**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D. C. 20549**

 

**FORM 10-K**

 

**Annual Report Pursuant to Section13 or 15(d) of the**

**Securities Exchange Act of 1934**

 

**For the fiscal year endedDecember 31, 2005**

 

**Commission file number 0-12422**

 

**MAINSOURCE FINANCIAL GROUP, INC.**

(Exact name of registrant asspecified in its charter)

 
| **Indiana**                        | ** ** | **35-1562245**      |
|------------------------------------|------------|---------------------|
| (State or other  jurisdiction      |       | (I.R.S. Employer    |
| of incorporation or  organization) |       | Identification No.) |

 

**201 North Broadway**

**Greensburg, Indiana 47240**

(Address of principalexecutive offices) (Zip code)

 

Registrant’s telephonenumber, including area code: **(812) 663-0157**

 

Securities registeredpursuant to Section 12(b) of the Act:

**None**

 

Securities registeredpursuant to Section 12(g) of the Act

 

**Common shares, no-par value**

(Title of Class)

 

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  o    No  ý

 

Indicate by check mark if the registrant isnot required to file reports pursuant to Section 13 or Section 15(d) of theAct. Yes  o    No  ý

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxyor information statementsincorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant (1) has filed all reportsrequiredto be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was requiredto file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  ý    No  o

 

The aggregate market value (not necessarily a reliable indication ofthe priceat which morethan a limited number of shares would trade) of the voting stock held by non-affiliates of the registrant was$238,973,748 as of June 30, 2005.

 

Indicate by check mark whether the registrantis a large accelerated filer, an accelerated filer, or a non-accelerated filer.See definition of accelerated filer and large accelerated filer in Rule 12b-2of the Exchange Act. Large accelerated filer oAccelerated filer ý Non acceleratedfiler o

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Act). Yes  o    No  ý

 

As of March 10, 2006, there were outstanding 13,472,616 common shares,without par value, of the registrant.

 

DOCUMENTS INCORPORATED BYREFERENCE

 
| **Documents**                         | ** ** | **Part of Form 10-K  Into Which Incorporated** |
|---------------------------------------|------------|------------------------------------------------|
| Definitive Proxy Statement for Annual |       |                                           | Part III (Items 10 through 14) |
| Meeting of Shareholders to be held    |       |                                           |
| April 26, 2006                        |       |                                           |
|                                  |       |                                           |

 

 

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FORM 10-K TABLE OF CONTENTS

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

 

Pursuant to General Instruction G, the information called for by Items10-14 is omitted by MainSource Financial Group, Inc. since MainSource FinancialGroup, Inc. will file with the Commission a definitive proxy statement toshareholders pursuant to regulation 14A not later than 120 days after the closeof the fiscal year containing the information required by Items 10-14.

 

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**Part I.**

 

**ITEM 1.     BUSINESS**

 

**(Dollars in thousands except per share data)**

 

**GENERAL**

 

MainSource Financial Group, Inc. (“the Company”) is a financial holdingcompany based in Greensburg, Indiana. As of December 31, 2005, the Companyowned two banking subsidiaries: MainSource Bank and MainSource Bank of Illinois(together “the Banks”). Through its non-bank affiliates, the Company providesservices incidental to the business of banking. Since its formation in 1982,the Company has acquired and established various institutions and financialservices companies and may acquire additional financial institutions andfinancial services companies in the future. For further discussion of the businessof the Company see Management’s Discussion and Analysis in Part II, Item 7.

 

As of December 31, 2005, the Company operated 60 branch banking officesin Indiana and Illinois as well as eight insurance offices in Indiana. As ofDecember 31, 2005, the Company had consolidated assets of $1,645,605,consolidated deposits of $1,352,697 and shareholders’ equity of $161,069.

 

Through its Banks, the Company offers a broad range of financialservices, including: accepting time and transaction deposits; making consumer,commercial, agribusiness and real estate mortgage loans; renting safe depositfacilities; providing general agency personal and business insurance services;providing personal and corporate trust services; and providing other corporateservices such as letters of credit and repurchase agreements.

 

The lending activities of the Banks are separated into primarily thecategories of commercial/agricultural, real estate and consumer. Loans areoriginated by the lending officers of the Banks subject to limitations setforth in lending policies. The Boards of Directors of each Bank reviews loansup to the Bank’s legal lending limits, monitors concentrations of credit,problem and past due loans and charge-offs of uncollectible loans andformulates loan policy. The Banks maintain conservative loan policies andunderwriting practices in order to address and manage loan risks. Thesepolicies and practices include granting loans on a sound and collectible basis,serving the legitimate needs of the community and the general market area whileobtaining a balance between maximum yield and minimum risk, ensuring thatprimary and secondary sources of repayment are adequate in relation to theamount of the loan, developing and maintaining adequate diversification of theloan portfolio as a whole and of the loans within each category and developingand applying adequate collection policies.

 

Commercial loans include secured and unsecured loans, including realestate loans, to individuals and companies and to governmental units within themarket area of the Banks for a myriad of business purposes.

 

Agricultural loans are generated in the Banks’ markets. Most of theloans are real estate loans on farm properties. Loans are also made foragricultural production and such loans are generally reviewed annually.

 

Residential real estate lending has been the largest component of theloan portfolio for many years. All affiliate banks generate residentialmortgages for their own portfolios. However, the Company elects to sell themajority of its fixed rate mortgages into the secondary market whilemaintaining the servicing of such loans. At December 31, 2005, the Company was servicing a $509 million loanportfolio.  By originating loans for salein the secondary market, the Company can more fully satisfy customer demand forfixed rate residential mortgages and increase fee income, while reducing therisk of loss caused by rising interest rates.

 

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The principal source of revenues for the Company is interest and feeson loans, which accounted for 63.7% of total revenues in 2005, 61.9% in 2004and 61.8% in 2003.

 

The Company’s investment securities portfolio is primarily comprised ofU. S. Treasuries, federal agencies, state and municipal bonds, mortgage-backedsecurities and corporate securities. The Company has classified its entireinvestment portfolio as available for sale, with market value changes reportedseparately in shareholders’ equity. Funds invested in the investment portfoliogenerally represent funds not immediately required to meet loan demand. Incomerelated to the Company’s investment portfolio accounted for 18.3% of totalrevenues in 2005, 16.6% in 2004 and 15.7% in 2003. As of December 31, 2005, theCompany had not identified any securities as being “high risk” as defined bythe FFIEC Supervisory Policy Statement on Securities Activities.

 

The primary sources of funds for the Banks are deposits generated inlocal market areas. To attract and retain stable depositors, the Banks marketvarious programs for demand, savings and time deposit accounts. These programsinclude interest and non-interest bearing demand and individual retirementaccounts.

 

Currently, national retailing and manufacturing subsidiaries, brokerageand insurance firms and credit unions are fierce competitors within thefinancial services industry. Mergers between financial institutions withinIndiana and neighboring states, which became permissible under the InterstateBanking and Branching Efficiency Act of 1994, have also added competitivepressure.

 

The Company’s Banks are located in predominantly non-metropolitan areasand their business is centered in loans and deposits generated within marketsconsidered largely rural in nature. In addition to competing vigorously withother banks, thrift institutions, credit unions and finance companies locatedwithin their service areas, they also compete, directly and indirectly, withall providers of financial services.

 

**EMPLOYEES**

 

As of December 31, 2005, the Company and its subsidiaries had 617full-time equivalent employees to whom it provides a variety of benefits andwith whom it enjoys excellent relations.

 

**REGULATION AND SUPERVISION OF THE COMPANY**

 

The Company is a financial holding company (“FHC”) within the meaningof theBank HoldingCompany Act of 1956, as amended (“Act”). This Act subjects FHC’s to regulationsof the Federal Reserve Board (“FRB”) and restricts the business of FHC’s tofinancial and related activities. 

 

The Gramm-Leach-Bliley Financial Modernization Act of 1999 was enactedon November 12, 1999. The Modernization Act, which amended the Bank HoldingCompany Act, provides the following:

 

•                  itallows bank holding companies that qualify as “financial holding companies” toengage in a broad range of financial and related activities;

 

•                  itallows insurers and other financial services companies to acquire banks;

 

•                  itremoves various restrictions that applied to bank holding company ownership ofsecurities firms and mutual fund advisory companies; and

 

•                  itestablishes the overall regulatory structure applicable to bank holdingcompanies that also engage in insurance and securities operations.

 

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The Company initially qualified as a financial holding company inDecember, 2004. Thus the Company is authorized to operate as a financialholding company and therefore is eligible to engage in, or acquire companiesengaged in, the broader range of activities that are permitted by theModernization Act. These activities include those that are determined to be “financialin nature,” including insurance underwriting, securities underwriting anddealing, and making merchant banking investments in commercial and financialcompanies. If any of our banking subsidiaries ceases to be “well capitalized”or “well managed” under applicable regulatory standards, the Federal ReserveBoard may, among other things, place limitations on our ability to conductthese broader financial activities or, if the deficiencies persist, require usto divest the banking subsidiary. In addition, if any of our bankingsubsidiaries receives a rating of less than satisfactory under the CommunityReinvestment Act of 1977 (“CRA”), we would be prohibited from engaging in anyadditional activities other than those permissible for bank holding companiesthat are not financial holding companies. Our banking subsidiaries currentlymeet these capital, management and CRA requirements.

 

Acquisitions by the Company of banks and savings associations aresubject to federal and state regulation. Any acquisition by the Company of morethan five percent of the voting stock of any bank requires prior approval ofthe FRB, the FHC and, if applicable, state regulators. Acquisition of savingsassociations is also subject to the approval of the OTS.

 

Indiana law permits FHCs to acquire bank holding companies and banksout of state on a reciprocal basis, subject to certain limitations. Undercurrent law, the Company may acquire banks, and may be acquired by bank holdingcompanies, located in any state in the United States that permits reciprocalentry by Indiana FHCs. Under the Act, FHCs may acquire savings associationswithout geographic restrictions.

 

A FHC and its subsidiaries are prohibited from engaging in certaintying arrangements in connection with the extension of credit, lease or sale ofproperty, or the provision of any property or service.

 

The Company is under the jurisdiction of the Securities and ExchangeCommission (“SEC”) and state securities commission for matters relating to theoffering and sale of its securities. The Company is subject to the SEC’s rulesand regulations relating to periodic reporting, reporting to shareholders,proxy solicitation and insider trading.

 

The Company’s liquidity is principally derived from dividends paid onthe common stock of its subsidiaries. The payment of these dividends is subjectto certain regulatory restrictions.

 

Under bank holding company policy, the Company is expected to act as asource of financial strength to, and commit resources to support, itsaffiliates. As a result of such policy, the Company may be required to commitresources to its affiliate banks in circumstances where it might not otherwisedo so.

 

Certain regulations define relevant capital measures for five capitalcategories. A “well capitalized” institution is one that has a total risk-basedcapital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least8%, a leverage ratio of at least 5% and is not subject to regulatory directionto maintain a specific level for any capital measure. An “adequatelycapitalized” institution is one that has ratios greater than 8%, 4% and 4%. Aninstitution is “undercapitalized” if its respective ratios are less than 8%, 4%and 4%.  “Significantly undercapitalized”institutions have ratios of less than 6%, 3% and 3%. An institution is deemedto be “critically undercapitalized” if it has a ratio of tangible equity tototal assets that is 2% or less. Institutions with capital ratios at levels of “undercapitalized”or lower are subject to various limitations that, in most situations, willreduce the competitiveness of the institution.

 

5

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**REGULATION AND SUPERVISION OF THE SUBSIDIARY BANKS**

 

The Company’s affiliate banks are supervised, regulated and examined bytheir respective state regulatory banking agencies and the Federal DepositInsurance Corporation (“FDIC”). A cease-and-desist order may be issued againstthe banks, if the respective agency finds that the activities of the bankrepresent an unsafe and unsound banking practice or violation of law. Thedeposits of the two banking subsidiaries are insured to the maximum extentpermitted by law by the Bank Insurance Fund (“BIF”) of the FDIC.

 

Branching by banks in Indiana is subject to the jurisdiction, andrequires the prior approval, of the bank’s primary federal regulatory authorityand, if the branching bank is a state bank, of the Indiana Department ofFinancial Institutions (“DFI”). Under Indiana law, banks may branch anywhere inthe state.

 

The Company is a legal entity separate and distinct from its subsidiaryBanks.

There are various legal limitations on the extent to which the Bankscan supply funds to the Company. The principal source of the Company’s fundsconsists of dividends from its subsidiary Banks. State and Federal lawrestricts the amount of dividends that may be paid by banks. In addition, theBanks are subject to certain restrictions on extensions of credit to theCompany, on investments in the stock or other securities of the Company and intaking such stock or securities as collateral for loans.

 

**CAPITAL REQUIREMENTS**

 

The Company and its subsidiary Banks must meet certain minimum capitalrequirements mandated by the FRB, FDIC and DFI. These regulatory agenciesrequire BHCs and banks to maintain certain minimum ratios of primary capital tototal assets and total capital to total assets. The FRB requires BHCs tomaintain a minimum Tier 1 leverage ratio of 3 percent capital to total assets; however,for all but the most highly rated institutions which do not anticipatesignificant growth, the minimum Tier 1 leverage ratio is 3 percent plus anadditional cushion of 100 to 200 basis points. As of December 31, 2005, theCompany’s leverage ratio of capital to total assets was 8.4%. The FRB and FDICeach have approved the imposition of “risk-adjusted” capital ratios on BHCs andfinancial institutions. The Company’s Tier 1 Capital to Risk-Weighted AssetsRatio was 12.6% and its Total Capital to Risk-Weighted Assets Ratio was 13.5%at December 31, 2005. The Company’s Banks had capital to asset ratios and risk-adjusted capital ratios at December 31, 2005, in excess of the applicableregulatory minimum requirements.

 

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**ITEM 1A.               RISK FACTORS**

 

In addition to the other information contained in this report, thefollowing risks may affect us.  If any ofthese risks  actually occur, our business, financialcondition or results of operations may suffer. As a result, the price of ourcommon shares could decline.

 

***Our historical growth and financial performancetrends may not continue if our acquisition strategy is not successful.***

 

Growth in asset size andearnings through acquisitions is an important and continuing part of ourbusiness strategy.  As consolidation ofthe banking industry continues, the competition for suitable acquisitioncandidates may increase.  We compete withother banking companies for acquisition opportunities, and many of thesecompetitors have greater financial resources and acquisition experience than wedo and may be able to pay more for an acquisition than we are able or willingto pay.  We also may need additional debtor equity financing in the future to fund acquisitions.  We may not be able to obtain additionalfinancing or, if available, it may not be in amounts and on terms acceptable tous.  We may use our common stock as theconsideration for an acquisition or we may issue additional common stock anduse the proceeds for the acquisition. Our issuance of additional securities will dilute your equity interestin us and may have a dilutive effect on our earnings per share.  If we are unable to locate suitable acquisitioncandidates willing to sell on terms acceptable to us, or we are otherwiseunable to obtain additional debt or equity financing necessary for us tocontinue our acquisition strategy, we would be required to find other methodsto grow our business and we may not grow at the same rate we have in the past,or at all.

 

***Acquisitions entail risks which could negativelyaffect our operations.***

 

Acquisitions involvenumerous risks, including:

 

•      exposure to asset quality problems of theacquired institution;

 

•      maintaining adequate regulatory capital;

 

•      diversion of management’s attention fromother business concerns;

 

•      risks and expenses of entering newgeographic markets;

 

•      potential significant loss of depositorsor loan customers from the acquired institution; and

 

•      exposure to undisclosed or unknownliabilities of an acquired institution.

 

Any of these acquisition risks could resultin unexpected losses or expenses and thereby reduce the expected benefits ofthe acquisition.

 

***Unanticipated costs related to ouracquisition strategy could reduce MainSource’s future earnings per share.***

 

MainSourcebelieves it has reasonably estimated the likely costs of integrating theoperations of the banks it acquires into MainSource and the incremental costsof operating such banks as a part of the MainSource family.  However, it is possible that unexpectedtransaction costs such as taxes, fees or professional expenses or unexpectedfuture operating expenses, such as increased personnel costs or increasedtaxes, as well as other types of unanticipated adverse developments, could havea material adverse effect on the results of operations and financial conditionof MainSource.  If unexpected costs areincurred, acquisitions could have a dilutive effect on MainSource’s earningsper share.  In other words, if MainSourceincurs such unexpected costs and expenses as a result of its acquisitions,MainSource believes that the earnings per share of MainSource common stockcould be less than they would have been if those acquisitions had not beencompleted.

 

***MainSource may be unable to successfullyintegrate the operations of the banks it is acquiring and retain employees ofsuch banks.***

 

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MainSource’sacquisition strategy involves the integration of the banks MainSource isacquiring as MainSource subsidiary banks. The difficulties of integrating the operations of such banks withMainSource and its other subsidiary banks include:

 

•     coordinatinggeographically separated organizations;

 

•     integratingpersonnel with diverse business backgrounds;

 

•     combining differentcorporate cultures; and

 

•      retainingkey employees.

 

The process of integratingoperations could cause an interruption of, or loss of momentum in, theactivities of one or more of MainSource, its subsidiary banks and the banksMainSource is acquiring and the loss of key personnel.  The integration of such banks as MainSourcesubsidiary banks will require the experience and expertise of certain keyemployees of such banks who are expected to be retained by MainSource.  We cannot be sure, however, that MainSourcewill be successful in retaining these employees for the time period necessaryto successfully integrate such banks’ operations as subsidiary banks ofMainSource.  The diversion ofmanagement’s attention and any delays or difficulties encountered in connectionwith the mergers, along with the integration of the banks as MainSourcesubsidiary banks, could have an adverse effect on the business and results ofoperation of MainSource.

 

***Like most bankingorganizations, our business is highly susceptible to credit risk.***

 

As a lender, we are exposedto the risk that our customers will be unable to repay their loans according totheir terms and that the collateral securing the payment of their loans (ifany) may not be sufficient to assure repayment. Credit losses could have amaterial adverse effect on our operating results.

