with no allocated allowance for loan  losses |       | $          | 19,206,000 |      | $          | 3,833,000 |   |
| Year-end loans with allocated Allowance for loan  losses    |       | 14,266,000 |       | 1,298,000 |       |
|                                                        |       |       |       |      |       |
| Total                                                       |       | $          | 33,472,000 |      | $          | 5,131,000 |   |
|                                                        |       |       |       |      |       |
| Amount of the allowance for loan losses allocated           |       | $          | 4,064,000  |      | $          | 320,000 |   |

 
| ** **                                          | ** ** | **2009**  | ** ** | **2008**  | ** ** | **2007**  | ** ** |
|-----------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                                |       |      |       |      |       |      |       |
| Average  of individually impaired loans during year |       | 7,758,000 |       | 3,263,000 |       | 1,379,000 |       |
| Cash-basis  interest income recognized              |       | 1,000     |       | 88,000    |       | 121,000   |       |

 

Nonperforming loans wereas follows:

 
| ** **                                   | ** ** | **2009**   | ** ** | **2008**  | ** ** |
|----------------------------------------------|------------|------------|------------|-----------|------------|
| Loans past due over 90 days still on accrual |       | $          | 2,526,000  |      | $          | 779,000 |   |
| Nonaccrual loans                             |       | 12,038,000 |       | 6,562,000 |       |
|                                              |            |            |            |           |            |  |  |

 

Nonaccrual loans secured by real estate make up 99% ofthe total nonaccruals.

 

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 2009 and 2008.  An analysis of the activity with respect toall director and executive officer loans is as follows:

 
| ** **                                          | ** ** | **2009**  | ** ** | **2008**   | ** ** |
|-----------------------------------------------------|------------|-----------|------------|------------|------------|
|                                                |       |      |       |       |       |
| Balance, beginning of year                          |       | $         | 3,969,000  |       | $          | 4,179,000 |   |
| New loans                                           |       | 1,200,000 |       | 1,020,000  |       |
| Effect of changes in composition of related parties |       | —    |       | —     |       |
| Repayments                                          |       | (448,000  | )          | (1,230,000 | )          |
|                                                |       |      |       |       |       |
| Balance, end of year                                |       | $         | 4,721,000  |       | $          | 3,969,000 |   |

 

Loan Servicing

 

Mortgage loans servicedfor others are not included in the accompanying consolidated balance sheets.  The unpaid principal balances of mortgageloans serviced for others were approximately $132,154,000 and $112,553,000 at December 31,2009 and 2008.  Custodial escrow balancesmaintained in connection 

 

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with the foregoing loanservicing, and included in demand deposits, were approximately $643,000 and$605,000 at December 31, 2009 and 2008.

 

Activity for mortgageservicing rights and the related valuation allowance follows:

 
| ** **                        | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                              |       |     |       |     |       |     |       |
| Servicing Rights:                 |       |     |       |     |       |     |       |
| Beginning balance                 |       | $        | 465,271    |     | $          | 696,826  |       | $ | 745,834 |   |
| Additions                         |       | 517,764  |       | 185,362  |       | 165,059  |       |
| Amortization                      |       | (235,589 | )          | (203,917 | )          | (214,067 | )          |
| Change in valuation allowance     |       | 75,000   |       | (213,000 | )          | —   |       |
|                              |       |     |       |     |       |     |       |
| Ending balance                    |       | $        | 822,446    |     | $          | 465,271  |       | $ | 696,826 |   |
|                              |       |     |       |     |       |     |       |
| Valuation Allowance:              |       |     |       |     |       |     |       |
| Beginning balance                 |       | $        | 213,000    |     | $          | —   |       | $ | — |   |
| Additions expensed                |       | —   |       | 213,000  |       | —   |       |
| Reductions credited to operations |       | 75,000   |       | —   |       | —   |       |
|                              |       |     |       |     |       |     |       |
| Ending balance                    |       | $        | 138,000    |     | $          | 213,000  |       | $ | — |   |

 

The fair value ofservicing rights was $976,000 and $539,000 at year-end 2009 and 2008.  Fair value at year-end 2009 was determinedusing a discount rate of 12.0%, prepayment speeds ranging from 8.0% to 26.3%,depending on the stratification of the specific right, and default ratesranging from 0.1% to 0.9%.  Fair value atyear-end 2008 was determined using a discount rate of 12.0%, prepayment speedsranging from 14.1% to 40.5%, depending on the stratification of the specificright, and default rates ranging from 0.1% to 0.9%.

 

The weighted averageamortization period is 6.2 years.  Estimatedamortization expense for each of the next five years is:

 
| 2010 |   | $       | 196,000 |   |
|------|--------|---------|---------|--------|
| 2011 |   | 162,000 |    |
| 2012 |   | 131,000 |    |
| 2013 |   | 102,000 |    |
| 2014 |   | 75,000  |    |

 

# **NOTE 5 - REAL ESTATE OWNED**

 

Activity in the valuation allowance was as follows:

 
| ** **                    | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                          |       |     |       |     |       |     |       |
| Beginning  of year            |       | $        | 46,000     |     | $          | —   |       | $ | 8,125 |   |
| Additions  charged to expense |       | 32,950   |       | 46,000   |       | —   |       |
| Recovery from sale            |       | (66,750  | )          | —   |       | (8,125   | )          |
|                          |       |     |       |     |       |     |       |
| End of year                   |       | $        | 12,200     |     | $          | 46,000   |       | $ | — |   |

 

Expenses related toforeclosed assets include:

 
| ** **                                | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                      |       |     |       |     |       |     |       |
| Net  loss (gain) on sales                 |       | $        | (54,075    | )        | $          | 48,213   |       | $ | (5,023 | ) |
| Provision  for unrealized losses          |       | 32,950   |       | 46,000   |       | 8,125    |       |
| Operating  expenses, net of rental income |       | 292,898  |       | 198,128  |       | 12,912   |       |
|                                      |       |     |       |     |       |     |       |
| End of year                               |       | $        | 271,773    |     | $          | 292,341  |       | $ | 16,014 |   |

 

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# **NOTE 6 - PREMISES ANDEQUIPMENT**

 

Year-end premises andequipment were as follows:

 
| ** **                    | ** ** | **2009**    | ** **       | **2008**    | ** ** |
|-------------------------------|------------|-------------|------------------|-------------|------------|
|                          |       |        |             |        |       |
| Land and buildings            |       | $           | 19,562,508       |        | $          | 18,789,227 |   |
| Furniture and equipment       |       | 13,945,340  |             | 13,030,204  |       |
| Construction projects         |       | —      |             | 1,249,305   |       |
|                          |       | 33,507,848  |             | 33,068,736  |       |
| Less accumulated depreciation |       | (15,898,048 | )                | (15,194,030 | )          |
|                          |       |        |             |        |       |
|                          |       | $           |  17,609,800 |        | $          | 17,874,706 |   |

 

Depreciation expense was$1,026,504, $1,154,156 and $1,041,368 in 2009, 2008, and 2007.