 

As of December 31, 2005, ourtotal loan portfolio was approximately $958 million or 58% of our total assets.Three major components of the loan portfolio are loans principally secured byreal estate, approximately $662 million or 68% of total loans, other commercialloans, approximately $149 million or 16% of total loans, and consumer loans,approximately $123 million or 13% of total loans.  Our credit risk with respect to our consumerinstallment loan portfolio and commercial loan portfolio relates principally tothe general creditworthiness of individuals and businesses within our localmarket area.  Our credit risk withrespect to our residential and commercial real estate mortgage and constructionloan portfolio relates principally to the general creditworthiness ofindividuals and businesses and the value of real estate serving as security forthe repayment of the loans.  A relatedrisk in connection with loans secured by commercial real estate is the effectof unknown or unexpected environmental contamination, which could make the realestate effectively unmarketable or otherwise significantly reduce its value assecurity.

 

***Our allowance for loan losses maynot be sufficient to cover actual loan losses, which could adversely affect ourearnings.***

 

We maintain an allowance forloan losses in an attempt to cover loan losses inherent in our loanportfolio.  Additional loan losses willlikely occur in the future and may occur at a rate greater than we haveexperienced to date.  In determining thesize of the allowance, our management makes various assumptions and judgmentsabout the collectibility of our loan portfolio, including the diversificationby industry of our commercial loan portfolio, the effect of changes in thelocal real estate market on collateral values, the results of recent regulatoryexaminations, the effects on the loan portfolio of current economic indicatorsand their probable impact on borrowers, the amount of charge-offs for theperiod, the amount of nonperforming loans and related collateral security, andthe evaluation of our loan portfolio by an external loan review.  If our assumptions and judgments prove to beincorrect, our current allowance may not be sufficient and adjustments may benecessary to allow for different economic conditions or adverse developments inour loan portfolio.  Federal and stateregulators also periodically review our allowance for loan losses and mayrequire us to increase our provision for loan losses or recognize further loancharge-offs, based on judgments different than those of our management.  Any increase in our allowance for loan lossesor loan charge-offs could have an adverse effect on our operating results andfinancial condition.

 

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***We rely heavily on our management and otherkey personnel, and the loss of any of them may adversely affect our operations.***

 

Weare and will continue to be dependent upon the services of our management team,including James L. Saner, Sr., our President and Chief Executive Officer, JamesM. Anderson, our Senior Vice President and Chief Financial Officer, thepresidents of our subsidiary banks and our other senior managers.  The loss of either Mr. Saner orMr. Anderson, or any of our other senior managers, could have an adverse effecton our growth and performance because of their skills, knowledge of the marketsin which we operate and years of industry experience and the difficulty ofpromptly finding qualified replacement personnel.  The loss of key personnel in a particularmarket could have an adverse effect on our performance in that market becauseit may be difficult to find qualified replacement personnel who are alreadylocated in or would be willing to relocate to a non-metropolitan market.

 

***Significant interest ratevolatility could reduce our profitability.***

 

Our results of operationsare affected principally by net interest income, which is the differencebetween interest earned on loans and investments and interest expense paid ondeposits and other borrowings. We cannot predict or control changes in interestrates. National, regional and local economic conditions and the policies ofregulatory authorities, including monetary policies of the Board of Governorsof the Federal Reserve System, affect market interest rates.  While we have instituted policies andprocedures designed to manage the risks from changes in market interest rates,at any given time our assets and liabilities will likely be affecteddifferently by a given change in interest rates, principally because we do notmatch the maturities of our loans and investments precisely with our depositsand other funding sources.  Changes ininterest rates may also affect the level of voluntary prepayments on our loansand the level of financing or refinancing by customers.   As of December 31, 2005, we had a negativeinterest rate gap of 23% of interest earning assets in the one-year time frame.Although this is within our internal policy limits, our earnings will beadversely affected in periods of rising interest rates because, during suchperiods, the interest expense paid on deposits and borrowings will generallyincrease more rapidly than the interest income earned on loans and investments.  If such an interest rate increase occurredgradually, we would use our established procedures to attempt to mitigate theeffects over time.  However, if such aninterest rate increase occurred rapidly, or interest rates exhibited volatileincreases and decreases, we might be unable to mitigate the effects, and ournet interest income could suffer significant adverse effects.  While management intends to continue to takemeasures to mitigate interest rate risk, we cannot assure you that suchmeasures will be entirely effective in minimizing our exposure to the risk ofrapid changes in interest rates.

 

***Changes in governmental regulation and legislation could limit ourfuture performance and growth.***

 

We are subject to extensivestate and federal regulation, supervision and legislation that govern almostall aspects of our operations, as well as any acquisitions we may propose tomake. Any change in applicable federal or state laws or regulations could havea substantial impact on us, our subsidiary banks and our operations. While wecannot predict what effect any presently contemplated or future changes in thelaws or regulations or their interpretations would have on us, these changescould reduce the value of your investment.

*** ***

***Our strategy to minimize Indiana state taxeson our investment portfolio may be unsuccessful.***

 

Since2002, our Indiana state financial institutions taxes have been reduced by ouruse of subsidiaries we formed in the State of Nevada to hold the investmentportfolios of two of our bank subsidiaries. Nevada has no state or local income tax, and we take the position thatnone of this income is subject to the Indiana financial institutions tax.  For the year ended December 31, 2005, our netsavings in Indiana tax from this arrangement (after federal tax) wasapproximately $600,000.   Althoughmanagement believes that this arrangement is permitted under Indiana law, andIndiana tax authorities have not challenged our tax returns in this regard, weunderstand that Indiana tax authorities have recently challenged a similararrangement implemented by at least one other Indiana-based bank holdingcompany.   If we were not permitted torealize state tax savings from this arrangement, it would cause our net incomeafter taxes to be lower in the future, and if Indiana tax authoritieschallenged our arrangement and were successful in assessing additional taxes,interest and penalties for prior years, we might be forced to take a specialcharge to our earnings in the amount of the assessment.

 

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***The geographic concentration of our markets makesour business highly susceptible to local economic conditions.***

 

Unlike larger bankingorganizations that are more geographically diversified, our operations are currentlyconcentrated in 22 counties in Indiana and three counties in Illinois. As aresult of this geographic concentration in two fairly contiguous markets, ourfinancial results depend largely upon economic conditions in these marketareas. A deterioration in economic conditions in one or both of these marketscould result in one or more of the following:

 

•      an increase in loan delinquencies;

 

•      an increase in problem assets andforeclosures;

 

•      a decrease in the demand for our productsand services; and

 

•      a decrease in the value of collateral forloans, especially real estate, in turn reducing customers’ borrowing power, thevalue of assets associated with problem loans and collateral coverage.

 

***If we do not adjust to rapid changes in the financial servicesindustry, our financial performance may suffer.***

 

We face substantialcompetition for deposit, credit and trust relationships, as well as othersources of funding in the communities we serve. Competing providers includeother banks, thrifts and trust companies, insurance companies, mortgage bankingoperations, credit unions, finance companies, money market funds and otherfinancial and nonfinancial companies which may offer products functionallyequivalent to those offered by our banks. Competing providers may have greaterfinancial resources than we do and offer services within and outside the marketareas we serve.  In addition to thischallenge of attracting and retaining customers for traditional banking services,our competitors now include securities dealers, brokers, mortgage bankers,investment advisors and finance and insurance companies who seek to offerone-stop financial services to their customers that may include services thatbanks have not been able or allowed to offer to their customers in the past.The increasingly competitive environment is primarily a result of changes inregulation, changes in technology and product delivery systems and theaccelerating pace of consolidation among financial service providers.  If we are unable to adjust both to increasedcompetition for traditional banking services and changing customer needs andpreferences, it could adversely affect our financial performance and yourinvestment in our common stock.

 

**ITEM1B.               UNRESOLVED STAFFCOMMENTS.**

 

None.

 

**ITEM 2.      PROPERTIES**

 

In September 2005, MainSource Financial Group purchased a property inGreensburg, Indiana that will eventually serve as its corporateheadquarters.  The Company’s totalcurrent investment in this property is $1.2 million and expects to occupythe property by the end of 2006.  As ofDecember 31, 2005, the Company leased space from one of its subsidiaries foruse as its corporate headquaters.   TheCompany's subsidiaries own, or lease, all of the facilities from which theyconduct business. All leases are comparable to other leases in the respectivemarket areas and do not contain provisions materially detrimental to theCompany or its subsidiaries. As of December 31, 2005 the Company had 60 bankinglocations of which MainSource Bank had 53 and MainSource Bank of Illinois had7. In addition, the Company operates eight insurance offices in Indiana. AtDecember 31, 2005, the Company had approximately $28 million invested inpremises and equipment.

 

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**ITEM 3.      LEGAL PROCEEDINGS**

 

The Company’s subsidiaries may be parties (both plaintiff anddefendant) to ordinary litigation incidental to the conduct of business.Management is presently not aware of any material claims.

 

**ITEM 4.      SUBMISSION OF MATTERSTO A VOTE OF SECURITY HOLDERS**

 

No matters were submitted during the fourth quarter of 2005 to a voteof security holders, through the solicitation of proxies or otherwise.

 

**PART II**

 

**ITEM 5.       MARKET FOR THEREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER’S PURCHASESOF EQUITY SECURITIES**

 

**Market Information**

 

The Company’s Common Stock is traded on NASDAQ’s National Market Systemunder the symbol MSFG. The Common Stock was held by approximately 3,200shareholders at March 10, 2006. The quarterly high and low closing prices forthe Company’s common stock as reported by NASDAQ and quarterly cash dividendsdeclared and paid are set forth in the tables below. All per share data isretroactively restated for all stock dividends and splits.

 

The range of known per share prices by calendar quarter, based onactual transactions, excluding commissions, is shown below.

 
| ** ** | ** ** | **Market Prices** | ** ** |
|------------|------------|-------------------|------------|
| **2005**   | ** ** | **Q4**            | ** ** | **Q3** | ** ** | **Q2** | ** ** | **Q1** | ** ** |
| High       |       | $                 | 18.82      |   | $ | 19.55 |   | $ | 21.62 |   | $ | 23.96 |   |
| Low        |       | $                 | 17.15      |   | $ | 17.73 |   | $ | 17.30 |   | $ | 20.96 |   |

 
| **2004** | ** ** | **Q4** | ** ** | **Q3** | ** ** | **Q2** | ** ** | **Q1** | ** ** |
|----------|------------|--------|------------|--------|------------|--------|------------|--------|------------|
| High     |       | $      | 25.21      |   | $          | 20.50  |       | $      | 22.92      |   | $ | 23.08 |   |
| Low      |       | $      | 18.35      |   | $          | 16.48  |       | $      | 17.81      |   | $ | 20.12 |   |

 
| ** ** | ** ** | **Cash Dividends** | ** ** |
|------------|------------|--------------------|------------|
| **2005**   | ** ** | **Q4**             | ** ** | **Q3** | ** ** | **Q2** | ** ** | **Q1** | ** ** |
|       |       | $                  | 0.130      |   | $ | 0.130 |   | $ | 0.130 |   | $ | 0.130 |   |
|            |            |                    |            |  |  |  |  |  |  |  |  |  |  |

 
| **2004** | ** ** | **Q4** | ** ** | **Q3** | ** ** | **Q2** | ** ** | **Q1** | ** ** |
|----------|------------|--------|------------|--------|------------|--------|------------|--------|------------|
|     |       | $      | 0.124      |   | $          | 0.119  |       | $      | 0.119      |   | $ | 0.114 |   |
|          |            |        |            |        |            |        |            |        |            |  |  |  |  |

 

**EquityCompensation Plan Information**

 

The following table sets forth informationregarding securities authorized for issuance under equity compensation plans:

 
| **Plan category**                                           | ** ** | **Number of securities to be  issued upon exercise of  outstanding options, warrants and rights  (a)** | ** ** | **Weighted-average exercise  price of outstanding options,  warrants and rights  (b)** | ** ** | **Number of securities remaining  available for future issuance  under equity compensation  plans (excluding securities  reflected in column (a))  (c)** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity compensation plans approved by  security holders     |       | 173,906                                                                                                     |       | $                                                                                      | 19.71      |                                                                                                                                                     | 390,333    |   |
| Equity compensation plans not approved by  security holders |       | —                                                                                                      |       | —                                                                                 |       | —                                                                                                                                                   |       |
| **Total**                                                   |       | 173,906                                                                                                     |       | $                                                                                      | 19.71      |                                                                                                                                                     | 390,333    |   |

 

**ITEM 6.      SELECTED FINANCIAL DATA**

 

**Selected Financial Data**

*(Dollaramounts in thousands except per share data)*

 
| ** **                                                                   | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** | **2002**  | ** ** | **2001**  | ** ** |
|------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|
| **Results  of Operations**                                                   |       |      |       |      |       |      |       |      |       |      |       |
| Net interest income                                                          |       | $         | 53,648     |      | $          | 50,002    |       | $         | 44,232     |      | $          | 45,050 |   | $ | 41,768 |   |
| Provision for loan losses                                                    |       | 1,040     |       | 600       |       | 1,325     |       | 2,995     |       | 2,136     |       |
| Noninterest income                                                           |       | 17,332    |       | 19,544    |       | 19,443    |       | 14,379    |       | 11,486    |       |
| Noninterest expense                                                          |       | 48,576    |       | 45,880    |       | 40,448    |       | 35,610    |       | 34,311    |       |
| Income before income tax                                                     |       | 21,364    |       | 23,066    |       | 21,902    |       | 20,824    |       | 16,807    |       |
| Income tax                                                                   |       | 5,172     |       | 6,273     |       | 6,597     |       | 6,813     |       | 5,630     |       |
| Net income                                                                   |       | 16,192    |       | 16,793    |       | 15,305    |       | 14,011    |       | 11,177    |       |
| Dividends paid on common stock                                               |       | 6,514     |       | 5,421     |       | 4,873     |       | 4,485     |       | 4,121     |       |
|                                                                         |       |      |       |      |       |      |       |      |       |      |       |
| **Per  Common Share ***                                                      |       |      |       |      |       |      |       |      |       |      |       |
| Earnings per share (basic)                                                   |       | $         | 1.29       |      | $          | 1.48      |       | $         | 1.37       |      | $          | 1.24 |   | $ | 0.99 |   |
| Earnings per share (diluted)                                                 |       | 1.29      |       | 1.48      |       | 1.37      |       | 1.24      |       | 0.99      |       |
| Dividends paid                                                               |       | 0.520     |       | 0.476     |       | .435      |       | 0.397     |       | 0.365     |       |
| Book value - end of period                                                   |       | 11.96     |       | 10.68     |       | 9.47      |       | 8.88      |       | 7.78      |       |
| Market price - end of period                                                 |       | 17.85     |       | 23.88     |       | 19.47     |       | 14.52     |       | 10.10     |       |
|                                                                         |       |      |       |      |       |      |       |      |       |      |       |
| **At Year  End**                                                             |       |      |       |      |       |      |       |      |       |      |       |
| Total assets                                                                 |       | $         | 1,645,605  |      | $          | 1,549,379 |       | $         | 1,442,729  |      | $          | 1,251,760 |   | $ | 1,178,392 |   |
| Investment securities                                                        |       | 450,814   |       | 428,686   |       | 425,542   |       | 351,143   |       | 276,304   |       |
| Loans, excluding held for sale                                               |       | 957,995   |       | 929,005   |       | 855,471   |       | 740,167   |       | 760,785   |       |
| Allowance for loan losses                                                    |       | 10,441    |       | 11,698    |       | 11,509    |       | 9,517     |       | 8,894     |       |
| Total deposits                                                               |       | 1,352,697 |       | 1,226,367 |       | 1,191,310 |       | 1,034,307 |       | 1,014,687 |       |
| Notes payable                                                                |       | —    |       | 9,100     |       | 12,500    |       | 2,400     |       | 4,062     |       |
| Federal Home Loan Bank advances                                              |       | 41,547    |       | 90,981    |       | 62,751    |       | 50,235    |       | 20,346    |       |
| Subordinated debentures                                                      |       | 29,898    |       | 29,898    |       | 29,898    |       | 30,425    |       | 22,425    |       |
| Shareholders’ equity                                                    |       | 161,069   |       | 123,320   |       | 105,424   |       | 99,771    |       | 87,872    |       |
|                                                                         |       |      |       |      |       |      |       |      |       |      |       |
| **Financial  Ratios**                                                        |       |      |       |      |       |      |       |      |       |      |       |
| Return on average assets                                                     |       | 1.04      | %          | 1.13      | %          | 1.14      | %          | 1.16      | %          | 0.93      | %          |
| Return on average common shareholders’  equity                          |       | 11.27     |       | 14.70     |       | 15.07     |       | 14.90     |       | 13.24     |       |
| Allowance for loan losses to total loans  (year end,excluding held for sale) |       | 1.09      |       | 1.26      |       | 1.35      |       | 1.29      |       | 1.17      |       |
| Allowance for loan losses to total non-performing  loans (year end)          |       | 102.19    |       | 83.31     |       | 77.65     |       | 119.86    |       | 79.61     |       |
| Shareholders’ equity to total assets (year  end)                        |       | 9.79      |       | 7.96      |       | 7.31      |       | 7.97      |       | 7.46      |       |
| Average equity to average total assets                                       |       | 9.18      |       | 7.67      |       | 7.57      |       | 7.77      |       | 7.04      |       |
| Dividend payout ratio                                                        |       | 40.23     |       | 32.28     |       | 31.84     |       | 32.01     |       | 36.87     |       |

 

----

*Adjustedfor stock split and dividends

 

11

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**ITEM 7.      MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Management’s Discussion and Analysis**

**(Dollar amounts in thousands except per share data)**

 

**Forward-Looking Statements**

 

Except for historical information contained herein, the discussion inthis Annual Report includes certain forward-looking statements based uponmanagement expectations. Factors which could cause future results to differfrom these expectations include the following: general economic conditions;legislative and regulatory initiatives; monetary and fiscal policies of thefederal government; deposit flows; the cost of funds; general market rates ofinterest; interest rates on competing investments; demand for loan products;demand for financial services; changes in accounting policies or guidelines;and changes in the quality or composition of the Company’s loan and investmentportfolios.

 

The forward-looking statements included in the Management’s Discussionand Analysis (“MD&A”) relating to certain matters involve risks anduncertainties, including anticipated financial performance, business prospects,and other similar matters, and reflect management’s best judgment based onfactors currently known. Actual results and experience could differ materiallyfrom the anticipated results or other expectations expressed in the Company’sforward-looking statements as a result of a number of factors, including butnot limited to those discussed in the MD&A.

 

**Overview**

 

MainSource Financial Group, Inc. (“MainSource or Company”) is afinancial holding company whose principal activity is the ownership andmanagement of its two wholly owned subsidiary banks (“Banks”): MainSource Bankof Indiana headquartered in Greensburg, Indiana and MainSource Bank of Illinoisheadquartered in Kankakee, Illinois.  Thebanks operate under state charters and are subject to regulation by theirrespective state regulatory agencies and the Federal Deposit InsuranceCorporation. MainSource Insurance is a wholly owned subsidiary of the Companyoperating eight insurance agency offices in Indiana and is subject toregulation by the Indiana Department of Insurance. The Company also has whollyowned subsidiaries to hold investment securities. These investment subsidiariesare incorporated in Nevada. During 2005, the Company also formed MainSourceTitle, LLC, a title insurance agency, and MainSource Mortgage, LLC, a mortgageorigination company.

 

**Business Strategy**

 

The Company operates under the broad tenets of a long-term strategicplan (“Plan”) designed to improve the Company’s financial performance, expandits competitive position and enhance long-term shareholder value. The Plan ispremised on the belief of the Company’s board of directors that it can bestpromote long-term shareholder interests by pursuing strategies which willcontinue to preserve its community-focused philosophy. The dynamics of the Planassure continually evolving goals, with the enhancement of shareholder valuebeing the constant, overriding objective. The extent of the Company’s successwill depend upon how well it anticipates and responds to competitive changeswithin its markets, the interest rate environment and other external forces.

 

The Company continued its history of external growth throughacquisitions during 2005. In August 2005, the Company completed its acquisitionof The Madison Bank & Trust Company (“Madison) in a cash transaction.  The total consideration paid was $30,267. Asof the date of acquisition, Madison had total assets of approximately $200million.  In addition to the acquisitionof Madison, the Company announced three other acquisitions during the secondhalf of 2005.

 

12

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On August 23, 2005, the Company entered into a definitiveagreement to acquire Union Community Bancorp (“Union Community”) ofCrawfordsville, Indiana. Union Community’s subsidiary financial institution,Union Federal Savings and Loan Association, will be merged into a newly formedsubsidiary of the Company.  The agreementprovides that shareholders of Union Community will have the right to elect toreceive cash, stock, or a combination thereof, in the approximate amount of$27.33 per share for each share of Union Community common stock owned by them.The transaction value is estimated at $56 million. Consideration for 55% of theoutstanding Union Community common stock must be paid in shares of MainSourcecommon stock.   MainSource expects toissue approximately 1.6 million shares of its common stock in the transaction.  The transaction is expected to close in thefirst quarter of 2006 and is subject to various regulatory approvals and theapproval of Union Community’s shareholders.

 

On September 28, 2005, MainSource entered into a definitiveagreement to acquire Peoples Ohio Financial Corporation (“Peoples Ohio”) ofTroy, Ohio.  Peoples Ohio’s subsidiarybank, Peoples Savings Bank of Troy, will be merged into a newly formedsubsidiary of the Company.  The agreementprovides that shareholders of Peoples Ohio will have the right to elect toreceive cash, stock, or a combination thereof, in the approximate amount of$5.60 per share for each share of Peoples Ohio common stock owned by them.  The transaction value is estimated at $42million.  Consideration for 75% of theoutstanding Peoples Ohio common stock must be paid in shares of MainSourcecommon stock.  MainSource expects toissue approximately 1.7 million shares of its common stock in thetransaction.  The transaction, which isexpected to close in the second quarter of 2006, is subject to variousregulatory approvals and the approval of Peoples Ohio’s shareholders.

 

On October 26, 2005, MainSource entered into a definitiveagreement to acquire HFS Bank, F.S.B. (“HFS”), a federal savings bank locatedin Hobart, Indiana.  The agreementprovides that shareholders of HFS will have the right to elect to receive cash,stock, or a combination thereof, in the approximate amount of $19.35 per sharefor each share of HFS common stock owned by them. The transaction value isestimated at $36 million.  Considerationfor 52% of the outstanding HFS common stock must be paid in shares ofMainSource common stock.  MainSourceexpects to issue approximately 1.0 million shares of its common stock in thetransaction.  The transaction, which isexpected to close in the second quarter of 2006, is subject to variousregulatory approvals and the approval of HFS’ shareholders.

 

The Company is continuously reviewing other acquisition targetsincluding branches, whole banks, and other financial service related entitiesfocusing on the four-state Midwest region of Indiana, Illinois, Kentucky, andOhio.

 

**Results of Operations**

 

Net income was $16,192 in 2005, $16,793 in 2004, and $15,305 in2003.  Earnings per common share on afully diluted basis were $1.29 in 2005, $1.48 in 2004, and $1.37 in 2003. In thefourth quarter of 2005, the Company elected to restructure a portion of itsinvestment security portfolio. Approximately $85 million of under-performing securities were sold.  As a result of this action, a pre-tax loss of$2,421 was incurred, which reduced earnings per share for the year by$0.12.  In addition to the aforementionedloss recorded in the fourth quarter, the Company incurred certain costs relatedto the acquisition of Madison and the consolidation of the Company’s otherIndiana banking affiliates. In total, these costs amounted to $700 on a pre-taxbasis, or $0.04 per share on an after-tax basis. The Company’s earnings pershare for 2005 also include the addition of two million shares of common stockissued in its public offering in June and July of 2005. The offering negativelyimpacted earnings per share by $0.04 in 2005 as the Company was not able tofully utilize the new capital generated from the offering until the close ofits acquisition of Madison, which occurred on August 26, 2005. Therefore, on anoperating basis, the Company’s earnings per share would have been $1.49 for thefull year 2005 or basically flat when compared to the same period a year ago.

 

13

----

 

 

**Net Interest Income**

 

Net interest income and net interest margin are influenced by thevolume and yield or cost of earning assets and interest-bearing liabilities.Tax equivalent net interest income of $56,205 in 2005 increased from $52,042 in2004. As rates rose throughout 2005, the Company’s yield on earning assetsincreased to 5.89% in 2005 from 5.50% in 2004. Offsetting the decrease in yield, the Company’s deposits and borrowingsalso repriced throughout the year, although to a lesser extent.  The Company’s total cost of funds was 2.12%in 2005 compared to 1.77% in 2004. The overall effect was an increase in theCompany’s net interest margin in 2005 of 12 basis points going from 3.87% in2004 to 3.99% in 2005.

 

The following table summarizes net interest income (on a tax-equivalentbasis) for each of the past three years.

 

**Average Balance Sheet and Net Interest Analysis (TaxableEquivalent Basis)***

 
| ** **                                                                                         | ** ** | **2005**    | ** ** | **2004**     | ** ** | **2003**    | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-------------|------------|--------------|------------|-------------|------------|
| ** **                                                                                         | ** ** | **Average** | ** ** | ** **   | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                                                         | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate**    | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| Assets                                                                                             |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Short-term  investments                                                                            |       | $           | 4,010      |         | $          | 71          |       | 1.77 | % | $ | 6,139 |   | $ | 42 |   | 0.68 | % | $ | 1,224 |   | $ | 7 |   | 0.57 | % |
| Federal funds  sold and money market accounts                                                      |       | 4,889       |       | 197          |       | 4.03        |       | 4,377 |   | 76 |   | 1.74 |   | 15,679 |   | 192 |   | 1.22 |   |
| Securities                                                                                         |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable                                                                                            |       | 359,116     |       | 13,819       |       | 3.85        |       | 353,457 |   | 12,094 |   | 3.42 |   | 352,813 |   | 11,480 |   | 3.25 |   |
| Non-taxable*                                                                                       |       | 105,251     |       | 6,251        |       | 5.94        |       | 79,882 |   | 4,691 |   | 5.87 |   | 52,820 |   | 3,341 |   | 6.33 |   |
| Total securities                                                                                   |       | 464,367     |       | 20,070       |       | 4.32        |       | 433,339 |   | 16,785 |   | 3.87 |   | 405,633 |   | 14,821 |   | 3.65 |   |
| Loans **                                                                                           |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                                                                                         |       | 490,832     |       | 33,056       |       | 6.73        |       | 490,595 |   | 31,455 |   | 6.41 |   | 430,992 |   | 29,456 |   | 6.83 |   |
| Residential real  estate                                                                           |       | 225,358     |       | 14,083       |       | 6.25        |       | 223,100 |   | 13,913 |   | 6.24 |   | 218,461 |   | 14,543 |   | 6.66 |   |
| Consumer                                                                                           |       | 219,281     |       | 15,555       |       | 7.09        |       | 185,783 |   | 11,610 |   | 6.25 |   | 151,127 |   | 10,005 |   | 6.62 |   |
| Total loans                                                                                        |       | 935,471     |       | 62,694       |       | 6.70        |       | 899,478 |   | 56,978 |   | 6.33 |   | 800,580 |   | 54,004 |   | 6.75 |   |
| Total earning  assets                                                                              |       | 1,408,737   |       | 83,032       |       | 5.89        |       | 1,343,333 |   | 73,881 |   | 5.50 |   | 1,223,116 |   | 69,024 |   | 5.64 |   |
|                                                                                               |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from  banks                                                                           |       | 47,595      |       |         |       |        |       | 46,920 |   |   |   |   |   | 38,413 |   |   |   |   |   |
| Unrealized gains  (losses) on securities                                                           |       | (2,601      | )          |         |       |        |       | 693 |   |   |   |   |   | 3,750 |   |   |   |   |   |
| Allowance for  loan losses                                                                         |       | (11,754     | )          |         |       |        |       | (11,798 | ) |   |   |   |   | (11,065 | ) |   |   |   |   |
| Premises and  equipment, net                                                                       |       | 26,291      |       |         |       |        |       | 24,769 |   |   |   |   |   | 21,500 |   |   |   |   |   |
| Intangible assets                                                                                  |       | 50,845      |       |         |       |        |       | 44,332 |   |   |   |   |   | 34,206 |   |   |   |   |   |
| Accrued interest  receivable and other assets                                                      |       | 44,905      |       |         |       |        |       | 40,617 |   |   |   |   |   | 32,199 |   |   |   |   |   |
| Total assets                                                                                       |       | $           | 1,564,018  |         |       |        |       |   | $ | 1,488,866 |   |   |   |   |   | $ | 1,342,119 |   |   |   |   |   |
|                                                                                               |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Liabilities                                                                                        |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits                                                                         |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| DDA, savings, and  money market accounts                                                           |       | $           | 616,398    |         | $          | 6,916       |       | 1.12 |   | $ | 551,885 |   | $ | 3,438 |   | 0.62 |   | $ | 476,627 |   | $ | 3,050 |   | 0.64 |   |
| Certificates of  deposit                                                                           |       | 483,457     |       | 13,183       |       | 2.73        |       | 521,112 |   | 12,928 |   | 2.48 |   | 526,304 |   | 15,494 |   | 2.94 |   |
| Total  interest-bearing deposits                                                                   |       | 1,099,855   |       | 20,099       |       | 1.83        |       | 1,072,997 |   | 16,366 |   | 1.53 |   | 1,002,931 |   | 18,544 |   | 1.85 |   |
| Short-term  borrowings                                                                             |       | 38,720      |       | 975          |       | 2.52        |       | 44,806 |   | 580 |   | 1.29 |   | 18,565 |   | 172 |   | 0.93 |   |
| Subordinated  debentures                                                                           |       | 29,898      |       | 1,938        |       | 6.48        |       | 29,898 |   | 1,677 |   | 5.61 |   | 26,845 |   | 1,626 |   | 6.06 |   |
| Notes payable and  FHLB borrrowings                                                                |       | 95,525      |       | 3,815        |       | 3.99        |       | 82,836 |   | 3,216 |   | 3.88 |   | 67,706 |   | 3,027 |   | 4.47 |   |
| Total  interest-bearing liabilities                                                                |       | 1,263,998   |       | 26,827       |       | 2.12        |       | 1,230,537 |   | 21,839 |   | 1.77 |   | 1,116,047 |   | 23,369 |   | 2.09 |   |
| Demand deposits                                                                                    |       | 144,647     |       |         |       |        |       | 131,110 |   |   |   |   |   | 111,480 |   |   |   |   |   |
| Other liabilities                                                                                  |       | 11,737      |       |         |       |        |       | 13,004 |   |   |   |   |   | 13,013 |   |   |   |   |   |
| Total liabilities                                                                                  |       | 1,420,382   |       |         |       |        |       | 1,374,651 |   |   |   |   |   | 1,240,540 |   |   |   |   |   |
| Shareholders’  equity                                                                         |       | 143,636     |       |         |       |        |       | 114,215 |   |   |   |   |   | 101,579 |   |   |   |   |   |
| Total liabilities  and shareholders’ equity                                                   |       | $           | 1,564,018  |         | 26,827     |        | 1.90       | *** | $ | 1,488,866 |   | 21,839 |   | 1.63 | *** | $ | 1,342,119 |   | 23,369 |   | 1.91 | *** |
| Net interest  income                                                                               |       |        |       | $            | 56,205     |        | 3.99       | **** |   |   | $ | 52,042 |   | 3.87 | **** |   |   | $ | 45,655 |   | 3.73 | **** |
|                                                                                               |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Conversion of tax  exempt income to a fully taxable equivalent basis using a marginal rate of  35% |       |        |       | $            | 2,557      |        |       |   |   |   | $ | 2,040 |   |   |   |   |   | $ | 1,423 |   |   |   |

 

----

| *    |   | Adjusted to  reflect income related to securities and loans exempt from Federal income  taxes. |
|------|--------|------------------------------------------------------------------------------------------------|
| **   |   | Nonaccruing  loans have been included in the average balances.                                 |
| ***  |   | Total  interest expense divided by total earning assets.                                       |
| **** |   | Net interest  income divided by total earning assets.                                          |

 

The following table sets forth for the periods indicated a summary ofthe changes in interest income and interest expense resulting from changes involume and changes in rates.

 

14

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**Volume/Rate Analysis of Changes in Net Interest Income**

*(Tax Equivalent Basis)*

 
| ** **                                                      | ** ** | **2005 OVER 2004** | ** ** | **2004 OVER 2003** | ** ** |
|-----------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                      | ** ** | **Volume**         | ** ** | **Rate**           | ** ** | **Total** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Total** | ** ** |
| **Interest  income**                                            |       |               |       |               |       |   |   |   |   |   |   |   |   |
| Loans                                                           |       | $                  | 2,388      |               | $          | 3,328 |   | $ | 5,716 |   | $ | 6,336 |   | $ | (3,362 | ) | $ | 2,974 |   |
| Securities                                                      |       | 1,335              |       | 1,950              |       | 3,285 |   | 1,072 |   | 892 |   | 1,964 |   |
| Federal funds sold and money market funds                       |       | 22                 |       | 99                 |       | 121 |   | (198 | ) | 82 |   | (116 | ) |
| Short-term investments                                          |       | (38                | )          | 67                 |       | 29 |   | 34 |   | 1 |   | 35 |   |
| Total interest income                                           |       | 3,707              |       | 5,444              |       | 9,151 |   | 7,244 |   | (2,387 | ) | 4,857 |   |
| **Interest  expense**                                           |       |               |       |               |       |   |   |   |   |   |   |   |   |
| Interest-bearing DDA, savings, and money  market accounts       |       | $                  | 719        |               | $          | 2,759 |   | $ | 3,478 |   | $ | 483 |   | $ | (95 | ) | $ | 388 |   |
| Certificates of deposit                                         |       | (1,048             | )          | 1,303              |       | 255 |   | (145 | ) | (2,421 | ) | (2,566 | ) |
| Borrowings                                                      |       | 352                |       | 642                |       | 994 |   | 930 |   | (333 | ) | 597 |   |
| Subordinated debentures                                         |       | —             |       | 261                |       | 261 |   | 172 |   | (121 | ) | 51 |   |
| Total interest expense                                          |       | 23                 |       | 4,965              |       | 4,988 |   | 1,440 |   | (2,970 | ) | (1,530 | ) |
| Change in net interest income                                   |       | $                  | 3,684      |               | $          | 479 |   | 4,163 |   | $ | 5,804 |   | $ | 583 |   | 6,387 |   |
| Change in tax equivalent adjustment                             |       |               |       |               |       | 517 |   |   |   |   |   | 617 |   |
| Change in net interest income before tax  equivalent adjustment |       |               |       |               |       | $ | 3,646 |   |   |   |   |   | $ | 5,770 |   |

 

**Provision for Loan Losses**

The Company expensed $1,040 in provision for loan losses in 2005. Thislevel of provision allowed the Company to maintain an adequate allowance forloan losses. This topic is discussed in detail under the heading “Loans, CreditRisk and the Allowance and Provision for Loan Losses”.