# ** **

# **NOTE 7 — GOODWILL ANDINTANGIBLE ASSETS**

 

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

 
| ** **        | ** ** | **2009** | ** ** | **2008** | ** ** | **2007**   | ** ** |
|-------------------|------------|----------|------------|----------|------------|------------|------------|
|              |       |     |       |     |       |       |       |
| Beginning of year |       | $        | 13,116,710 |     | $          | 13,116,710 |       | $ | 13,116,710 |   |
| Acquired goodwill |       | —   |       | —   |       | —     |       |
| 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:

 
| ** **                    | ** ** | **2009**     | ** ** | **2008**         | ** ** |
|-------------------------------|------------|--------------|------------|------------------|------------|
| ** **                    | ** ** | **Gross**    | ** ** | ** **       | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **Carrying** | ** ** | **Accumulated**  | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                    | ** ** | **Amount**   | ** ** | **Amortization** | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Amortized intangible  assets: |       |         |       |             |       |   |   |   |   |
| Core deposit intangibles      |       | $            | 2,530,102  |             | $          | 1,267,161 |   | $ | 2,530,102 |   | $ | 1,007,425 |   |
|                               |            |              |            |                  |            |  |  |  |  |  |  |  |  |

 

Aggregate amortizationexpense was $259,736, $264,736 and $270,736 for 2009, 2008 and 2007.

 

Estimatedamortization expense for each of the next five years:

 
| 2010 |   | $       | 253,736 |   |
|------|--------|---------|---------|--------|
| 2011 |   | 243,736 |    |
| 2012 |   | 233,736 |    |
| 2013 |   | 214,973 |    |
| 2014 |   | 139,760 |    |

 

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

 

Our annual impairment analysis as of December 31,2009, indicated that the Step 2 analysis was not necessary.  If needed, Step 2 of the goodwill impairmenttest is performed to measure the impairment loss.  Step 2 requires that the implied fair valueof the reporting unit goodwill be compared to the 

 

53

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carrying amount of that goodwill.  If the carrying amount of the reporting unitgoodwill exceeds the implied fair value of that goodwill, an impairment lossshall be recognized in an amount equal to that excess.

 

**NOTE 8 -DEPOSITS**

 

Time deposits of $100,000or more were $105,036,000 and $108,466,000 at year-end 2009 and 2008,respectively.

 

At December 31,2009, the scheduled maturities of time deposits for the next five years are asfollows:

 
| 2010 |   | $          | 172,778,253 |   |
|------|--------|------------|-------------|--------|
| 2011 |   | 78,896,099 |        |
| 2012 |   | 4,956,084  |        |
| 2013 |   | 1,697,384  |        |
| 2014 |   | 3,882,469  |        |

 

Certain directors and executive officers of theCompany and companies in which they have beneficial ownership are depositcustomers of the Bank. The amount of these deposits was approximately$2,479,000 and $2,212,000 at December 31, 2009 and 2008.

 

# **NOTE 9 - REPURCHASEAGREEMENTS AND OTHER BORROWINGS**

 

Securities sold underagreements to repurchase are secured by U.S. Government securities with a carryingamount of $6,504,052 and $12,667,471 at year-end 2009 and 2008.

 

Repurchase agreementsgenerally mature within one year from the transaction date and range inmaturities from 1 day to 26 months.  Thesecurities underlying the agreements are maintained in a third-party custodian’saccount under a written custodial agreement. Information concerning repurchase agreements for 2009, 2008 and 2007 issummarized as follows:

 
| ** **                                 | ** ** | **2009** | ** ** | **2008** | ** ** | **2007**   | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|------------|------------|
|                                       |       |     |       |     |       |       |       |
| Average daily balance during the year      |       | $        | 8,575,533  |     | $          | 9,685,901  |       | $ | 10,415,241 |   |
| Average interest rate during the year      |       | 2.43     | %          | 2.97     | %          | 4.18       | %          |
| Maximum month-end balance during the year  |       | $        | 11,935,308 |     | $          | 13,125,185 |       | $ | 16,072,679 |   |
| Weighted average interest rate at year end |       | 1.33     | %          | 3.09     | %          | 4.72       | %          |

 

Promissory note payableof $2,900,000 at December 31, 2009 matures July 30, 2010, and has noscheduled principal payments and interest payable quarterly at prime, and issecured by 100% of the common stock of the bank.  The 2009 loan agreement contains certaincovenants and performance terms.  TheBank was not in compliance with the non-performing asset covenant at December 31,2009.  However, a debt covenant waiverwas obtained from the lending institution.

 

**NOTE 10 -FEDERAL HOME LOAN BANK ADVANCES**

 

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

 
| ** **                                                                                                | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Maturities  February 2010 through March 2030, fixed rates from 1.00% to 7.23%, averaging  3.65% |       | $        | 56,095,638 |     | $          | 77,300,931 |   |
|                                                                                                           |            |          |            |          |            |  |  |

 

Advances are paid eitheron a monthly basis or at maturity.  Alladvances require a prepayment penalty, and are secured by the FHLB stock and 

 

54

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substantially all firstmortgage residential, multi-family and farm real estate loans.

 

Scheduled principalpayments due on advances during the years subsequent to December 31, 2009are as follows:

 
| 2010       |   | $          | 11,159,205 |   |
|------------|--------|------------|------------|--------|
| 2011       |   | 11,321,633 |       |
| 2012       |   | 11,466,738 |       |
| 2013       |   | 8,511,476  |       |
| 2014       |   | 6,250,000  |       |
| Thereafter |   | 7,386,586  |       |
|       |   |       |       |
|       |   | $          | 56,095,638 |   |

 

# **NOTE 11 — SUBORDINATEDDEBENTURES**

 

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 paidinterest quarterly at 7.06% for the first 5 years.  Starting September 2009, the rateconverted to three-month LIBOR plus 3.00 adjusted quarterly, which was 3.29% atyear-end 2009.  The Company is not considered the primarybeneficiary of this Trust (variable interest entity), therefore the trust isnot consolidated in the Company’s financial statements, but rather thesubordinated debentures are shown as a liability.

 

TheCompany may redeem the subordinated debentures, in whole or in part, beginning September 2009at a price of 100% of face value.  Thesubordinated debentures must be redeemed no later than 2033.  The Company has the option to defer interest paymentson the subordinated debentures from time to time for a period not to exceedfive consecutive years.

 

The subordinateddebentures may be included in Tier I capital (with certain limitationsapplicable) under current regulatory guidelines and interpretations.

 

**NOTE 12 -INCOME TAXES**

 

Income tax expense was asfollows:

 
| ** ** | ** ** | **2009** | ** ** | **2008** | ** ** | **2007**  | ** ** |
|------------|------------|----------|------------|----------|------------|-----------|------------|
|       |       |     |       |     |       |      |       |
| Current    |       | $        | 209,944    |     | $          | 1,234,414 |       | $ | 2,457,421 |   |
| Deferred   |       | (25,390  | )          | (550,340 | )          | (53,289   | )          |
|       |       |     |       |     |       |      |       |
|       |       | $        | 184,554    |     | $          | 684,074   |       | $ | 2,404,132 |   |

 

55

----

 