 

**Non-interest Income and Expense**

 
| ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Percent Change** | ** ** |
|-----------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|--------------------|------------|
| ** **                                          | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **05/04**          | ** ** | **04/03** | ** ** |
|                                                |       |       |       |       |       |       |       |               |       |   |   |
| Non-interest  income                                |       |       |       |       |       |       |       |               |       |   |   |
| Insurance commissions                               |       | $          | 1,991      |       | $          | 2,643      |       | $                  | 2,400      |   | -24.7 | % | 10.1 | % |
| Mortgage banking                                    |       | 2,693      |       | 3,198      |       | 5,671      |       | -15.8              | %          | -43.6 | % |
| Trust and investment product fees                   |       | 1,119      |       | 911        |       | 678        |       | 22.8               | %          | 34.4 | % |
| Service charges on deposit accounts                 |       | 7,510      |       | 6,912      |       | 5,092      |       | 8.7                | %          | 35.7 | % |
| Net realized gains/(losses) on securities  sales    |       | (2,179     | )          | 991        |       | 1,300      |       | -319.9             | %          | -23.8 | % |
| Increase in cash surrender value of life  insurance |       | 891        |       | 1,016      |       | 626        |       | -12.3              | %          | 62.3 | % |
| Interchange income                                  |       | 1,926      |       | 1,996      |       | 1,796      |       | -3.5               | %          | 11.1 | % |
| Other                                               |       | 3,381      |       | 1,877      |       | 1,880      |       | 80.1               | %          | -0.2 | % |
| Total non-interest income                           |       | $          | 17,332     |       | $          | 19,544     |       | $                  | 19,443     |   | -11.3 | % | 0.5 | % |
|                                                |       |       |       |       |       |       |       |               |       |   |   |
| Non-interest  expense                               |       |       |       |       |       |       |       |               |       |   |   |
| Salaries and employee benefits                      |       | $          | 27,121     |       | $          | 25,411     |       | $                  | 22,421     |   | 6.7 | % | 13.3 | % |
| Net occupancy                                       |       | 3,542      |       | 3,165      |       | 2,753      |       | 11.9               | %          | 15.0 | % |
| Equipment                                           |       | 4,123      |       | 3,949      |       | 3,488      |       | 4.4                | %          | 13.2 | % |
| Intangibles amortization                            |       | 1,306      |       | 1,059      |       | 909        |       | 23.3               | %          | 16.5 | % |
| Telecommunications                                  |       | 1,664      |       | 1,581      |       | 1,287      |       | 5.2                | %          | 22.8 | % |
| Stationery, printing, and supplies                  |       | 984        |       | 988        |       | 916        |       | -0.4               | %          | 7.9 | % |
| Other                                               |       | 9,836      |       | 9,727      |       | 8,674      |       | 1.1                | %          | 12.1 | % |
| Total non-interest expense                          |       | $          | 48,576     |       | $          | 45,880     |       | $                  | 40,448     |   | 5.9 | % | 13.4 | % |

 

**Non-interest Income**

Total non-interest income was $17,332 for 2005 compared to $19,544 for2004.  Excluding the aforementioned$2,421 loss on the sale of securities incurred in the fourth quarter of 2005,non-interest income would have been $19,753 for 2005 or relatively flatcompared to 2004.  Increases in servicecharges on deposit accounts and other income were offset by decreases inmortgage banking and insurance commissions. Service charges increased primarily due to the increase in overallaccount levels from acquisitions.  Otherincome increased due to death benefits on bank-owned life insurance, theestablishment of the title insurance agency, an increase in annuity sales, theacquisition of Madison, and the full-year effect of the Peoples Trustacquisition in June 2004.  Insurancecommissions decreased as the Company disposed of the Kentucky division of itsinsurance subsidiary in the first quarter of 2005.

 

Non-interest income was relatively flat in 2004 compared to 2003. Theacquisition of Peoples Trust and increased service charge income related to theCompany’s overdraft program were offset by decreases in mortgage bankingactivity and lower gains on sales of investment securities. Mortgage bankingincome was $3,198 in 2004 versus $5,671 in 2003, a decrease of 43.6%. As thelevel of refinancings declined throughout the year, the Company anticipatedthis decrease in income.

 

**Non-interest Expense**

Total non-interest expense increased 5.9% in 2005 to $48,576 comparedto $45,880 in 2004, an increase of $2,696. The largest component ofnon-interest expense in both years was salaries and employee benefits. Theseexpenses were $27,121 in 2005 compared to $25,411 in 2004. The increase of$1,710 was primarily related to the full-year effect of the acquisition ofPeoples Trust, the acquisition of Madison in August 2005, and normal staffsalary increases.  Occupancy andintangible amortization expenses increased in 2005 due to the acquisitionactivity in 2004 and 2005.

 

15

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Total non-interest expense increased 13.4% in 2004 to $45,880 comparedto $40,448 in 2003, or an increase of $5,432. The largest component ofnon-interest expense in both years was salaries and benefits. These expenseswere $25,411 in 2004 compared to $22,421 in 2003. The increase of $2,990 wasprimarily related to the full-year effect of the acquisition of FirstCommunity, the acquisition of Peoples Trust in June 2004, and normal staffsalary increases. The Company also incurred certain costs in 2004 related tothe restructuring of its banking affiliates that were not incurred in 2003.  These costs included system conversion costs,costs associated with the name change of the Company’s Illinois affiliate, andcontract termination penalties.  Thetotal restructuring costs incurred in 2004 were $650.

 

**Income Taxes**

The effective tax rate was 24.2% in 2005, 27.2% in 2004, and 30.1% in2003.  The decrease in the Company’seffective tax rate in 2005 was primarily related to an increase in tax-freeincome from state and municipal securities and an increase in tax-free incomerelated to bank-owned life insurance policies.

 

**Balance Sheet**

At December 31, 2005, total assets were $1,645,605 compared to$1,549,379 at December 31, 2004, an increase of $96,226. The increase wasprimarily attributable to the acquisition of Madison, which accounted for approximately$200 million in assets.  The Company useda portion of the cash received in this acquisition to reduce the overall levelof its borrowings.

 

**Loans, Credit Risk and the Allowance and Provision forLoan Losses**

Loans remain the Company’s largest concentration of assets and continueto represent the greatest potential risk. The loan underwriting standardsobserved by the Company’s subsidiaries are viewed by management as a means ofcontrolling problem loans and the resulting charge-offs.

 

The Company’s conservative loan underwriting standards havehistorically resulted in higher loan quality and generally lower levels of netcharge-offs than peer group averages. The Company also believes credit risksmay be elevated if undue concentrations of loans in specific industry segmentsand to out-of- area borrowers are incurred. Accordingly, the Company’s Board ofDirectors regularly monitors such concentrations to determine compliance withits loan concentration policy. The Company believes it has no undue concentrationsof loans.

 

Total loans (excluding those held for sale) increased by $28,990 fromyear-end 2004. The increase was primarily related to the acquisition ofMadison, which added $54,835 in net loans. Excluding the acquisition ofMadison, the Company’s total loan portfolio decreased by $25,845. This decreasewas due primarily to pay offs of approximately $35,000 in the Company’s hotelloan portfolio.  Residential real estateloans continue to represent the largest portion of the total loan portfolio.  Such loans represented 38.5% and 38.1% oftotal loans at December 31, 2005 and 2004, respectively.

 

The following table details the Company’s loan portfolio by type ofloan.

 

**Loan Portfolio**

 
| ** **                         | ** ** | **December 31** | ** ** |
|------------------------------------|------------|-----------------|------------|
| ** **                         | ** ** | **2005**        | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Types of  loans**                |       |            |       |   |   |   |   |   |   |   |   |
| Commercial  and industrial         |       | $               | 134,754    |   | $ | 143,511 |   | $ | 141,571 |   | $ | 98,526 |   | $ | 83,143 |   |
| Agricultural  production financing |       | 23,871          |       | 22,647 |   | 25,897 |   | 25,105 |   | 20,726 |   |
| Farm real  estate                  |       | 38,833          |       | 38,281 |   | 37,107 |   | 43,762 |   | 46,524 |   |
| Commercial  real estate mortgage   |       | 202,047         |       | 213,359 |   | 183,938 |   | 156,277 |   | 150,677 |   |
| Residential  real estate mortgage  |       | 368,953         |       | 353,515 |   | 315,848 |   | 301,232 |   | 328,107 |   |
| Construction  and development      |       | 51,736          |       | 38,056 |   | 34,686 |   | 34,987 |   | 53,753 |   |
| Consumer                           |       | 123,481         |       | 108,430 |   | 99,724 |   | 72,702 |   | 69,957 |   |
| State and  political               |       | 14,320          |       | 11,206 |   | 16,700 |   | 7,576 |   | 7,898 |   |
| Total loans                        |       | $               | 957,995    |   | $ | 929,005 |   | $ | 855,471 |   | $ | 740,167 |   | $ | 760,785 |   |

 

The following table indicates the amounts of loans (excludingresidential and commercial mortgages and consumer loans) outstanding as ofDecember 31, 2005 which, based on remaining scheduled repayments of principal,are due in the periods indicated.

 

**Maturities and Sensitivity to Changes in InterestRates of Commercial and Construction Loans**

 
| **Due:**                          | ** ** | **Within 1 Year** | ** ** | **1 - 5 Years** | ** ** | **Over 5 years** | ** ** | **Total** | ** ** |
|-----------------------------------|------------|-------------------|------------|-----------------|------------|------------------|------------|-----------|------------|
| **Loan  Type**                    |       |              |       |            |       |             |       |      |       |
| Commercial and industrial         |       | $                 | 52,785     |            | $          | 38,690           |       | $         | 43,279     |   | 134,754 |   |
| Agricultural production financing |       | 17,283            |       | 4,700           |       | 1,888            |       | 23,871    |       |
| Construction and development      |       | 29,533            |       | 13,821          |       | 8,382            |       | 51,736    |       |
| Totals                            |       | $                 | 99,601     |            | $          | 57,211           |       | $         | 53,549     |   | $ | 210,361 |   |
|                              |       |              |       |            |       |             |       |      |       |
| Percent                           |       | 47                | %          | 27              | %          | 26               | %          | 100       | %          |
|                              |       |              |       |            |       |             |       |      |       |
| **Rate  Sensitivity**             |       |              |       |            |       |             |       |      |       |
|                              |       |              |       |            |       |             |       |      |       |
| Fixed Rate                        |       | $                 | 20,132     |            | $          | 26,029           |       | $         | 5,708      |   | $ | 51,869 |   |
| Variable Rate                     |       | 112,512           |       | 44,062          |       | 1,918            |       | 158,492   |       |
| Totals                            |       | $                 | 132,644    |            | $          | 70,091           |       | $         | 7,626      |   | $ | 210,361 |   |

 

The Company regards its ability to identify and correct loan qualityproblems as one of its greatest strengths. Loans are placed on “non-accrual”status when, in management’s judgment, the collateral value and/or theborrower’s financial condition does not justify accruing interest.

 

16

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As a general rule, commercial and real estate loans are reclassified tononaccrual status at or before becoming 90 days past due. Interest previouslyrecorded is reversed and charged against current income. Subsequent interestpayments collected on nonaccrual loans are thereafter applied as a reduction ofthe loan’s principal balance.

 

Non-performing loans were $10,217 as of December 31, 2005 compared to$14,042 as of December 31, 2004 and represented 1.07% of total loans atDecember 31, 2005 versus 1.51% one year ago.

 

The following table details the Company’s non-performing loans as ofDecember 31 for the years indicated.

 

**Non-performing Loans**

 
| ** **                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Nonaccruing  loans                                      |       | $        | 9,984      |     | $          | 13,611   |       | $        | 14,626     |     | $          | 7,695 |   | $ | 10,406 |   |
| Accruing loans contractually   past due 90 days or more |       | 233      |       | 431      |       | 196      |       | 245      |       | 766      |       |
| Total                                                   |       | $        | 10,217     |     | $          | 14,042   |       | $        | 14,822     |     | $          | 7,940 |   | $ | 11,172 |   |
| % of total loans                                        |       | 1.07     | %          | 1.51     | %          | 1.73     | %          | 1.07     | %          | 1.47     | %          |

 

The provision for loan losses was $1,040 in 2005, $600 in 2004, and$1,325 in 2003.  The increase in theCompany’s provision in 2005 was primarily due to the increase in netcharge-offs during 2005. Net charge-offs were $3,299 in 2005 compared to $2,186in 2004 and $1,411 in 2003. As a percentage of average loans, net charge-offsequaled .35%, .24%, and .18% in 2005, 2004 and 2003, respectively.

 

**Summary of the Allowance for Loan Losses**

 
| ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Balance at  January 1                      |       | $        | 11,698     |     | $          | 11,509   |       | $        | 9,517      |     | $          | 8,894 |   | $ | 8,716 |   |
| Chargeoffs                                 |       |     |       |     |       |     |       |     |       |     |       |
| Commercial                                 |       | 1,164    |       | 1,069    |       | 588      |       | 1,715    |       | 1,392    |       |
| Commercial real estate mortgage            |       | 594      |       | 43       |       | —   |       | —   |       | 100      |       |
| Residential real estate mortgage           |       | 869      |       | 534      |       | 555      |       | 473      |       | 266      |       |
| Consumer                                   |       | 956      |       | 886      |       | 777      |       | 583      |       | 621      |       |
| Total Chargeoffs                           |       | 3,583    |       | 2,532    |       | 1,920    |       | 2,771    |       | 2,379    |       |
| Recoveries                                 |       |     |       |     |       |     |       |     |       |     |       |
| Commercial                                 |       | 46       |       | 123      |       | 160      |       | 116      |       | 127      |       |
| Commercial real estate mortgage            |       | —   |       | 2        |       | 43       |       | 5        |       | 24       |       |
| Residential real estate mortgage           |       | 35       |       | 43       |       | 54       |       | 127      |       | 40       |       |
| Consumer                                   |       | 203      |       | 178      |       | 252      |       | 151      |       | 230      |       |
| Total Recoveries                           |       | 284      |       | 346      |       | 509      |       | 399      |       | 421      |       |
| Net  Chargeoffs                            |       | 3,299    |       | 2,186    |       | 1,411    |       | 2,372    |       | 1,958    |       |
| Addition  resulting from acquisition       |       | 1,002    |       | 1,775    |       | 2,078    |       | —   |       | —   |       |
| Provision  for loan losses                 |       | 1,040    |       | 600      |       | 1,325    |       | 2,995    |       | 2,136    |       |
| Balance at  December 31                    |       | $        | 10,441     |     | $          | 11,698   |       | $        | 11,509     |     | $          | 9,517 |   | $ | 8,894 |   |
| Net  Chargeoffs to average loans           |       | 0.35     | %          | 0.24     | %          | 0.18     | %          | 0.31     | %          | 0.25     | %          |
| Provision for loan losses to average loans |       | 0.11     | %          | 0.07     | %          | 0.17     | %          | 0.39     | %          | 0.27     | %          |
| Allowance to total loans at year end       |       | 1.09     | %          | 1.26     | %          | 1.35     | %          | 1.29     | %          | 1.17     | %          |

 

**Allocation of the Allowance for Loan Losses**

 
| ** **                   | ** ** | **2005**   | ** ** | **2004**                                | ** ** | **2003**   | ** ** | **2002**                                | ** ** | **2001**   | ** ** |
|------------------------------|------------|------------|------------|-----------------------------------------|------------|------------|------------|-----------------------------------------|------------|------------|------------|
| **December 31**              | ** ** | **Amount** | ** ** | **Percent   of loans  to total  loans** | ** ** | **Amount** | ** ** | **Percent   of loans  to total  loans** | ** ** | **Amount** | ** ** | **Percent   of loans  to total  loans** | ** ** | **Amount** | ** ** | **Percent   of loans  to total  loans** | ** ** | **Amount** | ** ** | **Percent   of loans  to total  loans** | ** ** |
| Real estate                  |       |       |       |                                    |       |       |       |                                    |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Residential                  |       | $          | 1,018      |                                    | 39         | %          | $          | 1,123                                   |       | 38         | %          | $ | 1,230 |   | 37 | % | $ | 2,097 |   | 41 | % | $ | 2,159 |   | 43 | % |
| Farm real estate             |       | 625        |       | 4                                       |       | 681        |       | 4                                       |       | 704        |       | 4 |   | 776 |   | 6 |   | 301 |   | 6 |   |
| Commercial                   |       | 3,233      |       | 21                                      |       | 3,997      |       | 23                                      |       | 3,907      |       | 21 |   | 2,715 |   | 21 |   | 2,453 |   | 20 |   |
| Construction and development |       | 763        |       | 5                                       |       | 648        |       | 4                                       |       | 658        |       | 4 |   | 647 |   | 5 |   | 858 |   | 7 |   |
| Total real estate            |       | 5,639      |       | 69                                      |       | 6,449      |       | 69                                      |       | 6,499      |       | 66 |   | 6,235 |   | 73 |   | 5,771 |   | 75 |   |
| Commercial                   |       |       |       |                                    |       |       |       |                                    |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Agribusiness                 |       | 412        |       | 3                                       |       | 464        |       | 3                                       |       | 491        |       | 3 |   | 388 |   | 3 |   | 368 |   | 3 |   |
| Other commercial             |       | 2,440      |       | 16                                      |       | 2,831      |       | 17                                      |       | 3,003      |       | 19 |   | 1,810 |   | 14 |   | 1,349 |   | 11 |   |
| Total Commercial             |       | 2,852      |       | 19                                      |       | 3,295      |       | 20                                      |       | 3,494      |       | 22 |   | 2,198 |   | 17 |   | 1,717 |   | 14 |   |
| Consumer                     |       | 1,435      |       | 12                                      |       | 1,581      |       | 11                                      |       | 1,053      |       | 12 |   | 951 |   | 10 |   | 952 |   | 11 |   |
| Unallocated                  |       | 515        |       |                                    |       | 373        |       |                                    |       | 463        |       |   |   | 133 |   |   |   | 554 |   |   |   |
| Total                        |       | $          | 10,441     |                                    | 100        | %          | $          | 11,698                                  |       | 100        | %          | $ | 11,509 |   | 100 | % | $ | 9,517 |   | 100 | % | $ | 8,994 |   | 100 | % |
|                              |            |            |            |                                         |            |            |            |                                         |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Management maintains a listof loans warranting either the assignment of a specific reserve amount or otherspecial administrative attention. This watch list, together with a listing ofall classified loans, nonaccrual loans and delinquent loans, is reviewedmonthly by the board of directors of each subsidiary. Additionally, the Companyevaluates its consumer and residential real estate loan pools for probablelosses incurred based on historical trends, adjusted by current delinquency andnon-performing loan levels.

 

The ability to absorb loanlosses promptly when problems are identified is invaluable to a bankingorganization. Most often, losses incurred as a result of prompt, aggressivecollection actions are much lower than losses incurred after prolonged legalproceedings. Accordingly, the Company observes the practice of quicklyinitiating stringent collection efforts in the early stages of loandelinquency.

 

17

----

 

The adequacy of theallowance for loan losses in each subsidiary is reviewed at least quarterly.The determination of the provision amount in any period is based uponmanagement’s continuing review and evaluation of loan loss experience, changesin the composition of the loan portfolio, classified loans includingnon-accrual and impaired loans, current economic conditions, the amount ofloans presently outstanding, and the amount and composition of loan growth. TheCompany’s allowance for loan losses was $10,441, or 1.09% of total loans, atDecember 31, 2005 compared to $11,698, or 1.26% of total loans, at the end of2004. The reduction in non-performing loans supports the decrease in theoverall level of the allowance for loan losses.

 

The acquisition of Madison resulted in anaddition to the allowance for loan losses of $1,002.  As of December 31, 2005 management wasevaluating the appropriate level of allowance consistent with the probableincurred loss of the portfolio acquired. This acquired allowance is subject toadjustments in the future as part of the finalization of purchase accounting.

 

**Securities**

Securities offer flexibility in the Company’s management of interestrate risk, and are the primary means by which the Company provides liquidityand responds to changing maturity characteristics of assets and liabilities.The Company’s investment policy prohibits trading activities and does not allowinvestment in high-risk derivative products or junk bonds.

 

As of December 31, 2005, allof the securities are classified as “available for sale” (“AFS”) and arecarried at fair value with unrealized gains and losses, net of taxes, excludedfrom earnings and reported as a separate component of shareholders’equity. A net unrealized loss of $5,272 was recorded to adjust the AFSportfolio to current market value at December 31, 2005 compared to a netunrealized gain of $175 at December 31, 2004.

 

18

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**Investment Securities**

**(Carrying Values at December 31)**

 
| ** **                  | ** ** | **Within 1 Year** | ** ** | **2-5 Yrs** | ** ** | **6-10 Yrs** | ** ** | **Beyond  10  Years** | ** ** | **Total  2004** | ** ** |
|-----------------------------|------------|------------------------|------------|-------------|------------|--------------|------------|-----------------------|------------|-----------------|------------|
| Available  for sale         |       |                   |       |        |       |         |       |                  |       |            |       |
| Federal agencies            |       | $                      | 494        |        | $          | 64,786       |       | $                     | 11,916     |            | $          | — |   | $ | 77,196 |   |
| State and municipal         |       | 6,712                  |       | 13,457      |       | 32,173       |       | 60,443                |       | 112,785         |       |
| Mortgage-backed securities  |       | 51                     |       | 904         |       | 60,773       |       | 185,266               |       | 246,994         |       |
| Equity and other securities |       | 1,016                  |       | 2,282       |       | 607          |       | 9,934                 |       | 13,839          |       |
| Total available for sale    |       | $                      | 8,273      |        | $          | 81,429       |       | $                     | 105,469    |            | $          | 255,643 |   | $ | 450,814 |   |
|                        |       |                   |       |        |       |         |       |                  |       |            |       |
| Weighted average yield*     |       | 5.38                   | %          | 4.73        | %          | 5.30         | %          | 5.02                  | %          | 5.04            | %          |

 

----

*Adjusted to reflect incomerelated to securities exempt from federal income taxes

 

Amountsin the table above are based on scheduled maturity dates.  Variable interest rates are subject to changenot less than annually based upon certain interest rate indices.  Expected maturities will differ fromcontractual maturities because issuers may have the right to call or prepayobligations with or without call or prepayment penalties.

 

As of December 31, 2005, there were no corporate bonds and othersecurities which represent more than 10% of shareholders’ equity.

 

For 2005 the tax equivalentyield of the investment securities portfolio was 4.32%, compared to 3.87% and3.65% for 2004 and 2003, respectively. The average life of the Company’sinvestment security portfolio was 5.45 years at December 31, 2005. During 2005the investment portfolio shifted from a shorter than average duration to aslightly longer than average duration when compared to the Company’s averagetargeted duration.  This move was indirect response to the aggressive move up in short term interest rates as theFederal Reserve increased rates throughout 2005.  The duration extension allowed the portfolioto improve its yield performance throughout the year.  At the end of 2005 management determined thata selective divestiture of underperforming securities would better position theportfolio for the future.  Thetransaction resulted in a one time pre-tax loss on sale of $2,421 that isexpected to be recovered in the next 18 months. Entering 2006 the portfolio is now positioned to provide consistentyield performance and stable cash flows for reinvestment.  Management anticipates that the portfoliowill likely maintain its current duration and expects limited changes to itsoverall yield performance.

 

**Sources of Funds**

The Company relies primarily on customer deposits and securities sold underagreement to repurchase (“repurchase agreements”), along with shareholders’equity to fund earning assets. Federal Home Loan Bank (“FHLB”) advances areused to provide additional funding. The Company also attempts to obtaindeposits through branch acquisitions.

 

Deposits generated within local markets provide the major source offunding for earning assets. Average total deposits were 88.5% and 89.6% oftotal average earning assets in 2005 and 2004, respectively. Totalinterest-bearing deposits averaged 88.4% and 89.1% of average total depositsduring 2005 and 2004. Management is continuing efforts to increase thepercentage of transaction-related deposits to total deposits due to thepositive effect on earnings.

 

Repurchase agreements are high denomination investments utilized bypublic entities and commercial customers as an element of their cash managementresponsibilities. During 2005, repurchase agreements averaged $21,661.

 

Another source of funding is the Federal Home Loan Bank (FHLB). TheCompany had FHLB advances of $41,547 outstanding at December 31, 2005. Theseadvances have interest rates ranging from 2.4% to 6.3% (see note 10 to theconsolidated financial statements for the maturity schedule of these advances).The Company averaged $89,674 in FHLB advances during 2005 compared to $69,861during 2004.

 

**Average Deposits**

 
| ** **               | ** ** | **2005**   | ** ** | **2004** | ** ** | **2003**   | ** ** |
|--------------------------|------------|------------|------------|----------|------------|------------|------------|
| ** **               | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| Demand                   |       | $          | 144,647    |     |       |       | $          | 131,110 |   |   |   | $ | 111,480 |   |   |   |
| Interest  Bearing Demand |       | 309,551    |       | 0.84     | %          | 301,611    |       | 0.54 | % | 258,213 |   | 0.60 | % |
| Savings/Money  Markets   |       | 306,847    |       | 1.41     |       | 250,274    |       | 0.73 |   | 218,414 |   | 0.69 |   |
| Certificates  of Deposit |       | 483,457    |       | 2.73     |       | 521,112    |       | 2.48 |   | 526,304 |   | 2.94 |   |
| Totals                   |       | $          | 1,244,502  |     | 1.62       | %          | $          | 1,204,107 |   | 1.36 | % | $ | 1,114,411 |   | 1.67 | % |

 

Asof December 31, 2005, certificates of deposit and other time deposits of $100or more mature as follows:

 
| ** ** | ** ** | **3 months or less** | ** ** | **4-6 months** | ** ** | **6-12 months** | ** ** | **over 12 months** | ** ** | **Total** | ** ** |
|------------|------------|----------------------|------------|----------------|------------|-----------------|------------|--------------------|------------|-----------|------------|
| Amount     |       | $                    | 80,335     |           | $          | 20,872          |       | $                  | 25,336     |      | $          | 47,113 |   | $ | 173,656 |   |
| Percent    |       | 46                   | %          | 12             | %          | 15              | %          | 27                 | %          |      |       |
|            |            |                      |            |                |            |                 |            |                    |            |           |            |  |  |  |  |  |

 

**Capital Resources**

The Federal Reserve Board and other regulatory agencies have adoptedrisk-based capital guidelines that assign risk weightings to assets andoff-balance sheet items. The Company’s core capital (“Tier 1”) consists ofcommon shareholders’ equity adjusted for unrealized gains or losses onavailable for sale (AFS) securities plus limited amounts of Trust PreferredSecurities less goodwill and intangible assets. Total capital consists of corecapital, certain debt instruments and a portion of the allowance for loanlosses. At December 31, 2005, Tier 1 capital to average assets was 8.4%. Totalcapital to risk-weighted assets was 13.5%. Both ratios exceed all requiredratios established for bank holding companies. Risk-adjusted capital levels ofeach of the Company’s subsidiary banks exceed regulatory definitions ofwell-capitalized institutions.

 

19

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The Trust PreferredSecurities (which are classified as subordinated debentures) qualify as Tier 1capital or core capital with respect to the Company under the risk-basedcapital guidelines established by the Federal Reserve. Under such guidelines,capital received from the proceeds of the sale of these securities cannotconstitute more than 25% of the total Tier 1 capital of the Company.Consequently, the amount of Trust Preferred Securities in excess of the 25%limitation constitutes Tier 2 capital, or supplementary capital, of theCompany.  As of December 31, 2005, all ofthe Company’s Trust Preferred Securities qualify as Tier 1 capital.

 

Common shareholders’ equityis impacted by the Company’s decision to categorize its securities portfolio asavailable for sale (AFS). Securities in this category are carried at fairvalue, and common shareholders’ equity is adjusted to reflect unrealized gainsand losses, net of taxes.

 

The Company declared andpaid common dividends of $.520 per share in 2005 compared to $.476 and $.435 in2004 and 2003 respectively. Book value per common share increased to $11.96 atDecember 31, 2005 compared to $10.68 at the end of 2004. The net adjustment forAFS securities decreased book value per share by $.23 at December 31, 2005 andincreased book value per share by $.01 at December 31, 2004. Depending onmarket conditions, the adjustment for AFS securities can cause significantfluctuations in equity.

 

**Liquidity**

Liquidity management involves maintaining sufficient cash levels to fundoperations and to meet the requirements of borrowers, depositors and creditors.Higher levels of liquidity bear higher corresponding costs, measured in termsof lower yields on short-term, more liquid earning assets and higher interestexpense involved in extending liability maturities. Liquid assets include cashand cash equivalents, loans and securities maturing within one year and moneymarket instruments. In addition, the Company holds approximately $425 millionof AFS securities maturing after one year, which can be sold to meet liquidityneeds.

 

Maintaining a relativelystable funding base, which is achieved by diversifying funding sources,supports liquidity, extends the contractual maturity of liabilities, and limitsreliance on volatile short-term purchased funds. Short-term funding needs mayarise from declines in deposits or other funding sources, funding of loancommitments and requests for new loans. The Company’s strategy is to fundassets to the maximum extent possible with core deposits, which provide asizable source of relatively stable low-cost funds. The Company defines coredeposits as all deposits except certificates of deposits greater than $100.Average core deposits funded approximately 78.8% of total earning assets during2005 and approximately 79.3% in 2004.

 

Management believes theCompany has sufficient liquidity to meet all reasonable borrower, depositor andcreditor needs in the present economic environment. The Company has notreceived any directives from regulatory authorities that would materiallyaffect liquidity, capital resources or operations.

 

**Contractual Obligations as of December 31, 2005**

 
| ** **               | ** ** | ** ** | ** ** | **Less than** | ** ** | **1 - 3** | ** ** | **3 - 5** | ** ** | **More than** | ** ** |
|--------------------------|------------|------------|------------|---------------|------------|-----------|------------|-----------|------------|---------------|------------|
| ** **               | ** ** | **Total**  | ** ** | **1 Year**    | ** ** | **Years** | ** ** | **Years** | ** ** | **5 Years**   | ** ** |
| Time  Deposits           |       | $          | 538,876    |          | $          | 336,680   |       | $         | 161,627    |          | $          | 31,038 |   | $ | 9,531 |   |
| FHLB  Advances           |       | 41,547     |       | 132           |       | 15,305    |       | 5,581     |       | 20,529        |       |
| Subordinated  Debentures |       | 29,898     |       | —        |       | —    |       | —    |       | 29,898        |       |
| Total                    |       | $          | 610,321    |          | $          | 336,812   |       | $         | 176,932    |          | $          | 36,619 |   | $ | 59,958 |   |

** **

**Interest Rate Sensitivity**

At year-end 2005, the Company held approximately $666 million in assetscomprised of securities, loans, short-term investments, and federal funds sold,which were interest rate sensitive in one year or less time horizons. TheCompany’s interest rate sensitivity analysis for the year ended December 31,2005 appears in the table below. A significant assumption that creates thelarge negative gap in the 0 to 3 month category is that all interest-bearingdemand and savings accounts are subject to immediate repricing. While it is truethat, contractually, those accounts are subject to immediate repricing, therates paid on those accounts are generally not tied to specific indices and areinfluenced by market conditions and other factors. Accordingly, a generalmovement in interest rates, either up or down, may not have any immediateeffect on the rates paid on these deposit accounts. The following tableillustrates only one source of information about sensitivity to interest ratemovements. Our asset and liability management process also uses simulationsthat take into account the time that various assets and liabilities may repriceand the degree to which various categories of such assets and liabilities willrespond to general interest rate movements. Interest rate risk can only be representedby a measurement of the effects of changing interest rates given the capacityfor and magnitude of change on specific assets and liabilities.

 

 

20

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**RateSensitivity Analysis at December 31, 2005**

 
| ** **                                      | ** ** | **3 Months** | ** ** | **1 Year** | ** ** | **2 Years** | ** ** | **5 Years** | ** ** | **Over 5   Years or   Insensitive** | ** ** | **Total** | ** ** |
|-------------------------------------------------|------------|--------------|------------|------------|------------|-------------|------------|-------------|------------|-------------------------------------|------------|-----------|------------|
| Interest-earning assets                         |       |         |       |       |       |        |       |        |       |                                |       |      |       |
| Loans                                           |       | $            | 320,739    |       | $          | 237,795     |       | $           | 148,668    |                                | $          | 185,781   |       | $ | 67,578 |   | $ | 960,561 |   |
| Securities                                      |       | 19,170       |       | 42,041     |       | 49,355      |       | 135,143     |       | 205,105                             |       | 450,814   |       |
| Federal funds sold and money market fund        |       | 35,136       |       |       |       |        |       |        |       |                                |       | 35,136    |       |
| Interest-bearing deposits in banks              |       | 210          |       |       |       |        |       |        |       |                                |       | 210       |       |
| Restricted stock                                |       | 10,940       |       |       |       |        |       |        |       |                                |       | 10,940    |       |
| Total Interest-earning assets                   |       | 386,195      |       | 279,836    |       | 198,023     |       | 320,924     |       | 272,683                             |       | 1,457,661 |       |
| Other assets                                    |       |         |       |       |       |        |       |        |       | 198,385                             |       | 198,385   |       |
| Allowance for loan losses                       |       |         |       |       |       |        |       |        |       | (10,441                             | )          | (10,441   | )          |
| Total assets                                    |       | $            | 386,195    |       | $          | 279,836     |       | $           | 198,023    |                                | $          | 320,924   |       | $ | 460,627 |   | $ | 1,645,605 |   |
|                                            |       |         |       |       |       |        |       |        |       |                                |       |      |       |
| Interest-bearing liabilities                    |       |         |       |       |       |        |       |        |       |                                |       |      |       |
| Interest-bearing demand                         |       | $            | 330,592    |       |       |        |       |        |       |                                |       |      | $          | 330,592 |   |
| Savings                                         |       | 321,661      |       |       |       |        |       |        |       |                                |       | 321,661   |       |
| Certificates of deposit                         |       | 149,575      |       | 186,166    |       | 115,560     |       | 77,105      |       | 10,470                              |       | 538,876   |       |
| Short term borrowings                           |       | 26,516       |       |       |       |        |       |        |       |                                |       | 26,516    |       |
| Federal Home Loan Bank advances                 |       | 132          |       |       |       | 15,305      |       | 6,110       |       | 20,000                              |       | 41,547    |       |
| Subordinated debentures                         |       | 29,898       |       |       |       |        |       |        |       |                                |       | 29,898    |       |
| Total Interest-bearing liabilities              |       | 858,374      |       | 186,166    |       | 130,865     |       | 83,215      |       | 30,470                              |       | 1,289,090 |       |
| Demand deposits                                 |       | —       |       | —     |       | —      |       | —      |       | 161,568                             |       | 161,568   |       |
| Other liabilities                               |       | —       |       | —     |       | —      |       | —      |       | 33,878                              |       | 33,878    |       |
| Stockholders equity                             |       | —       |       | —     |       | —      |       | —      |       | 161,069                             |       | 161,069   |       |
| Total Liabilities and stockholders’ equity |       | $            | 858,374    |       | $          | 186,166     |       | $           | 130,865    |                                | $          | 83,215    |       | $ | 386,985 |   | $ | 1,645,605 |   |
| Rate sensitivity gap (assets less  liabilities) |       | $            | (472,179   | )          | $          | 93,670      |       | $           | 67,158     |                                | $          | 237,709   |       |   |   |   |   |
| Rate sensitivity gap(cumulative)                |       | (472,179     | )          | (378,509   | )          | (311,351    | )          | (73,642     | )          |                                |       |      |       |
| Percent of total assets (cumulative)            |       | -28.69       | %          | -23.00     | %          | -18.92      | %          | -4.48       | %          |                                |       |      |       |
| Rate sensitive assets/liabilities (cumulative)  |       | 44.99        | %          | 63.76      | %          | 73.51       | %          | 94.15       | %          |                                |       |      |       |

 

Management believes that the Company has taken steps to position itselfto react to changes in the current interest rate environment.  Short term interest rates rose significantlyin 2005 as the Federal Reserve increased rates in response to a maturingeconomic expansion.  The Company was ableto increase its margin in this environment but increased deposit pricingcompetition will likely pressure this trend in 2006.  The Company continues to monitor therepricing characteristics of its balance sheet so as to maintain an acceptablenet interest margin during interest rate fluctuations. Assuming a stable tomoderately higher interest rate environment, the Company does not foresee itsearnings materially impacted for 2006.

 

Asset/liability management strategies are developed by the Company tomanage market risk. Market risk is the risk of loss in financial instrumentsincluding investments, loans, deposits and borrowings arising from adversechanges in prices/rates. Interest rate risk is the Company’s primary marketrisk exposure and represents the sensitivity of earnings to changes in marketinterest rates.