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

 
| ** **                    | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|-------------------------------|------------|------------|------------|------------|------------|
|                          |       |       |       |       |       |
| Deferred tax assets           |       |       |       |       |       |
| Allowance for loan losses     |       | $          | 2,609,702  |       | $          | 1,883,554 |   |
| Pension plan cost             |       | —     |       | 524,547    |       |
| Other                         |       | 147,768    |       | 125,668    |       |
|                          |       |       |       |       |       |
| Deferred tax liabilities      |       |       |       |       |       |
| Unrealized gain on securities |       | (688,053   | )          | (7,249     | )          |
| Bank premises and equipment   |       | (974,155   | )          | (843,316   | )          |
| FHLB stock                    |       | (1,343,242 | )          | (1,343,242 | )          |
| Mortgage servicing rights     |       | (279,632   | )          | (158,192   | )          |
| Core deposit intangibles      |       | (399,031   | )          | (440,106   | )          |
| Other                         |       | (188,050   | )          | (200,943   | )          |
|                          |       |       |       |       |       |
| Net deferred tax liability    |       | $          | (1,114,693 | )          | $          | (459,279 | ) |

 

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

 
| ** **                                                                  | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                        |       |     |       |     |       |     |       |
| U. S. federal income tax rate                                               |       | 34.0     | %          | 34.0     | %          | 34.0     | %          |
| Changes from the statutory rate                                             |       |     |       |     |       |     |       |
| Tax-exempt investment income                                                |       | (23.8    | )          | (21.4    | )          | (9.2     | )          |
| Historic and low income tax credits                                         |       | (8.5     | )          | —   |       | —   |       |
| Non-deductible interest expense related to carrying  tax-exempt investments |       | 2.2      |       | 2.5      |       | 1.3      |       |
| Other                                                                       |       | (0.2     | )          | 0.5      |       | 0.6      |       |
|                                                                        |       |     |       |     |       |     |       |
|                                                                        |       | 3.7      | %          | 15.6     | %          | 26.7     | %          |

 

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, 2009.  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 does not haveany beginning and ending unrecognized tax benefits. The Company does not expectthe total amount of unrecognized tax benefits to significantly increase ordecrease in the next twelve months.

 

There were no interestand penalties recorded in the income statement or accrued for the years ended December 31,2009 and December 31, 2008 related to unrecognized tax benefits.

 

The Company and itssubsidiary 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 2006.

 

56

----

 

**NOTE 13 -EARNINGS PER SHARE**

 

The factors used in theearnings per share computation follow:

 
| ** **                                                                | ** ** | **2009**  | ** ** | **2008**  | ** ** | **2007**  | ** ** |
|---------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                                                      |       |      |       |      |       |      |       |
| Basic Earnings Per Share Net income                                       |       | $         | 4,847,739  |      | $          | 3,713,062 |       | $ | 6,585,952 |   |
| Weighted average common shares outstanding                                |       | 2,736,631 |       | 2,778,037 |       | 2,852,094 |       |
| Basic earnings per share                                                  |       | $         | 1.77       |      | $          | 1.34      |       | $ | 2.31 |   |
|                                                                      |       |      |       |      |       |      |       |
| Diluted Earnings Per Share                                                |       |      |       |      |       |      |       |
| Net income                                                                |       | $         | 4,847,739  |      | $          | 3,713,062 |       | $ | 6,585,952 |   |
| Weighted average common shares outstanding                                |       | 2,736,631 |       | 2,778,037 |       | 2,852,094 |       |
| Add dilutive effects of assumed exercise of stock  options                |       | —    |       | 4,040     |       | 10,292    |       |
| Weighted average common and dilutive potential  common shares outstanding |       | 2,736,631 |       | 2,782,077 |       | 2,862,386 |       |
| Diluted earnings per share                                                |       | $         | 1.77       |      | $          | 1.33      |       | $ | 2.30 |   |

 

Stock options of 36,250shares common stock from 2009, 30,700 shares common stock from 2008 and 29,200shares common stock from 2007 were excluded from diluted earnings per sharebecause their impact was antidilutive.  Stockgrants of 17,655 shares common stock from 2009 were excluded from dilutedearnings per share because their impact was antidilutive.

 

**NOTE 14 -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.  Finaldistributions were at the discretion of the employee.  Expense recognized in connection with thetermination of the plan was $874,391 in 2009 and $562,607 in 2008.

 

Componentsof net periodic pension cost and other amounts recognized in othercomprehensive income:

 
| ** **                                                                    | ** ** | **2009** | ** ** | **2008**   | ** ** | **2007** | ** ** |
|-------------------------------------------------------------------------------|------------|----------|------------|------------|------------|----------|------------|
|                                                                          |       |     |       |       |       |     |       |
| Service cost                                                                  |       | $        | —     |       | $          | 518,241  |       | $ | 483,518 |   |
| Interest cost                                                                 |       | —   |       | 469,542    |       | 405,547  |       |
| Expected return on plan assets                                                |       | —   |       | (480,850   | )          | (439,253 | )          |
| Amortization                                                                  |       | —   |       | 33,506     |       | 34,592   |       |
|                                                                          |       |     |       |       |       |     |       |
| Net periodic cost                                                             |       | $        | —     |       | $          | 540,439  |       | $ | 484,404 |   |
|                                                                          |       |     |       |       |       |     |       |
| 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 |   |

 

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. 

 

57

----

 

The difference of$1,542,786 was recognized in other liabilities on the consolidated balancesheet.  An additional $874,391 wasexpensed in 2009 to make final distributions to the employees.

 

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 thediscretion of the Company’s Board of Directors. Expense recognized in connection with the plan was $560,588, $408,491and $434,203 in 2009, 2008 and 2007.

 

**NOTE 15 -STOCK BASED COMPENSATION**

 

The Company has fourshare based compensation plans as described below.  Total compensation cost that has been chargedagainst income for those plans was $115,020, $135,327, and $96,178 for 2009,2008 and 2007.  The total income taxbenefit was $0, $1,446, and $3,611.

 

Two Stock Option Plans

 

Under its expired 1999Employee Stock Option Plan, the Company has granted certain officers and keyemployees stock option awards which vest and become fully exercisable at theend of five years and provided for issuance of up to 100,000 options.  Under the expired 1993 Non-Employee DirectorsStock Ownership Incentive Plan, the Company had also granted certain directorsstock option awards which vest and become fully exercisable immediately andprovided for issuance 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.

 

The fair value of eachoption 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 estimate optionexercise and post-vesting termination behavior. The expected term of options granted is based on historical data andrepresents the period of time that options granted are expected to beoutstanding, which takes into account that the options are not transferable.  The risk-free interest rate for the expectedterm of the option is based on the U.S. Treasury yield curve in effect at thetime of the grant.

 

The fair value of optionsgranted under both plans was determined using the following weighted-averageassumptions as of grant date.  No optionshave been granted in 2009.

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

 

58

----

 

Summary of activity inthe stock option plan for 2009 follows:

 
| ** **                     | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** **  | ** **    | ** ** |
|--------------------------------|------------|------------|------------|--------------|------------|-----------------|-------------|---------------|------------|
| ** **                     | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**     | ** **  | ** **    | ** ** |
| ** **                     | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**   | ** **  | **Aggregate** | ** ** |
| ** **                     | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** **  | **Intrinsic** | ** ** |
| ** **                     | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Term**        | ** **  | **Value**     | ** ** |
|                           |       |       |       |         |       |            |        |          |       |
| Outstanding, beginning of year |       | 50,169     |       | $            | 28.57      |            |        |          |       |   |
| Granted                        |       | —     |       | —       |       |            |        |          |       |
| Forfeited or expired           |       | (13,919    | )          | 26.36        |       |            |        |          |       |
| Exercised                      |       | —     |       | —       |       |            |        |          |       |
| Outstanding, end of year       |       | 36,250     |       | $            | 29.42      |            | 48.7 months |          | $          | — |   |
|                           |       |       |       |         |       |            |        |          |       |
| Vested and expected to vest    |       | 36,250     |       | $            | 29.42      |            | 48.7 months |          | $          | — |   |
|                           |       |       |       |         |       |            |        |          |       |
| Exercisable, end of year       |       | 33,880     |       | $            | 29.34      |            | 47.9 months |          | $          | — |   |

 

Options outstanding at year-end2009 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 $23.50 to $28.00 per share             |       | 12,850          |       | 29.4            |       | 25.47 |   | 12,850 |   | 25.47 |   |
| From $29.50 to $31.00 per share             |       | 15,750          |       | 64.6            |       | 30.46 |   | 13,380 |   | 30.45 |   |
| From $33.90 to $34.00 per share             |       | 7,650           |       | 48.3            |       | 33.91 |   | 7,650 |   | 33.91 |   |
|                                        |       | 36,250          |       |            |       |   |   | 33,880 |   |   |   |

 

Information related tothe stock option plan during each year follows:

 
| ** **                                     | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                           |       |     |       |     |       |     |       |
| Intrinsic value of options exercised           |       | $        | —     |     | $          | 59,700   |       | $ | 141,258 |   |
| Cash received from option exercises            |       | —   |       | 148,293  |       | 178,692  |       |
| Tax benefit realized from option exercises     |       | —   |       | 1,446    |       | 3,611    |       |
| Weighted average fair value of options granted |       | —   |       | 1,904    |       | 3,376    |       |
|                                                |            |          |            |          |            |          |            |  |  |  |

 

Asof December 31, 2009, there was $0 of total unrecognized compensation costrelated to nonvested stock options granted under the Plan.  Since both stock options have expired, as of December 31,2009 neither plan allows for additional options to be issued.

 

# **2005 Restricted Stock Grant Plan**

 

On May 10, 2005, theCompany’s stockholders approved a restricted stock grant plan.  Total shares issuable under the plan are 50,000.  There were 4,150 shares issued during 2009and 4,025 shares issued during 2008.  Therewere 516 shares forfeited during 2009 and 312 shares forfeited during 2008.

 

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, 2009   |       | 10,006     |       | $                    | 306,023    |   |
| Granted                             |       | 4,150      |       | 71,173               |       |
| Vested                              |       | (3,518     | )          | (102,983             | )          |
| Forfeited                           |       | (516       | )          | (13,180              | )          |
|                                |       |       |       |                 |       |
| Nonvested at December 31, 2009 |       | 10,122     |       | $                    | 261,033    |   |

 

59

----

 

As of December 31,2009, there was $225,424 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, 2009, 2008 and 2007 was$45,192, $53,784 and $23,839.  As of December 31,2009, the restricted stock grant plan allows for additional restricted stock shareawards of up to 33,847 shares.

 

2009 Stock Award Plan

 

On May 13, 2009, theCompany’s stockholders approved a stock award plan that provides for thegranting of both incentive and nonqualified stock options and other share basedawards.  Total shares issuable under theplan are 150,000.  As of December 31,2009 no awards have been granted under the plan and 150,000 shares are stillavailable.

 

# **NOTE 16 - LIMITATION ON BANKDIVIDENDS**

 

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 2010 the Bank could, without priorapproval, declare dividends on any 2010 net profits retained to the date of thedividend declaration plus $2,365,000.

 

**NOTE 17 -FAIR VALUE**

 

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

 

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

 

Level2 - Significant other observable inputs other than Level 1 prices such asquoted prices for similar assets or liabilities; quoted prices in markets thatare not active; or other inputs that are observable or can be corroborated byobservable market data.

 

Level3 - Significant unobservable inputs that reflect a company’s own assumptionsabout the assumptions that market participants would use in pricing an asset orliability.

 

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

 

InvestmentSecurities:  The fair values for investment securities aredetermined by quoted market prices, if available (Level 1).  For securities where quoted prices are notavailable, fair values are calculated based on market prices of similarsecurities (Level 2).  For securitieswhere quoted prices or market prices of similar securities are not available,fair values are calculated using discounted cash flows or other marketindicators (Level 3).

 

Impaired Loans:  Thefair value of impaired loans with specific allocations of the allowance forloan losses 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 are routinely made in the appraisalprocess by the appraisers to 

 

60

----

 

adjust for differencesbetween the comparable sales and income data available. Such adjustments areusually significant and typically result in a Level 3 classification of theinputs for determining fair value.

 

Other Real EstateOwned:  Nonrecurring adjustments to certaincommercial and residential real estate properties classified as other realestate owned (OREO) are measured at the lower of carrying amount or fair value,less costs to sell.  Fair values aregenerally based on third party appraisals of the property, resulting in a Level3 classification.  In cases where thecarrying amount exceeds the fair value, less costs to sell, an impairment lossis recognized.

 

Loan ServicingRights:  Fair Value is based on market prices forcomparable mortgage servicing contracts, when available, or alternatively basedon a valuation model that calculates the present value of estimated future netservicing income, resulting in a Level 3 classification.

 

Assets andLiabilities Measured on a Recurring Basis

 

Forthis disclosure, the Company only has available for sale investment securitiesthat meet the requirement.

 

Availablefor sale investment securities are the Company’s only balance sheet item thatmeet the disclosure requirements for instruments measured at fair value on arecurring basis.  Disclosures are asfollows in the tables below.

 

(Inthousands)  

 
| ** **                    | ** ** | **Fair Value Measurements at December 31, 2009 Using:** | ** ** |
|-------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                    | ** ** | ** **                                                                                 | ** ** | **Quoted Prices** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | ** **                                                                                 | ** ** | **In Active** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | ** **                                                                                 | ** ** | **Markets for** | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                    | ** ** | ** **                                                                                 | ** ** | **Identical** | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                    | ** ** | **Carrying**                                                                               | ** ** | **Assets** | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| **Description**               | ** ** | **Value**                                                                                  | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
|                          |       |                                                                                       |       |   |   |   |   |   |   |
| U. S. government agencies     |       | $                                                                                          | 44,733     |   | $ | — |   | $ | 44,733 |   | $ | — |   |
| States and municipals         |       | 80,123                                                                                     |       | — |   | 80,123 |   | — |   |
| Mortgage-backed - residential |       | 43,263                                                                                     |       | — |   | 43,263 |   | — |   |
| Equity securities             |       | 292                                                                                        |       | 292 |   | — |   | — |   |
| Total                         |       | $                                                                                          | 168,411    |   | $ | 292 |   | $ | 168,119 |   | $ | — |   |

 

(Inthousands)

 
| ** **                    | ** ** | **Fair Value Measurements at December 31, 2008 Using:** | ** ** |
|-------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                    | ** ** | ** **                                                                                 | ** ** | **Quoted Prices** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | ** **                                                                                 | ** ** | **In Active** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | ** **                                                                                 | ** ** | **Markets for** | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                    | ** ** | ** **                                                                                 | ** ** | **Identical** | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                    | ** ** | **Carrying**                                                                               | ** ** | **Assets** | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| **Description**               | ** ** | **Value**                                                                                  | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
|                          |       |                                                                                       |       |   |   |   |   |   |   |
| U. S. government agencies     |       | $                                                                                          | 19,350     |   | $ | — |   | $ | 19,350 |   | $ | — |   |
| States and municipals         |       | 63,971                                                                                     |       | — |   | 63,971 |   | — |   |
| Mortgage-backed - residential |       | 89,223                                                                                     |       | — |   | 89,223 |   | — |   |
| Equity securities             |       | 290                                                                                        |       | 290 |   | — |   | — |   |
| Total                         |       | $                                                                                          | 172,834    |   | $ | 290 |   | $ | 172,544 |   | $ | — |   |