 

The following table provides information about the Company’ssignificant financial instruments at December 31, 2005 that are sensitive tochanges in interest rates. The table presents principal cash flows and relatedweighted average interest rates by maturity dates. The table presents only astatic measurement of asset and liability volumes based on maturity, cash flowestimates and interest rates. It does not reflect the differences in the timingand degree of repricing of assets and liabilities due to interest rate changes.

 

21

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**Principal Cash Flows**

 
| **December 31**                         | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **There-  after** | ** ** | **Total** | ** ** | **Fair  Value** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|-------------------|------------|-----------|------------|-----------------|------------|
|                                    |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Assets                                  |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Investment  securities                  |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Fixed rate                              |       | $        | 27,287     |     | $          | 5,494    |       | $        | 70,905     |     | $          | 44,054            |       | $         | 145,455    |            | $          | 155,813 |   | $ | 449,008 |   | $ | 449,008 |   |
| Average interest  rate                  |       | 4.07     | %          | 6.11     | %          | 4.09     | %          | 4.63     | %          | 4.86     | %          | 5.84              | %          | 5.02      | %          |            |       |
| Variable rate                           |       | $        | 273        |     | —     |     | $          | 4        |       | —   |       | $                 | 29         |      | $          | 1,500           |       | $ | 1,806 |   | $ | 1,806 |   |
| Average interest  rate                  |       | 4.90     | %          | —   |       | 5.15     | %          | —   |       | 4.83     | %          | 5.99              | %          | 5.81      | %          |            |       |
|                                    |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Loans                                   |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Fixed rate                              |       | $        | 35,032     |     | $          | 18,531   |       | $        | 32,624     |     | $          | 40,270            |       | $         | 53,039     |            | $          | 103,271 |   | $ | 282,767 |   | $ | 278,637 |   |
| Average interest  rate                  |       | 6.66     | %          | 6.93     | %          | 6.57     | %          | 6.60     | %          | 6.69     | %          | 6.55              | %          | 6.62      | %          |            |       |
| Variable rate                           |       | $        | 92,938     |     | $          | 13,645   |       | $        | 14,711     |     | $          | 9,159             |       | $         | 23,653     |            | $          | 523,688 |   | $ | 677,794 |   | $ | 669,513 |   |
| Average interest  rate                  |       | 7.67     | %          | 7.08     | %          | 7.20     | %          | 7.35     | %          | 6.44     | %          | 6.51              | %          | 6.71      | %          |            |       |
|                                    |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Liabilities                             |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
|                                    |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Deposits                                |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| NOW, money market  and savings deposits |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Variable rate                           |       | $        | 652,253    |     | —     |     | —     |     | —     |     | —     |              | —     |      | $          | 652,253         |       | $ | 640,168 |   |
| Average interest  rate                  |       | 1.39     | %          | —   |       | —   |       | —   |       | —   |       | —            |       | 1.39      | %          |            |       |
| Certificates of  deposit                |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Fixed rate                              |       | $        | 306,657    |     | $          | 111,911  |       | $        | 45,144     |     | $          | 28,488            |       | $         | 1,788      |            | $          | 9,528 |   | $ | 503,516 |   | $ | 503,054 |   |
| Average interest  rate                  |       | 3.17     | %          | 3.54     | %          | 3.67     | %          | 4.02     | %          | 4.26     | %          | 3.74              | %          | 3.37      | %          |            |       |
| Variable rate                           |       | $        | 30,022     |     | $          | 3,649    |       | $        | 923        |     | $          | 229               |       | $         | 534        |            | $          | 3 |   | $ | 35,360 |   | $ | 35,360 |   |
| Average interest  rate                  |       | 3.90     | %          | 3.11     | %          | 2.42     | %          | 3.28     | %          | 3.86     | %          | 3.66              | %          | 3.78      | %          |            |       |
|                                    |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Borrowings                              |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Variable rate                           |       | $        | 26,516     |     | —     |     | —     |     | —     |     | —     |              | —     |      | $          | 26,516          |       | $ | 26,516 |   |
| Average interest  rate                  |       | 2.36     | %          | —   |       | —   |       | —   |       | —   |       | —            |       | 2.36      | %          |            |       |
|                                    |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| FHLB advances                           |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Fixed rate                              |       | $        | 132        |     | $          | 15,305   |       | —   |       | —   |       | $                 | 5,581      |      | $          | 20,529          |       | $ | 41,547 |   | $ | 40,951 |   |
| Average interest  rate                  |       | 6.20     | %          | 4.91     | %          | —   |       | —   |       | 3.38     | %          | 4.24              | %          | 4.38      | %          |            |       |
|                                    |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Subordinated  debentures                |       |     |       |     |       |     |       |     |       |     |       |              |       |      |       |            |       |
| Variable rate                           |       | —   |       | —   |       | —   |       | —   |       | —   |       | $                 | 29,898     |      | $          | 29,898          |       | $ | 31,090 |   |
| Average interest  rate                  |       | —   |       | —   |       | —   |       | —   |       | —   |       | 6.98              | %          | 6.98      | %          |            |       |
|                                         |            |          |            |          |            |          |            |          |            |          |            |                   |            |           |            |                 |            |  |  |  |  |  |  |  |  |  |

 

In analyzing interest rate sensitivity, management considers thesedifferences and incorporates other assumptions and factors, such as balancesheet growth and prepayments, to better measure interest rate risk. The Companycannot make any assurances as to the outcome of these assumptions, nor can itassess the impact of customer product preference changes and competitivefactors as well as other internal and external variables. In addition, thisanalysis cannot reflect actions taken by the asset/liability managementcommittees; therefore, this analysis should not be relied upon as indicative ofexpected operating results.

 

**Effects of Changing Prices**

The Company’s asset and liability structure is substantially differentfrom that of an industrial company in that most of its assets and liabilitiesare monetary in nature. Management believes the impact of inflation onfinancial results depends upon the Company’s ability to react to changes ininterest rates and, by such reaction, reduce the inflationary impact onperformance. Interest rates do not necessarily move in the same direction atthe same time, or at the same magnitude, as the prices of other goods andservices. As discussed previously, management relies on its ability to managethe relationship between interest-sensitive assets and liabilities to protectagainst wide interest rate fluctuations, including those resulting frominflation.

 

22

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**Critical Accounting Policies**

The accounting and reporting policies of the Company comply withaccounting principles generally accepted in the United States and conform togeneral practices within the banking industry. These policies require estimatesand assumptions. Changes in underlying factors, assumptions, or estimates inany of these areas could have a material impact on the Company’s futurefinancial condition and results of operations. In management’s opinion, some ofthese areas have a more significant impact than others on the Company’sfinancial reporting. These areas currently include accounting for the allowancefor loan losses and goodwill.

 

Allowance for Loan Losses —The level of the allowance for loan losses is based upon management’sevaluation of the loan and lease portfolios, past loan loss experience, knownand inherent risks in the portfolio, adverse situations that may affect theborrower’s ability to repay (including the timing of future payments), theestimated value of any underlying collateral, composition of the loanportfolio, economic conditions, and other pertinent factors. This evaluation isinherently subjective as it requires material estimates including the amountsand timing of future cash flows expected to be received on impaired loans thatmay be susceptible to significant change. The level of allowance maintained isbelieved by management to be adequate to cover losses inherent in theportfolio. The allowance is increased by provisions charged to expense anddecreased by charge-offs, net of recoveries of amounts previously charged-off.

 

Goodwill — Statement ofFinancial Accounting Standards No. 141 “Business Combinations” and No. 142 “Goodwilland Other Intangible Assets” were issued in June of 2001 and were effective forfiscal years beginning after December 15, 2001. Under these rules, goodwill andintangible assets deemed to have indefinite lives, if any, will no longer beamortized, but will be subject to annual impairment tests in accordance withthe Statements. The Company has selected June 30 as its date for annualimpairment testing.

 

**New Accounting Matters**

See Note 1 to the Consolidated Financial Statements regarding theadoption of new accounting standards in 2005.

 

**ITEM 7A.      QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

The information required in this section is incorporated herein byreference to the information provided in the “Interest Rate Sensitivity”section of Item 7.

 

23

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**ITEM 8.      FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

** **

 

24

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

Member Horwath  International |

 

REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON FINANCIAL STATEMENTS

 

Shareholdersand Board of Directors

MainSourceFinancial Group, Inc.

Greensburg,Indiana

 

Wehave audited the accompanying balance sheets of MainSource Financial Group,Inc. as of December 31, 2005 and 2004, and the related statements of income,shareholders’ equity, and cash flows for each of the three years in the periodended December 31, 2005. These financial statements are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of the Company as ofDecember 31, 2005 and 2004, and the results of its operations and its cashflows for each of the three years in the period ended December 31, 2005, inconformity with U.S. generally accepted accounting principles.

 

We also have audited, in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates), the effectiveness of the MainSource Financial Group Inc.’s internalcontrol over financial reporting as of December 31, 2005, based on criteriaestablished in Internal Control - Integrated Framework issued by the Committeeof Sponsoring Organizations of the Treadway Commission and our report datedFebruary 10, 2006 expressed an unqualified opinion thereon.

 

 
|                  |   | Crowe Chizek and Company LLC |
|-----------------------|--------|------------------------------|
|                  |   |                         |
| Indianapolis, Indiana |   |                         |
| February 10, 2006     |   |                         |

 

25

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**MAINSOURCEFINANCIAL GROUP, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(Dollaramounts in thousands except per share data)**

 
| ** **                                                                                                  | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                  |       |                        |       |                        |       |
| Cash and due from banks                                                                                     |       | $                           | 51,069     |                        | $          | 71,607 |   |
| Money market and federal funds sold                                                                         |       | 35,136                      |       | 4,662                       |       |
| Cash and cash equivalents                                                                                   |       | 86,205                      |       | 76,269                      |       |
| Interest bearing time deposits                                                                              |       | 210                         |       | 304                         |       |
| Investment securities                                                                                       |       |                        |       |                        |       |
| Available for sale                                                                                          |       | 450,814                     |       | 425,443                     |       |
| Held to maturity (fair value of $0 and  $3,414)                                                             |       | —                      |       | 3,243                       |       |
| Total investment securities                                                                                 |       | 450,814                     |       | 428,686                     |       |
| Loans held for sale                                                                                         |       | 2,566                       |       | 824                         |       |
| Loans, net of allowance for loan losses of  $10,441 and $11,698                                             |       | 947,554                     |       | 917,307                     |       |
| Restricted stock, at cost                                                                                   |       | 10,940                      |       | 7,902                       |       |
| Premises and equipment, net                                                                                 |       | 27,863                      |       | 25,766                      |       |
| Goodwill                                                                                                    |       | 51,301                      |       | 40,642                      |       |
| Purchased intangible assets                                                                                 |       | 9,274                       |       | 6,429                       |       |
| Cash surrender value of life insurance                                                                      |       | 24,467                      |       | 24,776                      |       |
| Interest receivable and other assets                                                                        |       | 34,411                      |       | 20,474                      |       |
| **Total assets**                                                                                            |       | $                           | 1,645,605  |                        | $          | 1,549,379 |   |
|                                                                                                        |       |                        |       |                        |       |
| **Liabilities**                                                                                             |       |                        |       |                        |       |
| Deposits                                                                                                    |       |                        |       |                        |       |
| Noninterest bearing                                                                                         |       | $                           | 161,568    |                        | $          | 145,999 |   |
| Interest bearing                                                                                            |       | 1,191,129                   |       | 1,080,368                   |       |
| Total deposits                                                                                              |       | 1,352,697                   |       | 1,226,367                   |       |
| Short-term borrowings                                                                                       |       | 26,516                      |       | 57,175                      |       |
| Federal Home Loan Bank (FHLB) advances                                                                      |       | 41,547                      |       | 90,981                      |       |
| Subordinated debentures                                                                                     |       | 29,898                      |       | 29,898                      |       |
| Notes payable                                                                                               |       | —                      |       | 9,100                       |       |
| Other liabilities                                                                                           |       | 33,878                      |       | 12,538                      |       |
| **Total liabilities**                                                                                       |       | 1,484,536                   |       | 1,426,059                   |       |
|                                                                                                        |       |                        |       |                        |       |
| **Shareholders’ equity**                                                                               |       |                        |       |                        |       |
| Preferred stock, no par value  Authorized shares - 400,000   Issued and outstanding shares - none           |       | —                      |       | —                      |       |
| Common stock $.50 stated value:  Authorized shares - 25,000,000   Issued shares - 13,755,409 and 11,196,357 |       |                        |       |                        |       |
| Outstanding shares - 13,472,616 and  10,985,121                                                             |       | 6,881                       |       | 5,600                       |       |
| Common stock to be distributed, 0 and  559,818 shares                                                       |       | —                      |       | 280                         |       |
| Treasury stock - 282,793 and 211,236, at  cost                                                              |       | (4,835                      | )          | (3,479                      | )          |
| Additional paid-in capital                                                                                  |       | 105,089                     |       | 73,451                      |       |
| Retained earnings                                                                                           |       | 57,067                      |       | 47,371                      |       |
| Accumulated other comprehensive  income/(loss)                                                              |       | (3,133                      | )          | 97                          |       |
| **Total shareholders’ equity**                                                                         |       | 161,069                     |       | 123,320                     |       |
| **Total liabilities and shareholders’ equity**                                                         |       | $                           | 1,645,605  |                        | $          | 1,549,379 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

26

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**MAINSOURCE FINANCIAL GROUP, INC.**

**CONSOLIDATED STATEMENTS OF INCOME**

**(Dollar amounts in thousands except per sharedata)**

 
| ** **                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                 |       |     |       |     |       |     |       |
| Interest income                                      |       |     |       |     |       |     |       |
| Loans, including fees                                |       | $        | 62,321     |     | $          | 56,580   |       | $ | 53,754 |   |
| Investment securities                                |       |     |       |     |       |     |       |
| Taxable                                              |       | 13,819   |       | 12,094   |       | 11,480   |       |
| Tax exempt                                           |       | 4,067    |       | 3,049    |       | 2,172    |       |
| Federal funds sold and money market funds            |       | 197      |       | 76       |       | 192      |       |
| Deposits with financial institutions                 |       | 71       |       | 42       |       | 7        |       |
| Total interest income                                |       | 80,475   |       | 71,841   |       | 67,605   |       |
| Interest expense                                     |       |     |       |     |       |     |       |
| Deposits                                             |       | 20,099   |       | 16,366   |       | 18,628   |       |
| Short-term borrowings                                |       | 975      |       | 580      |       | 172      |       |
| Subordinated debentures                              |       | 1,938    |       | 1,677    |       | 1,638    |       |
| Other borrowings                                     |       | 3,815    |       | 3,216    |       | 2,935    |       |
| Total interest expense                               |       | 26,827   |       | 21,839   |       | 23,373   |       |
| Net interest income                                  |       | 53,648   |       | 50,002   |       | 44,232   |       |
| Provision for loan losses                            |       | 1,040    |       | 600      |       | 1,325    |       |
| Net interest income after provision for  loan losses |       | 52,608   |       | 49,402   |       | 42,907   |       |
| Non-interest income                                  |       |     |       |     |       |     |       |
| Insurance commissions                                |       | 1,991    |       | 2,643    |       | 2,400    |       |
| Mortgage banking                                     |       | 2,693    |       | 3,198    |       | 5,671    |       |
| Trust and investment product fees                    |       | 1,119    |       | 911      |       | 678      |       |
| Service charges on deposit accounts                  |       | 7,510    |       | 6,912    |       | 5,092    |       |
| Net realized gains/(losses) on securities  sales     |       | (2,179   | )          | 991      |       | 1,300    |       |
| Increase in cash surrender value of life  insurance  |       | 891      |       | 1,016    |       | 626      |       |
| Interchange income                                   |       | 1,926    |       | 1,996    |       | 1,796    |       |
| Other income                                         |       | 3,381    |       | 1,877    |       | 1,880    |       |
| Total non-interest income                            |       | 17,332   |       | 19,544   |       | 19,443   |       |
| Non-interest expense                                 |       |     |       |     |       |     |       |
| Salaries and employee benefits                       |       | 27,121   |       | 25,411   |       | 22,421   |       |
| Net occupancy expenses                               |       | 3,542    |       | 3,165    |       | 2,753    |       |
| Equipment expenses                                   |       | 4,123    |       | 3,949    |       | 3,488    |       |
| Intangibles amortization                             |       | 1,306    |       | 1,059    |       | 909      |       |
| Telecommunications                                   |       | 1,664    |       | 1,581    |       | 1,287    |       |
| Stationery printing and supplies                     |       | 984      |       | 988      |       | 916      |       |
| Other expenses                                       |       | 9,836    |       | 9,727    |       | 8,674    |       |
| Total non-interest expense                           |       | 48,576   |       | 45,880   |       | 40,448   |       |
| Income before income tax                             |       | 21,364   |       | 23,066   |       | 21,902   |       |
| Income tax expense                                   |       | 5,172    |       | 6,273    |       | 6,597    |       |
| Net income                                           |       | $        | 16,192     |     | $          | 16,793   |       | $ | 15,305 |   |
|                                                 |       |     |       |     |       |     |       |
| Net income per share - basic and diluted             |       | $        | 1.29       |     | $          | 1.48     |       | $ | 1.37 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

27

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**MAINSOURCE FINANCIAL GROUP, INC.**

**CONSOLIDATED STATEMENTS OF SHAREHOLDERS’EQUITY**

**(Dollar amounts in thousands except per sharedata)**

 
| ** **                                                        | ** ** | ** **       | ** ** | ** **                       | ** ** | ** **             | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------|------------|------------------|------------|----------------------------------|------------|------------------------|------------|-----------------------------------------------|------------|------------|------------|---------------------------|------------|------------|------------|
| ** **                                                        | ** ** | **Common Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Total**  | ** ** | **Comprehensive  Income** | ** ** |
| **Shares  Outstanding**                                           | ** ** | **Amount**       |
| **Balance,  January 1, 2003**                                |       | 6,794,877        |       | $                                | 2,720      |                   | $          | 43,025                                        |       | $          | 49,529     |                      | $          | 4,497      |       | $ | 99,771 |   |   |   |
| Net income                                                        |       |             |       |                             |       |                   |       | 15,305                                        |       |       |       | 15,305                    |       | $          | 15,305     |   |
| Unrealized loss  on cash flow hedge, net                          |       |             |       |                             |       |                   |       |                                          |       | (117       | )          | (117                      | )          | (117       | )          |
| Unrealized loss  on securities net of reclassification adjustment |       |             |       |                             |       |                   |       |                                          |       | (3,165     | )          | (3,165                    | )          | (3,165     | )          |
| Total  comprehensive income                                       |       |             |       |                             |       |                   |       |                                          |       |       |       |                      |       | $          | 12,023     |   |
| Cash dividends  ($.435 per share)                                 |       |             |       |                             |       |                   |       | (4,857                                        | )          |       |       | (4,857                    | )          |       |       |
| 5% Stock dividend  and fractional shares                          |       | 340,537          |       | 170                              |       | 10,453                 |       | (10,639                                       | )          |       |       | (16                       | )          |       |       |
| Purchase of  treasury stock                                       |       | (64,938          | )          | (1,497                           | )          |                   |       |                                          |       |       |       | (1,497                    | )          |       |       |
| **Balance,  December 31, 2003**                              |       | 7,070,476        |       | 1,393                            |       | $                      | 53,478     |                                          | $          | 49,338     |       | $                         | 1,215      |       | $          | 105,424 |   |   |   |
| Net income                                                        |       |             |       |                             |       |                   |       | 16,793                                        |       |       |       | 16,793                    |       | $          | 16,793     |   |
| Unrealized gain  on cash flow hedge, net                          |       |             |       |                             |       |                   |       |                                          |       | 148        |       | 148                       |       | 148        |       |
| Unrealized loss  on securities net of reclassification adjustment |       |             |       |                             |       |                   |       |                                          |       | (1,266     | )          | (1,266                    | )          | (1,266     | )          |
| Total comprehensive  income                                       |       |             |       |                             |       |                   |       |                                          |       |       |       |                      |       | $          | 15,675     |   |
| Cash dividends  ($.476 per share)                                 |       |             |       |                             |       |                   |       | (5,391                                        | )          |       |       | (5,391                    | )          |       |       |
| 3:2 Stock split  and fractional shares                            |       | 3,581,508        |       | 1,791                            |       | (1,800                 | )          |                                          |       |       |       | (9                        | )          |       |       |
| Issuance of  common stock in acquisition                          |       | 449,224          |       | 225                              |       | 8,701                  |       |                                          |       |       |       | 8,926                     |       |       |       |
| 5% Stock dividend  and fractional shares                          |       | 559,818          |       | 280                              |       | 13,068                 |       | (13,369                                       | )          |       |       | (21                       | )          |       |       |
| Exercise of stock  options                                        |       | 1,575            |       | 24                               |       | 4                      |       |                                          |       |       |       | 28                        |       |       |       |
| Purchase of  treasury stock                                       |       | (117,662         | )          | (1,312                           | )          |                   |       |                                          |       |       |       | (1,312                    | )          |       |       |
| **Balance,  December 31, 2004**                              |       | 11,544,939       |       | $                                | 2,401      |                   | $          | 73,451                                        |       | $          | 47,371     |                      | $          | 97         |       | $ | 123,320 |   |   |   |
| Net income                                                        |       |             |       |                             |       |                   |       | $                                             | 16,192     |       |       |                      | $          | 16,192     |       | $ | 16,192 |   |
| Unrealized gain  on cash flow hedge, net                          |       |             |       |                             |       |                   |       |                                          |       | 225        |       | 225                       |       | 225        |       |
| Unrealized loss  on securities net of reclassification adjustment |       |             |       |                             |       |                   |       |                                          |       | (3,455     | )          | (3,455                    | )          | (3,455     | )          |
| Total  comprehensive income                                       |       |             |       |                             |       |                   |       |                                          |       |       |       |                      |       | $          | 12,962     |   |
| Cash dividends  ($.52 per share)                                  |       |             |       |                             |       |                   |       | (6,496                                        | )          |       |       | (6,496                    | )          |       |       |
| 5% Stock dividend  - treasury shares                              |       | (10,562          | )          |                             |       |                   |       |                                          |       |       |       | —                    |       |       |       |
| 5% stock dividend  and fractional shares                          |       | (766             | )          |                             |       | (18                    | )          |                                          |       |       |       | (18                       | )          |       |       |
| Exercise of stock  options                                        |       | 3,142            |       | 52                               |       | (4                     | )          |                                          |       |       |       | 48                        |       |       |       |
| Purchase of  treasury stock                                       |       | (1,209           | )          | (27                              | )          |                   |       |                                          |       |       |       | (27                       | )          |       |       |
| Disposal of MSI -  Kentucky                                       |       | (62,928          | )          | (1,380                           | )          |                   |       |                                          |       |       |       | (1,380                    | )          |       |       |
| Issuance of  common stock in acquisition                          |       | 2,000,000        |       | 1,000                            |       | 31,660                 |       |                                          |       |       |       | 32,660                    |       |       |       |
| **Balance,  December 31, 2005**                              |       | 13,472,616       |       | $                                | 2,046      |                   | $          | 105,089                                       |       | $          | 57,067     |                      | $          | (3,133     | )          | $ | 161,069 |   |   |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

28

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** **

**MAINSOURCE FINANCIAL GROUP, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOW**

**(Dollars in thousands)**

 
| ** **                                                                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Operating Activities**                                                           |       |     |       |     |       |     |       |
| Net income                                                                         |       | $        | 16,192     |     | $          | 16,793   |       | $ | 15,305 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |     |       |     |       |     |       |
| Provision for loan losses                                                          |       | 1,040    |       | 600      |       | 1,325    |       |
| Depreciation and amortization                                                      |       | 3,087    |       | 2,962    |       | 2,629    |       |
| Amortization of mortgage servicing rights                                          |       | 558      |       | 956      |       | 1,863    |       |
| Securities amortization, net                                                       |       | 1,197    |       | 2,469    |       | 4,093    |       |
| Amortization of core deposit intangibles                                           |       | 1,306    |       | 1,059    |       | 909      |       |
| Increase in cash surrender value of life  insurance policies                       |       | (891     | )          | (930     | )          | (571     | )          |
| Gain on life insurance benefit                                                     |       | (459     | )          | —   |       | —   |       |
| Investment securities (gains)/losses                                               |       | 2,179    |       | (991     | )          | (1,300   | )          |
| Gain on the sale of loans                                                          |       | (944     | )          | (1,301   | )          | (3,836   | )          |
| Change in loans held for sale                                                      |       | (798     | )          | 2,442    |       | 15,898   |       |
| Change in other assets and liabilities                                             |       | 12,699   |       | 2,904    |       | 3,526    |       |
| Net cash provided by operating activities                                          |       | 35,166   |       | 26,963   |       | 39,841   |       |
|                                                                               |       |     |       |     |       |     |       |
| **Investing Activities**                                                           |       |     |       |     |       |     |       |
| Net change in short-term investments                                               |       | 94       |       | 197      |       | (201     | )          |
| Proceeds from maturities and payments on  securities held to maturity              |       | 277      |       | —   |       | 1,288    |       |
| Purchases of securities available for sale                                         |       | (257,256 | )          | (166,864 | )          | (379,327 | )          |
| Proceeds from maturities and payments on  securities available for sale            |       | 119,472  |       | 110,650  |       | 182,311  |       |
| Proceeds from sales of securities available  for sale                              |       | 106,556  |       | 69,347   |       | 117,382  |       |
| Purchases of restricted stock                                                      |       | (2,834   | )          | (455     | )          | —   |       |
| Proceeds from life insurance benefit                                               |       | 1,675    |       | —   |       | —   |       |
| Loan originations and payments, net                                                |       | 19,856   |       | 4,435    |       | 4,197    |       |
| Purchases of premises and equipment                                                |       | (3,455   | )          | (2,468   | )          | (1,960   | )          |
| Cash received from branch acquisitions, net                                        |       | —   |       | —   |       | 12,203   |       |
| Cash received/(paid) for bank acquisitions,  net                                   |       | 111,785  |       | (342     | )          | (12,836  | )          |
| Purchase of life insurance policies                                                |       | —   |       | —   |       | (15,000  | )          |
| Net cash provided (used) by investing  activities                                  |       | 96,170   |       | 14,500   |       | (91,943  | )          |
|                                                                               |       |     |       |     |       |     |       |
| **Financing Activities**                                                           |       |     |       |     |       |     |       |
| Net change in deposits                                                             |       | (58,374  | )          | (64,660  | )          | 21,869   |       |
| Net change in short-term borrowings                                                |       | (30,659  | )          | 29,343   |       | 7,229    |       |
| Repayment of note payable                                                          |       | (9,100   | )          | (4,100   | )          | (2,900   | )          |
| Proceeds from issuance of long term debt                                           |       | —   |       | —   |       | 13,000   |       |
| Proceeds from FHLB advances                                                        |       | 220,000  |       | 123,500  |       | —   |       |
| Repayment of FHLB advances                                                         |       | (269,434 | )          | (99,426  | )          | (1,262   | )          |
| Redemption of subordinated debentures                                              |       | —   |       | —   |       | (22,425  | )          |
| Proceeds from issuance of subordinated  debentures                                 |       | —   |       | —   |       | 21,898   |       |
| Proceeds from common stock issuance                                                |       | 32,660   |       | —   |       | —   |       |
| Purchase of treasury shares                                                        |       | (27      | )          | (1,312   | )          | (1,497   | )          |
| Cash dividends and fractional share  payments                                      |       | (6,514   | )          | (5,421   | )          | (4,873   | )          |
| Proceeds from exercise of stock options                                            |       | 48       |       | 28       |       | —   |       |
| Net cash provided (used) by financing  activities                                  |       | (121,400 | )          | (22,048  | )          | 31,039   |       |
| Net change in cash and cash equivalents                                            |       | 9,936    |       | 19,415   |       | (21,063  | )          |
| Cash and cash equivalents, beginning of  year                                      |       | 76,269   |       | 56,854   |       | 77,917   |       |
| Cash and cash equivalents, end of year                                             |       | $        | 86,205     |     | $          | 76,269   |       | $ | 56,854 |   |
|                                                                               |       |     |       |     |       |     |       |
| Supplemental Information                                                           |       |     |       |     |       |     |       |
| Interest paid                                                                      |       | $        | 25,845     |     | $          | 22,640   |       | $ | 23,683 |   |
| Income taxes paid                                                                  |       | 5,658    |       | 3,487    |       | 4,150    |       |
| Loan balances transferred to foreclosed  real estate                               |       | 3,692    |       | 2,741    |       | 1,896    |       |

 

See Note 2 regarding non-cash transactions included in acquisitions anddispositions and Note 4 regarding non-cash securities transfer in 2005.

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

29

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**NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS**

**(**Dollar amounts inthousands except per share data)

** **

**NOTE 1**– SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES

** **

Natureof Operations and Principles of Consolidation:  The consolidated financial statements includeMainSource Financial Group, Inc. and its wholly owned subsidiaries,together referred to as “the Company”. Intercompany transactions and balances are eliminated in consolidation.

 

TheCompany’s wholly owned subsidiaries include MainSource Bank, MainSource Bank ofIllinois (formerly known as Capstone Bank), MainSource Insurance, LLC,MainSource Title, LLC, MainSource Mortgage, LLC, and IUB Reinsurance Company,Ltd.  In February 2005, the Companydisposed of the Kentucky division of its insurance subsidiary.  The disposition did not result in asignificant gain or loss to the Company as it was sold at its approximate bookvalue.  In February 2005, theCompany merged its wholly-owned subsidiary of Regional Bank into MainSourceBank and in October 2005, the Company merged its wholly-owned subsidiaryof Peoples Trust Company into MainSource Bank.

 

TheCompany provides financial services through its offices in Indiana andIllinois.  Its primary deposit productsare checking, savings, and term certificate accounts, and its primary lendingproducts are residential mortgage, commercial, and installment loans.  Substantially all loans are secured byspecific items of collateral including business assets, consumer assets andreal estate.  Commercial loans areexpected to be repaid from cash flow from operations of businesses.  Real estate loans are secured by bothresidential and commercial real estate. Other financial instruments which potentially represent concentrationsof credit risk include deposit accounts in other financial institutions andfederal funds sold.

 

Use of Estimates:  To prepare financial statements in conformitywith accounting principles generally accepted in the United States of America,management makes estimates and assumptions based on available information.  These estimates and assumptions affect theamounts reported in the financial statements and the disclosures provided andactual results could differ.  Theallowance for loan losses, loan servicing rights, and fair values of financialinstruments are particularly subject to change.

 

Cash Flows:  Cash and cash equivalents include cash anddue from banks, interest bearing deposits with other financial institutionswith maturities under 90 days, money market funds and federal funds sold.  Net cash flows are reported for loan anddeposit transactions, federal funds purchased and repurchase agreements.

 

Securities:  Securities are classified as held to maturityand carried at amortized cost when management has the positive intent andability to hold them to maturity. Securities are classified as available for sale when they might be soldbefore maturity.  Securities availablefor sale are carried at fair value, with unrealized holding gains and lossesreported in other comprehensive income.

 

Interestincome includes amortization of purchase premium or discount.  Premiums and discounts on securities areamortized on the level-yield method, which considers prepayments onmortgage-backed securities.  Gains andlosses on sales are based on the amortized cost of the security sold.  Declines in the fair value of securitiesbelow their cost that are other than temporary are reflected as realizedlosses.  In estimatingother-than-temporary losses, management considers (1) the length of timeand extent that fair value has been less than cost, (2) the financialcondition and near term prospects of the issuer, and (3) the Company’sability and intent to hold the security for a period sufficient to allow forany anticipated recovery in fair value.

 

Loans Held for Sale: Loans originated and intended for sale in the secondary market arecarried at the lower of cost or market in the aggregate.  Net unrealized losses, if any, are recordedas a valuation allowance and charged to earnings.

 

Mortgageloans held for sale are generally sold with servicing rights retained.  The carrying value of mortgage loans sold isreduced by the cost allocated to the servicing right.  Gains and losses on sales of mortgage loansare based on the difference between the selling price and the carrying value ofthe related loan sold.

 

30

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Loans:  Loans that management has the intent andability to hold for the foreseeable future or until maturity or payoff arereported at the principal balance outstanding, net of unearned interest,deferred loan fees and costs, and an allowance for loan losses.  Interest income is accrued on the unpaidprincipal balance.  Loan originationsfees, net of certain direct origination costs, are deferred and recognized ininterest income using the level-yield method without anticipating prepayments.

 

Interestincome is not reported when full loan repayment is in doubt, typically when theloan is impaired or payments are past due over 90 days.  Loans are placed on non-accrual orcharged-off at an earlier date if collection of principal or interest isconsidered doubtful.

 

Allinterest accrued but not received for loans placed on nonaccrual is reversedagainst interest income.  Paymentsreceived on such loans subsequent to being placed on non-accrual are applied tothe principal balance of the loans. Loans are returned to accrual status when all the principal and interestamounts contractually due are brought current and future payments arereasonably assured.

 

Allowance for Loan Losses:  The allowance for loan lossesis a valuation allowance for probable incurred credit losses.  Loan losses are charged against the allowancewhen management believes the uncollectibility of a loan balance isconfirmed.  Subsequent recoveries, ifany, are credited to the allowance. Management estimates the allowance balance required using past loan lossexperience, the nature and volume of the portfolio, information about specificborrower situations and estimated collateral values, economic conditions, andother factors.  Allocations of theallowance may be made for specific loans, but the entire allowance is availablefor any loan that, in management’s judgment, should be charged-off.

 

Theallowance consists of specific and general components.  The specific component relates to loans thatare individually classified as impaired or loans otherwise classified assubstandard or doubtful.  The generalcomponent covers pools of other loans and is based on historical loss experienceadjusted for current factors.

 

Aloan is impaired when full payment under the loan terms is not expected.  Impairment is evaluated in total forsmaller-balance loans of similar nature such as residential real estate andconsumer loans, and is not separately identified for impairmentdisclosure.  Other loans are evaluatedindividually for impairment.  If a loanis impaired, a portion of the allowance is allocated so that the loan isreported, net, at the present value of estimated future cash flows using theloan’s existing rate or at the fair value of collateral if repayment isexpected solely from the collateral.

 

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

 

Foreclosed Assets:  Assets acquired through orinstead of loan foreclosure are initially recorded at fair value when acquirednet of estimated selling costs, establishing a new cost basis.  If fair value declines after acquisition, avaluation allowance is recorded through expense.  Costs after acquisition are expensed.

 

Premises and Equipment:  Land is carried at cost.  Premises and equipment are stated at costless accumulated depreciation.  Buildingsand related components are depreciated using the straight-line method withuseful lives ranging from 30 to 39 years for buildings and 5 to 15 years forcomponents.  Furniture, fixtures andequipment are depreciated using the straight-line method with useful livesranging from 3 to 10 years.

 

31

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Company Owned Life Insurance:  The Company has purchased lifeinsurance policies on certain employees. Company owned life insurance is recorded at its cash surrender value, orthe amount that can be realized.

 

Servicing Assets:  Servicing assets represent the allocatedvalue of retained servicing rights on loans sold.  Servicing assets are expensed in proportionto, and over the period of, estimated net servicing revenues.  Impairment is evaluated based on the fairvalue of the assets, using groupings of the underlying loans as to product typeand interest rates.  Fair value isdetermined using prices for similar assets with similar characteristics, whenavailable, or based upon discounted cash flows using market-basedassumptions.  Any impairment of agrouping is reported as a valuation allowance, to the extent that fair value isless than the capitalized amount for a grouping.