 

61

----

 

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

 

(In thousands)

 
| ** **                   | ** ** | **Fair Value Measurements at December 31, 2009 Using:** | ** ** |
|------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                   | ** ** | ** **                                                                                 | ** ** | **Quoted Prices** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | ** **                                                                                 | ** ** | **In Active** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | ** **                                                                                 | ** ** | **Markets for** | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                   | ** ** | ** **                                                                                 | ** ** | **Identical** | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                   | ** ** | **Carrying**                                                                               | ** ** | **Assets** | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| **Description**              | ** ** | **Value**                                                                                  | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
|                         |       |                                                                                       |       |   |   |   |   |   |   |
| Impaired loans               |       | $                                                                                          | 10,202     |   | $ | — |   | $ | — |   | $ | 10,202 |   |
| Other real estate owned, net |       | 68                                                                                         |       | — |   | — |   | 68 |   |
| Loan servicing rights        |       | 626                                                                                        |       | — |   | — |   | 626 |   |
|                              |            |                                                                                            |            |  |  |  |  |  |  |  |  |  |  |

 

(Inthousands)

 
| ** **                   | ** ** | **Fair Value Measurements at December 31, 2008 Using:** | ** ** |
|------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                   | ** ** | ** **                                                                                 | ** ** | **Quoted Prices** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | ** **                                                                                 | ** ** | **In Active** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | ** **                                                                                 | ** ** | **Markets for** | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                   | ** ** | ** **                                                                                 | ** ** | **Identical** | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                   | ** ** | **Carrying**                                                                               | ** ** | **Assets** | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| **Description**              | ** ** | **Value**                                                                                  | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
|                         |       |                                                                                       |       |   |   |   |   |   |   |
| Impaired loans               |       | $                                                                                          | 978        |   | $ | — |   | $ | — |   | $ | 978 |   |
| Other real estate owned, net |       | 293                                                                                        |       | — |   | — |   | 293 |   |
| Loan servicing rights        |       | 261                                                                                        |       | — |   | — |   | 261 |   |
|                              |            |                                                                                            |            |  |  |  |  |  |  |  |  |  |  |

 

Impaired loans, which are measured for impairment using thefair value of the collateral for collateral dependent loans, had a carrying amount of $14.3million, with a valuation allowance of$4.1 million at December 31, 2009, resulting in an additional provision for loan lossesof $3.8 million for the year ending December 31, 2009.  At December 31, 2008, impaired loans hada carrying amount of $1.3 million, with a valuation allowance of $320 thousand,resulting in no additional provision for loan losses for the year ending December 31,2008.

 

Other real estate ownedwhich is measured at the lower of carrying or fair value less costs to sell,had a net carrying amount of $68 thousand, which is made up of the outstandingbalance of $80 thousand, net of a valuation allowance of $12 thousand at December 31,2009, resulting in a write-down of $12 thousand for the year ending December 31,2009.

 

Loan servicing rights,which are carried at lower of cost or fair value, were carried at their fairvalue of $626 thousand, which is made up of the outstanding balance of $764thousand, net of a valuation allowance of $138 thousand at December 31,2009, resulting in a recovery of $75 thousand for the year ending December 31,2009.

 

62

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Fair Value of FinancialInstruments

 

The fair values of theCompany’s financial instruments at December 31, 2009 and 2008 are asfollows:

 
| ** **                                                           | ** ** | **2009**                | ** ** | **2008**            | ** ** |
|----------------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                                           | ** ** | **Carrying**            | ** ** | ** **          | ** ** | **Carrying** | ** ** | ** ** | ** ** |
| ** **                                                           | ** ** | **Amount**              | ** ** | **Fair Value** | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| ** **                                                           | ** ** | **(In Thousands)** | ** ** |
| Financial  assets                                                    |       |                    |       |                |       |   |   |   |   |
| Cash  and cash equivalents                                           |       | $                       | 34,421     |                | $          | 34,421 |   | $ | 37,106 |   | $ | 37,106 |   |
| Securities                                                           |       | 168,411                 |       | 168,411             |       | 172,834 |   | 172,834 |   |
| Loans,  net                                                          |       | 417,818                 |       | 417,759             |       | 418,812 |   | 418,635 |   |
| FHLB  stock                                                          |       | 6,731                   |       | N/A                 |       | 6,731 |   | N/A |   |
| Interest  receivable                                                 |       | 4,621                   |       | 4,621               |       | 5,156 |   | 5,156 |   |
|                                                                 |       |                    |       |                |       |   |   |   |   |
| Financial  liabilities                                               |       |                    |       |                |       |   |   |   |   |
| Deposits                                                             |       | $                       | 536,446    |                | $          | 541,691 |   | $ | 520,808 |   | $ | 528,949 |   |
| Securities  sold under agreements to repurchase and other borrowings |       | 8,226                   |       | 8,252               |       | 10,717 |   | 10,983 |   |
| FHLB  advances                                                       |       | 56,096                  |       | 57,633              |       | 77,301 |   | 79,665 |   |
| Subordinated  debentures                                             |       | 7,217                   |       | 6,029               |       | 7,217 |   | 4,253 |   |
| Interest  payable                                                    |       | 2,122                   |       | 2,122               |       | 2,874 |   | 2,874 |   |

 

The methods andassumptions, not previously presented, used to estimate fair value aredescribed as follows:  Carrying amount isthe estimated fair value for cash and cash equivalents, interest bearingdeposits, accrued interest receivable and payable, demand deposits, short-termdebt, and variable rate loans or deposits that reprice frequently andfully.  The methods for determining thefair values for securities were described previously.  For fixed rate loans or deposits and forvariable rate loans or deposits with infrequent repricing or repricing limits,fair value is based on discounted cash flows using current market rates appliedto the estimated life and credit risk (including consideration of wideningcredit spreads).  Fair value of debt isbased on current rates for similar financing. It was not practicable to determine the fair value of FHLB stock due torestrictions placed on its transferability. The fair value of off-balance sheet items 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 instruments withoff-balance sheet risk were as follows at year-end:

 
| ** **                 | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|----------------------------|------------|------------|------------|------------|------------|
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unused  lines of credit    |       | $          | 70,171,230 |       | $          | 64,791,109 |   |
| Commitments  to make loans |       | 2,961,000  |       | 5,214,000  |       |
| Letters  of credit         |       | 836,797    |       | 794,066    |       |
|                            |            |            |            |            |            |  |  |

 

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.

 

63

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**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 followingtable) of Total and Tier I capital (as defined in the regulations) torisk-weighted assets (as defined), and of Tier I capital to average assets (asdefined).  Management believes, as of December 31,2009 and 2008, 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)** | ** ** |
| 2009                                      |       |                                 |       |                       |       |                       |       |   |   |   |   |   |   |
| Consolidated                              |       |                                 |       |                       |       |                       |       |   |   |   |   |   |   |
| Total  Capital (to Risk-Weighted Assets)  |       | $                                    | 58,398     |                       | 12.6       | %                          | $          | 36,957 |   | 8 | % | $ | 46,196 |   | N/A |   |
| Tier  I Capital (to Risk-Weighted Assets) |       | 52,593                               |       | 11.4                       |       | 18,478                     |       | 4 |   | 27,718 |   | N/A |   |
| Tier  I Capital (to Average Assets)       |       | 52,593                               |       | 8.0                        |       | 26,201                     |       | 4 |   | 32,752 |   | N/A |   |
|                                      |       |                                 |       |                       |       |                       |       |   |   |   |   |   |   |
| Bank  Only                                |       |                                 |       |                       |       |                       |       |   |   |   |   |   |   |
| Total  Capital (to Risk-Weighted Assets)  |       | $                                    | 60,675     |                       | 13.1       | %                          | $          | 36,941 |   | 8 | % | $ | 46,177 |   | 10 | % |
| Tier  I Capital (to Risk-Weighted Assets) |       | 54,869                               |       | 11.9                       |       | 18,471                     |       | 4 |   | 27,706 |   | 6 |   |
| Tier  I Capital (to Average Assets)       |       | 54,869                               |       | 8.4                        |       | 26,200                     |       | 4 |   | 32,750 |   | 5 |   |
|                                      |       |                                 |       |                       |       |                       |       |   |   |   |   |   |   |
| 2008                                      |       |                                 |       |                       |       |                       |       |   |   |   |   |   |   |
| Consolidated                              |       |                                 |       |                       |       |                       |       |   |   |   |   |   |   |
| Total  Capital (to Risk-Weighted Assets)  |       | $                                    | 54,898     |                       | 12.5       | %                          | $          | 35,217 |   | 8 | % | $ | 44,021 |   | N/A |   |
| Tier  I Capital (to Risk-Weighted Assets) |       | 49,386                               |       | 11.2                       |       | 17,608                     |       | 4 |   | 26,412 |   | N/A |   |
| Tier  I Capital (to Average Assets)       |       | 49,386                               |       | 7.6                        |       | 25,873                     |       | 4 |   | 32,342 |   | N/A |   |
|                                      |       |                                 |       |                       |       |                       |       |   |   |   |   |   |   |
| Bank  Only                                |       |                                 |       |                       |       |                       |       |   |   |   |   |   |   |
| Total  Capital (to Risk-Weighted Assets)  |       | $                                    | 57,596     |                       | 13.1       | %                          | $          | 35,192 |   | 8 | % | $ | 43,989 |   | 10 | % |
| Tier  I Capital (to Risk-Weighted Assets) |       | 52,088                               |       | 11.8                       |       | 17,596                     |       | 4 |   | 26,394 |   | 6 |   |
| Tier  I Capital (to Average Assets)       |       | 52,088                               |       | 8.1                        |       | 25,863                     |       | 4 |   | 32,329 |   | 5 |   |

 

64

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**NOTE 21 - PARENT COMPANYFINANCIAL STATEMENTS**

 

Condensed BalanceSheets

December 31

 
| ** **                                          | ** ** | **2009**                | ** ** | **2008** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                          | ** ** | **(In Thousands)** | ** ** |
| **ASSETS**                                          |       |                    |       |     |       |
| Cash  on deposit with subsidiary                    |       | $                       | 413        |     | $          | 104 |   |
| Investment  in subsidiary                           |       | 70,242                  |       | 66,742   |       |
| Securities  available for sale                      |       | 20                      |       | 20       |       |
| Other  assets                                       |       | 417                     |       | 507      |       |
|                                                |       |                    |       |     |       |
| **Total assets**                                    |       | $                       | 71,092     |     | $          | 67,373 |   |
|                                                |       |                    |       |     |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**       |       |                    |       |     |       |
| Liabilities                                         |       |                    |       |     |       |
| Subordinated  debentures                            |       | $                       | 7,217      |     | $          | 7,217 |   |
| Notes  payable                                      |       | 2,900                   |       | 3,100    |       |
| Other  liabilities                                  |       | 9                       |       | 15       |       |
| Stockholders’  equity                          |       |                    |       |     |       |
| Preferred  stock                                    |       | —                  |       | —   |       |
| Common  stock                                       |       | 12,417                  |       | 12,344   |       |
| Retained  earnings                                  |       | 47,213                  |       | 44,683   |       |
| Accumulated  other comprehensive income (loss)      |       | 1,336                   |       | 14       |       |
|                                                |       |                    |       |     |       |
| **Total liabilities and stockholders’ equity** |       | $                       | 71,092     |     | $          | 67,373 |   |

 

65

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CondensedStatements of Income and Comprehensive Income

Years Ended December 31

 
| ** **                                                                   | ** ** | **2009**                | ** ** | **2008** | ** ** | **2007** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                                                   | ** ** | **(In Thousands)** | ** ** |
| Income                                                                       |       |                    |       |     |       |     |       |
| Dividends  from subsidiary                                                   |       | $                       | 3,100      |     | $          | 3,900    |       | $ | 4,300 |   |
| Interest  income                                                             |       | —                  |       | —   |       | 1        |       |
| Total  income                                                                |       | 3,100                   |       | 3,900    |       | 4,301    |       |
|                                                                         |       |                    |       |     |       |     |       |
| Expenses                                                                     |       |                    |       |     |       |     |       |
| Interest  expense                                                            |       | 377                     |       | 563      |       | 531      |       |
| Other  expenses                                                              |       | 101                     |       | 179      |       | 128      |       |
| Total  expenses                                                              |       | 478                     |       | 742      |       | 659      |       |
|                                                                         |       |                    |       |     |       |     |       |
| Income  before income taxes and equity in undistributed income of subsidiary |       | 2,622                   |       | 3,158    |       | 3,642    |       |
|                                                                         |       |                    |       |     |       |     |       |
| Applicable  income tax (expense) benefits                                    |       | 162                     |       | 253      |       | 224      |       |
|                                                                         |       |                    |       |     |       |     |       |
| Income  before equity in undistributed income of subsidiary                  |       | 2,784                   |       | 3,411    |       | 3,866    |       |
|                                                                         |       |                    |       |     |       |     |       |
| Equity  in undistributed income of subsidiary                                |       | 2,063                   |       | 302      |       | 2,720    |       |
|                                                                         |       |                    |       |     |       |     |       |
| Net income                                                                   |       | 4,847                   |       | 3,713    |       | 6,586    |       |
|                                                                         |       |                    |       |     |       |     |       |
| Other  comprehensive income (loss), net of tax:                              |       |                    |       |     |       |     |       |
| Unrealized  gains (losses) on securities arising during the period           |       | 2,390                   |       | 354      |       | 589      |       |
| Reclassification  of realized amount                                         |       | (1,068                  | )          | (434     | )          | (24      | )          |
|                                                                         |       |                    |       |     |       |     |       |
| Net  change in unrealized gain (loss) on securities                          |       | 1,322                   |       | (80      | )          | 565      |       |
|                                                                         |       |                    |       |     |       |     |       |
| Comprehensive  income                                                        |       | $                       | 6,169      |     | $          | 3,633    |       | $ | 7,151 |   |

 

66

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CondensedStatements of Cash Flows

Years Ended December 31

 
| ** **                                                                 | ** ** | **2009**                | ** ** | **2008**   | ** ** | **2007** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------|------------|------------|------------|----------|------------|
| ** **                                                                 | ** ** | **(In Thousands)** | ** ** |
| **Cash flows from operating activities**                                   |       |                    |       |       |       |     |       |
| Net  income                                                                |       | $                       | 4,847      |       | $          | 3,713    |       | $ | 6,586 |   |
| Adjustments  to reconcile net income to net cash from operating activities |       |                    |       |       |       |     |       |
| Equity  in undistributed earnings of subsidiary                            |       | (2,063                  | )          | (302       | )          | (2,720   | )          |
| Change  in other assets                                                    |       | 90                      |       | (24        | )          | (58      | )          |
| Change  in other liabilities                                               |       | (6                      | )          | (4         | )          | (27      | )          |
| **Net cash from operating activities**                                     |       | 2,868                   |       | 3,383      |       | 3,781    |       |
|                                                                       |       |                    |       |       |       |     |       |
| **Cash flows from investing activities**                                   |       |                    |       |       |       |     |       |
| Proceeds  from sales of securities available for sale                      |       | —                  |       | —     |       | —   |       |
| **Net cash from investing activities**                                     | ** ** | **—**              | ** ** | **—** |       | —   |       |
|                                                                       |       |                    |       |       |       |     |       |
| **Cash flows from financing activities**                                   |       |                    |       |       |       |     |       |
| Proceeds  from note payable                                                |       | 2,900                   |       | 5,500      |       | —   |       |
| Payments  on note payable                                                  |       | (3,100                  | )          | (2,700     | )          | (700     | )          |
| Dividends  paid                                                            |       | (2,195                  | )          | (3,121     | )          | (3,088   | )          |
| Proceeds  from issuance of common stock                                    |       | 2                       |       | 17         |       | 175      |       |
| Purchase  of common stock                                                  |       | (166                    | )          | (3,150     | )          | (933     | )          |
| **Net cash from financing activities**                                     |       | (2,559                  | )          | (3,454     | )          | (4,546   | )          |
|                                                                       |       |                    |       |       |       |     |       |
| Net  change in cash                                                        |       | 309                     |       | (71        | )          | (765     | )          |
|                                                                       |       |                    |       |       |       |     |       |
| Cash  at beginning of year                                                 |       | 104                     |       | 175        |       | 940      |       |
|                                                                       |       |                    |       |       |       |     |       |
| **Cash at end of year**                                                    |       | $                       | 413        |       | $          | 104      |       | $ | 175 |   |

 

67

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

 
| ** **      | ** ** | **Interest** | ** ** | **Net Interest** | ** ** | **Net**    | ** ** | **Earnings Per Share** | ** ** |
|-----------------|------------|--------------|------------|------------------|------------|------------|------------|------------------------|------------|
| ** **      | ** ** | **Income**   | ** ** | **Income**       | ** ** | **Income** | ** ** | **Basic**              | ** ** | **Fully Diluted** | ** ** |
| 2009            |       |         |       |             |       |       |       |                   |       |   |   |
| First  quarter  |       | $            | 8,197      |             | $          | 4,751      |       | $                      | 1,167      |   | $ | 0.43 |   | $ | 0.43 |   |
| Second  quarter |       | 7,908        |       | 4,674            |       | 904        |       | 0.33                   |       | 0.33 |   |
| Third  quarter  |       | 7,911        |       | 4,925            |       | 1,354      |       | 0.49                   |       | 0.49 |   |
| Fourth  quarter |       | 7,913        |       | 4,707            |       | 1,423      |       | 0.52                   |       | 0.52 |   |
|            |       |         |       |             |       |       |       |                   |       |   |   |
| 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 | ) |

 

The Company recorded a$874 thousand in additional pension plan expense during the second quarter of2009.  In the fourth quarter of 2009, theCompany recorded a $2.1 million addition to the allowance for loan losses.  This was partially offset by $1.3 million insecurities gains recorded in the fourth quarter of 2009.  Historic and Low Income Tax credits amountingto over $300 thousand were also booked during the fourth quarter of 2009.

 

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.

 

68

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

 

None

 

**Item 9A.  Controls and Procedures**

 

Evaluation of Disclosure Controls. The Company maintains disclosure controls and procedures designed toensure that it is able to collect the information it is required to disclose inthe reports it files with the Securities and Exchange Commission (SEC), and toprocess, summarize and disclose this information within the time periodsspecified in the rules of the SEC.  Based on their evaluation of theCompany’s disclosure controls and procedures which took place as of December 31,2009, the Chief Executive Officer and Chief Financial Officer believe thatthese controls and procedures are effective to ensure that the Company is ableto collect, process and disclose the information it is required to disclose inthe reports it files with the SEC within the required time periods

 

GeneralOverview of Internal Controls over Financial Reporting*. *Management of the Company isresponsible for establishing and maintaining effective internal control overfinancial reporting as defined in Rules 13a-15(f) under theSecurities 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, 2009.  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 thisassessment, management used the criteria set forth by the Committee ofSponsoring Organizations of the Treadway Commission (COSO) in Internal Control— Integrated Framework.

 

No Changes in Internal Controlsover Financial Reporting During Most Recent Quarter*. *TheCompany’s Chief Executive Officer and Chief Financial Officer have alsoconcluded that there were no changes in the Company’s internal control overfinancial reporting or in other factors that occurred during the Company’s mostrecent fiscal quarter that have materially affected, or are reasonably likelyto materially affect, the Company’s internal control over financial reportingor any corrective actions with regard to significant deficiencies and materialweaknesses in internal control over financial reporting.

 

69

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GeneralDescription of Internal Control over Financial Reporting*.  *Internal control over financial reportingrefers to a process designed by, or under the supervision of, the Company’sChief Executive Officer and Chief Financial Officer and effected by the Company’sBoard of Directors, management and other personnel, to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles and includes those policies and procedures that:

 

(1)         Pertain to the maintenance of recordsthat in reasonable detail accurately and fairly reflect the transactions anddispositions of Company assets;

 

(2)         Provide reasonable assurance thattransactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat Company’s receipts and expenditures are being made only in accordance withthe authorization of Company’s management and members of the Company’s Board ofDirectors; and

 

(3)         Provide reasonable assurance regardingprevention or timely detection of unauthorized acquisitions, uses ordispositions of Company assets that could have a material effect on the Company’sfinancial statements.

 

InherentLimitations in Internal Control over Financial Reporting*.  *Internal control over financial reportingcannot provide absolute assurance of achieving financial reporting objectivesbecause of its inherent limitations.  Internal control over financialreporting is a process that involves human diligence and compliance and issubject to lapses in judgment and breakdowns resulting from humanfailures.  Internal control over financial reporting also can becircumvented or overridden by collusion or other improperactivities.  Because of such limitations, there is a risk that materialmisstatements may not be prevented or detected on a timely basis by internalcontrol 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 report does notinclude an attestation report of the Company’s registered public accountingfirm 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 aresult of our assessment of the Company’s internal control over financialreporting, management concluded that the Company’s internal control overfinancial reporting was effective as of December 31, 2009 to ensure thatinformation required to be disclosed by the Company in reports that it files orsubmits under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in SEC rules and forms.

 

**Item 9B.  Other Information**

 

None

 

70

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**PART III**

 

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

 

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 29, 2010.

 
| **Name**            | ** ** | **Age** | ** ** | **Position with the Company**                                                                                   |
|---------------------|------------|---------|------------|-----------------------------------------------------------------------------------------------------------------|
|                |       |    |       |                                                                                                            |
| Brenda S. Bragonier |       | 53      |       | Senior Vice President, Director of Marketing and Human Resources  since 1999.                                   |
|                |       |    |       |                                                                                                            |
| Gregory J. Dawson   |       | 49      |       | Senior Vice President, Chief Financial Officer since 1989.                                                      |
|                |       |    |       |                                                                                                            |
| Norman J. Fryman    |       | 60      |       | Senior Vice President, Director of Sales and Service since 2004.                                                |
|                |       |    |       |                                                                                                            |
| Clark Nyberg        |       | 57      |       | Senior Vice President, Director of Wealth Management since 2004.                                                |
|                |       |    |       |                                                                                                            |
| Martha Woodford     |       | 56      |       | Senior Vice President, Director of Operations, Since 2006.  Assistant Director of Operations from 2004 to 2006. |

 

The remaining informationrequired by Item 10 is hereby incorporated by reference under the headings “CorporateGovernance” and “Proposal No. 2 — Election of Directors” from the Company’sdefinitive proxy statement in connection with its annual meeting ofstockholders scheduled for May 19, 2010, which will be filed with theCommission on or about April 15, 2010, pursuant to Regulation 14A (“2010Proxy Statement”).

 

**Item 11.  Executive Compensation**

 

The information requiredby Item 11 is hereby incorporated by reference under the headings “ExecutiveCompensation,” “Compensation Committee Report” and “Compensation of NamedExecutive Officers” in the 2010 Proxy Statement.

 

**Item 12.  Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters**

 

The information requiredby Item 12 is hereby incorporated by reference under the heading “StockOwnership of Directors and Executive Officers” in the 2010 Proxy Statement.

 

**Item 13.  Certain Relationships and RelatedTransactions, and Director Independence**

 

The information requiredby Item 13 is hereby incorporated by reference under the headings “CorporateGovernance” and “Transactions with Related Persons” in the 2010 ProxyStatement.

 

**Item 14.  Principal Accountant Fees and Services**

 

The information requiredby Item 14 is hereby incorporated by reference under the heading “Fees of IndependentRegistered Public Accounting Firm” in the 2010 Proxy Statement.

 

71

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## **Part IV**

## ** **

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

 

(a)(1)  FinancialStatements

 

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

 

Report of IndependentRegistered Public Accounting Firm

Consolidated BalanceSheets

Consolidated Statementsof Income

Consolidated Statementsof Changes in Stockholders’ Equity

Consolidated Statementsof Cash Flow

Notes to ConsolidatedFinancial Statements

 

(a)(2)  FinancialStatement 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 Non-Employee Directors Stock Ownership Incentive  Plan is incorporated by reference to Exhibit 10.3 of the Registrant’s  Registration Statement on Form S-4 (File No. 33-96358).             |
|   |                                                                                                                                                                                                                                                  |
| 10.2   | Kentucky  Bancshares, Inc. 1999 Employee Stock Option Plan is incorporated by  reference to Exhibit 99.1 of the Registrant’s Form 10-K for the  fiscal year ended December 31, 1998.                                         |
|   |                                                                                                                                                                                                                                                  |
| 10.3   | 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.                                                        |

 

72

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| 10.4   | 2005 Restricted Stock  Grant Plan, including form of Award Agreement, as incorporated by reference  to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K  dated February 15, 2005. |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                             |
| 10.5   | 2009 Stock Award Plan,  as incorporated by reference to Exhibit 10.1 of the Registrant’s  Quarterly Report on Form 10-Q for the quarterly period ending  June 30, 2009.                      |
|   |                                                                                                                                                                                                             |
| 11     | Computation of earnings  per share - See Note 13 in the notes to 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 Item15(a)(3).

 

(c)  FinancialStatement Schedules

See response to Item15(a)(2).

 

73

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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 31, 2010                                              |              |
|                                                                  |                   |  |

 

 

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 31, 2010                        |
|------------------------------------------------------------------|--------|--------------------------------------------|
| Louis Prichard,  President and Chief Executive Officer, Director |   |                                       |
|                                                             |   |                                       |
| /s/Gregory J. Dawson                                             |   | March 31, 2010                        |
| Gregory J. Dawson,  Chief Financial and Accounting Officer       |   |                                       |
|                                                             |   |                                       |
| /s/Buckner Woodford                                              |   | March 29, 2010                        |
| Buckner Woodford,  Chairman of the Board, Director               |   |                                       |
|                                                             |   |                                       |
|                                                             |   | March     ,  2010 |
| William Arvin, Director                                          |   |                                       |
|                                                             |   |                                       |
| /s/B. Proctor Caudill                                            |   | March 29, 2010                        |
| B. Proctor Caudill,  Director                                    |   |                                       |
|                                                             |   |                                       |
| /s/Henry Hinkle                                                  |   | March 26, 2010                        |
| Henry Hinkle, Director                                           |   |                                       |
|                                                             |   |                                       |
| /s/Theodore Kuster                                               |   | March 29, 2010                        |
| Theodore Kuster,  Director                                       |   |                                       |
|                                                             |   |                                       |
| /s/Betty J. Long                                                 |   | March 26, 2010                        |
| Betty J. Long, Director                                          |   |                                       |
|                                                             |   |                                       |
| /s/Ted McClain                                                   |   | March 26, 2010                        |
| Ted McClain, Director                                            |   |                                       |
|                                                             |   |                                       |
| /s/Edwin S. Saunier                                              |   | March 26, 2010                        |
| Edwin S. Saunier,  Director                                      |   |                                       |
|                                                             |   |                                       |
| /s/Robert G. Thompson                                            |   | March 26, 2010                        |
| Robert G. Thompson,  Director                                    |   |                                       |
|                                                             |   |                                       |
| /s/Woodford Van Meter                                            |   | March     ,  2010 |
| Woodford Van Meter, Director                                     |   |                                       |

 

74

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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 Non-Employee Directors Stock Ownership Incentive  Plan is incorporated by reference to Exhibit 10.3 of the Registrant’s  Registration Statement on Form S-4 (File No. 33-96358).             |
|   |                                                                                                                                                                                                                                                  |
| 10.2   | Kentucky  Bancshares, Inc. 1999 Employee Stock Option Plan is incorporated by  reference to Exhibit 99.1 of the Registrant’s Form 10-K for the  fiscal year ended December 31, 1998.                                         |
|   |                                                                                                                                                                                                                                                  |
| 10.3   | 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.                                                        |
|   |                                                                                                                                                                                                                                                  |
| 10.4   | 2005 Restricted Stock  Grant Plan, including form of Award Agreement, as incorporated by reference  to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K  dated February 15, 2005.                                      |
|   |                                                                                                                                                                                                                                                  |
| 10.5   | 2009 Stock Award Plan,  as incorporated by reference to Exhibit 10.1 of the Registrant’s Quarterly  Report on Form 10-Q for the quarterly period ending June 30, 2009.                                                            |
|   |                                                                                                                                                                                                                                                  |
| 11     | Computation of earnings  per share - See Note 13 in the notes to 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.                                                                                        |

 

75

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