 

**Transfers of Financial Assets**:  Transfers offinancial assets are accounted for as sales when control over the assets hasbeen surrendered.  Control overtransferred assets is deemed to be surrendered when (1) the assets havebeen isolated from the Company, (2) the transferee obtains the right (freeof conditions that constrain it from taking advantage of that right) to pledgeor exchange the transferred assets, and (3) the Company does not maintaineffective control over the transferred assets through an agreement or option torepurchase them before their maturity.

** **

Goodwill and Other Intangible Assets:  Goodwill results from business acquisitionsand represents the excess of the purchase price over the fair value of acquiredtangible assets and liabilities and identifiable intangible assets. Goodwill isassessed at least annually for impairment and any such impairment will berecognized in the period identified.

 

Other intangible assets consist of core deposit intangiblesarising from whole bank and branch acquisitions.  They are initially measured at fair value andthen are amortized on an accelerated method over their estimated useful lives,generally ten years.

 

Long-term Assets:** **Premises and equipment and otherlong-term assets are reviewed for impairment when events indicate theircarrying amount may not be recoverable from future undiscounted cashflows.  If impaired, the assets arerecorded at fair value.

 

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.  Repurchaseagreements are included in short-term borrowings on the consolidated balancesheets.

 

Income Taxes:  Income tax expense is the total of thecurrent year income tax due or refundable and the change in deferred tax assetsand liabilities.  Deferred tax assets andliabilities are the expected future tax amounts for the temporary differencesbetween carrying amounts and tax bases of assets and liabilities, computedusing enacted tax rates.  A valuationallowance, if needed, reduces deferred tax assets to the amount expected to berealized.

 

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

 

Derivatives:  All derivative instruments are recorded attheir fair values.  If derivativeinstruments are designated as hedges of fair values, both the change in thefair value of the hedge and the hedged item are included in currentearnings.  Fair value adjustments relatedto cash flow hedges are recorded in other comprehensive income and reclassifiedto earnings when the hedged transaction is reflected in earnings.  Ineffective portions of hedges are reflectedin earnings as they occur.

 

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Mortgage Banking Income:  Mortgage banking incomeconsists of gains on loan sales, mortgage servicing rights, and loan servicingfee income, net of amortization of mortgage servicing rights.

 

Stock Compensation:  Compensation expense for stockoptions is reported using the intrinsic value method.  No stock-based compensation cost is reflectedin net income, as all options granted had an exercise price equal to or greaterthan the market price of the underlying common stock at date of grant.  The following table illustrates the effect onnet income and earnings per share if expense was measured using the fair valuerecognition provisions of FASB Statement No. 123, “Accounting forStock-Based Compensation”.  During 2005,the Company accelerated vesting on selected pools of stock options granted inorder to reduce expense that would have been recognized upon adoption of FAS123R.

 
| ** **                                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income as reported                                                                   |       | $        | 16,192     |     | $          | 16,793   |       | $ | 15,305 |   |
| Deduct: Stock-based compensation expense,  net, determined under fair value based method |       | 517      |       | 92       |       | 29       |       |
| Pro forma net income                                                                     |       | $        | 15,675     |     | $          | 16,701   |       | $ | 15,276 |   |
|                                                                                     |       |     |       |     |       |     |       |
| Basic earnings per share as reported                                                     |       | $        | 1.29       |     | $          | 1.48     |       | $ | 1.37 |   |
| Pro forma basic earnings per share                                                       |       | $        | 1.25       |     | $          | 1.47     |       | $ | 1.37 |   |
|                                                                                     |       |     |       |     |       |     |       |
| Diluted earnings per share as reported                                                   |       | $        | 1.29       |     | $          | 1.48     |       | $ | 1.37 |   |
| Pro forma diluted earnings per share                                                     |       | $        | 1.25       |     | $          | 1.47     |       | $ | 1.37 |   |

 

The pro forma effects arecomputed using option pricing models, with the following weighted-averageassumptions for 2005 as of grant date: risk-free interest rate 4.08%, expectedoption life 6.83 years, expected stock price volatility 21.64% and dividendyield 2.50%.  For 2004, the followingweighted-average assumptions were used as of the grant date: risk-free interestrate 3.48%, expected option life 6.69 years, expected stock price volatility20.34% and dividend yield 2.75%.  For2003, the following weighted-average assumptions were used as of the grantdate: risk-free interest rate 2.80%, expected option life 6.54 years, expectedstock price volatility 18.60% and dividend yield 2.90%.

 

Earnings Per Common Share:  Basic earnings per commonshare is net income divided by the weighted average number of common sharesoutstanding during the period.  Dilutedearnings per common share includes the dilutive effect of additional potentialcommon shares issuable under stock options. Earnings and dividends per share are restated for all stock splits anddividends through the date of issue of the financial statements.

 

Comprehensive Income:  Comprehensive income consistsof net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses onsecurities available for sale and unrealized gains and losses on cash flowhedges, which are also recognized as a separate component of equity.  

 

Loss Contingencies:  Loss contingencies, includingclaims and legal actions arising in the ordinary course of business, arerecorded as liabilities when the likelihood of loss is probable and an amountor range of loss can be reasonably estimated. Management does not believe there are now any such matters that willhave a material effect on the financial statements.

 

Dividend Restriction:  Banking regulations requiremaintaining certain capital levels and may limit the dividends paid by thebanks to the holding company or by the holding company to shareholders.  These

 

33

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restrictionspose no practical limit on the ability of the banks or holding company to paydividends at historical levels.

 

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

 

Operating Segments:  While the Company’schief decision-makers monitor the revenue streams of the various Companyproducts and services, the identifiable segments are not material andoperations are managed and financial performance is evaluated on a Company-widebasis.  Accordingly, all of the Company’sfinancial service operations are considered by management to be aggregated inone reportable operating segment.

 

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

 

Recently Issued Accounting Standards: During 2005, the Companyadopted the following accounting standards and guidance: SOP 03-3 and FASBStaff Position 115-1.  Additionally, theCompany will adopt FAS 123R on January 1, 2006.  The impact of these issues is discussedbelow.

 

SOP 03-3requires that acquired loans to be recorded at the amount of the purchaser’sinitial investment and prohibits carrying over valuation allowances from theseller for those individually evaluated loans that have evidence ofdeterioration in credit quality since origination, and it is probable all contractualcash flows on the loan will be unable to be collected.  SOP 03-3 also requires the excess of allundiscounted cash flows expected to be collected at acquisition over thepurchaser’s initial investment to be recognized as interest income on a level-yieldbasis over the life of the loan. Subsequent increases in cash flows expected to be collected arerecognized prospectively through an adjustment of the loan’s yield over itsremaining life, while subsequent decreases are recognized as impairment.  Management adopted the provision of SOP 03-03effective January 1, 2005.  Theadoption of this standard did not have a material impact on financialcondition, results of operation, or liquidity as no material amount of loansacquired in the current year fell within the scope of this standard.

 

In November 2005,the Financial Accounting Standards Board (FASB) issued FASB Staff Position 115-1,“The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments.”  This FSP provides additionalguidance on when an investment in a debt or equity security should beconsidered impaired and when that impairment should be consideredother-than-temporary and recognized as a loss in earnings.  Specifically, the guidance clarifies that aninvestor should recognize an impairment loss no later than when the impairmentis deemed other-than-temporary, even if a decision to sell has not beenmade.  The FSP also requires certaindisclosures about unrealized losses that have not been recognized as other-than-temporaryimpairments.  Management applied thisguidance in this FSP in 2005.

 

FAS123, Revised, requires all public companies to record compensation cost forstock options provided to employees in return for employee service.  The cost is measured at the fair value of theoptions when granted, and this cost is expensed over the employee serviceperiod, which is normally the vesting period of the options.  This will apply to awards granted or modifiedin fiscal years beginning in 2006. Compensation cost will also be recorded for prior option grants thatvest after the date of adoption.  Theeffect on results of operations will depend on the level of future optiongrants and the calculation of the fair value of the options granted at suchfuture date, as well as the vesting periods provided, and so cannot currentlybe predicted.  Existing options that willvest after adoption date are expected to result in additional compensationexpense of approximately $28 during 2006, $13 in 2007, $3 in 2008, and $2 in2009.

 

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**NOTE 2 – BUSINESS COMBINATIONS**

 

InAugust 2005, the Company acquired 100% of the outstanding shares of TheMadison Bank & Trust Company. Operating results of this acquisition are included in the consolidatedfinancial statements since the date of the acquisition.  As a result of this acquisition, the Companyexpects to further solidify its market share in the southern Indiana market,expand its customer base to enhance deposit fee income, provide an opportunityto market additional products and services to new customers, and reduceoperating costs through economies of scale.

 

Theaggregate purchase price was $30.3 million in cash.  The purchase price resulted in approximately$12.0 million in goodwill, and $4.2 million in core deposit intangible.  The core deposit intangible asset is beingamortized over 10 years, using an accelerated method.  Goodwill will not be amortized but willinstead be evaluated periodically for impairment.  Goodwill and intangible assets will bededucted for tax purposes over 15 years using a straight line method.  As of the date of this report, the Companywas in the process of obtaining third party valuations and completing fair valueestimates for certain assets acquired and liabilities assumed, and theallocation of the purchase price is subject to refinement.

 

The following table summarizes the estimated fair value of assetsacquired and liabilities assumed at the date of acquisition.

 
| Cash                      |   | $        | 142,046 |   |
|---------------------------|--------|----------|---------|--------|
| Loans, net                |   | 54,835   |    |
| Goodwill                  |   | 11,990   |    |
| Core deposit intangible   |   | 4,151    |    |
| Other assets              |   | 2,372    |    |
| Total assets acquired     |   | 215,394  |    |
| Deposits                  |   | (184,704 | )       |
| Other liabilities         |   | (423     | )       |
| Total liabilities assumed |   | (185,127 | )       |
| Net assets acquired       |   | $        | 30,267  |   |

 

**Pending Acquisitions:**

 

InAugust 2005, the Company executed a definitive agreement to acquire UnionCommunity Bancorp (“Union”).  Union,which has approximately $255 million in assets, operates a total of six officesin Montgomery, Fountain, Warren, and Tippecanoe Counties in Indiana through itswholly-owned subsidiary, Union Federal Bank and Trust Association.  Thetransaction is expected to close in the first quarter of 2006.

 

InSeptember 2005, the Company executed a definitive agreement to acquirePeoples Ohio Financial Corporation (“Peoples”). Peoples, which has approximately $201 million in assets, operates atotal of six offices in Montgomery and Miami Counties in Ohio through its wholly-ownedsubsidiary, Peoples Savings Bank of Troy.  The transaction is expected toclose in the second quarter of 2006.

 

InOctober 2005, the Company executed a definitive agreement to acquire HFSBank, F.S.B. (“HFS”).  HFS, which hasapproximately $236 million in assets, operates a total of six offices inHobart, Portage, Griffith and Crown Point, Indiana.  The transaction is expected to close in thesecond quarter of 2006.

 

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**NOTE 3 – RESTRICTION ON CASH AND DUE FROMBANKS**

 

The Banks are required to maintain reserve funds in cash or on depositwith the Federal Reserve Bank which do not earn interest. The reserves requiredat December 31, 2005 and 2004 were $23,313 and $18,614, respectively.  The Company also had compensating balances of$3,382 and $6,229 at December 31, 2005 and 2004 respectively.

 

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**NOTE 4 - SECURITIES**

** **

Thefair value of securities available for sale and related unrealized gains/lossesrecognized in  accumulated othercomprehensive income (loss) were as follows:

 
| ** **                       | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross   Unrealized  Losses** | ** ** |
|----------------------------------|------------|-----------------|------------|------------------------------|------------|--------------------------------|------------|
| **As of Dectember 31, 2005**     | ** ** | ** **      | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| Available for Sale               |       |            |       |                         |       |                           |       |
| Federal agencies                 |       | $               | 77,196     |                         | $          | 94                             |       | $ | (552 | ) |
| State and municipal              |       | 112,785         |       | $                            | 995        |                           | (1,369     | ) |
| Mortgage-backed securities       |       | 246,994         |       | $                            | 344        |                           | (5,211     | ) |
| Equity and other securities      |       | 13,839          |       | $                            | 427        |                           | —     |   |
| Total available for sale         |       | $               | 450,814    |                         | $          | 1,860                          |       | $ | (7,132 | ) |
|                             |       |            |       |                         |       |                           |       |
| **As of December 31, 2004** |       |            |       |                         |       |                           |       |
| Available for Sale               |       |            |       |                         |       |                           |       |
| Federal agencies                 |       | $               | 56,557     |                         | $          | 152                            |       | $ | (388 | ) |
| State and municipal              |       | 88,338          |       | 1,546                        |       | (583                           | )          |
| Mortgage-backed securities       |       | 262,690         |       | 1,005                        |       | (1,924                         | )          |
| Equity and other securities      |       | 17,858          |       | 427                          |       | (60                            | )          |
| Total available for sale         |       | $               | 425,443    |                         | $          | 3,130                          |       | $ | (2,955 | ) |

 

During the third quarter of 2005, managementtransferred all held to maturity securities to available for  sale category. This redesignation resulted in the transfer of securities with anamortized cost of $3,005 and a fair value of $3,113 from held to maturity toavailable for sale.  This transferresulted in an increase to shareholders’ equity of $70 as of September 30,2005.  For the foreseeable future, newlyacquired securities will not be classified as held to maturity.

 

The carrying amount, unrecognized gains andlosses, and fair value of securities held to maturity  at year end 2004 were as follows:  

 
| **As of December 31, 2004** | ** ** | **Carrying  Amount** | ** ** | **Gross  Unrecognized  Gains** | ** ** | **Gross   Unrecognized  Losses** | ** ** | **Fair  Value** | ** ** |
|----------------------------------|------------|----------------------|------------|--------------------------------|------------|----------------------------------|------------|-----------------|------------|
| ** **                       | ** ** | ** **           | ** ** | ** **                     | ** ** | ** **                       | ** ** | ** **      | ** ** |
| Held to Maturity                 |       |                 |       |                           |       |                             |       |            |       |
| State and municipal              |       | $                    | 2,439      |                           | $          | 74                               |       | $               | —     |   | $ | 2,513 |   |
| Other securities                 |       | 804                  |       | 97                             |       | —                           |       | 901             |       |
| Total held to maturity           |       | $                    | 3,243      |                           | $          | 171                              |       | $               | —     |   | $ | 3,414 |   |

 

No securities were classified as held tomaturity at year end 2005. Contractual maturities of securities at December 31,2005 were as follows.  Securities not dueat a single  maturity at year end areshown separately.

 
| ** **                  | ** ** | **Available  for Sale** | ** **    |
|-----------------------------|------------|-------------------------|---------------|
| ** **                  | ** ** | **Fair  Value**         | ** **    |
| Within one year             |       | $                       |  7,206   |   |
| Two through five years      |       | 78,243                  |          |
| Six through ten years       |       | 44,089                  |          |
| After ten years             |       | 60,443                  |          |
| Mortgage-backed             |       | 246,994                 |          |
| Equity and other            |       | 13,839                  |          |
| Total investment securities |       | $                       |  450,814 |   |

 

Gross proceeds from sales of securitiesavailable for sale during 2005, 2004 and  2003 were $106,556, $69,347, and $117,382.Gross gains of $294, $1,020, and $1,443 and gross  losses of $2,473, $29, and $143 were realizedon those sales in 2005, 2004 and 2003, respectively.

 

Securities with a carrying value of $152,542and $110,175 were pledged at December 31, 2005 and 2004 to secure certain deposits, repurchaseagreements and for other  purposes aspermitted or required by law.

 

37

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Belowis a summary of securities with unrealized losses as of year-end 2005 and 2004presented by length of time the securities  have been in a continuous unrealized lossposition.

 

**2005**

 
| ** **                    | ** ** | **Less than 12 months** | ** ** | **12 months or longer** | ** ** | **Total**      | ** ** |
|-------------------------------|------------|-------------------------|------------|-------------------------|------------|----------------|------------|
| **Description of securities** | ** ** | **Fair Value**          | ** ** | **Unrealized  Losses**  | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| Federal agencies              |       | $                       | 52,984     |                    | $          | (552           | )          | $ | — |   | $ | — |   | $ | 52,984 |   | $ | (552 | ) |
| State and municipal           |       | 45,073                  |       | (689                    | )          | 20,782         |       | (680 | ) | 65,855 |   | (1,369 | ) |
| Mortgage-backed securities    |       | 172,599                 |       | (4,082                  | )          | 36,818         |       | (1,129 | ) | 209,417 |   | (5,211 | ) |
| Equity and other securities   |       | —                  |       | —                  |       | —         |       | — |   | — |   | — |   |
| Total temporarily impaired    |       | $                       | 270,656    |                    | $          | (5,323         | )          | $ | 57,600 |   | $ | (1,809 | ) | $ | 328,256 |   | $ | (7,132 | ) |

 

**2004**

 
| ** **                     | ** ** | **Less  than 12 months** | ** ** | **12  months or longer** | ** ** | **Total**       | ** ** |
|--------------------------------|------------|--------------------------|------------|--------------------------|------------|-----------------|------------|
| **Description  of securities** | ** ** | **Fair  Value**          | ** ** | **Unrealized  Losses**   | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
| Federal agencies               |       | $                        | 33,536     |                     | $          | (388            | )          | $ | — |   | $ | — |   | $ | 33,536 |   | $ | (388 | ) |
| State and municipal            |       | 32,139                   |       | (509                     | )          | 2,713           |       | (74 | ) | 34,852 |   | (583 | ) |
| Mortgage-backed securities     |       | 138,958                  |       | (879                     | )          | 56,602          |       | (1,045 | ) | 195,560 |   | (1,924 | ) |
| Equity and other securities    |       | —                   |       | —                   |       | 3,000           |       | (60 | ) | 3,000 |   | (60 | ) |
| Total temporarily impaired     |       | $                        | 204,633    |                     | $          | (1,776          | )          | $ | 62,315 |   | $ | (1,179 | ) | $ | 266,948 |   | $ | (2,955 | ) |

 

Unrealized losses on state and municipalsecurities have not been recognized into income because  management has the intent and ability to holdfor a period of time sufficient to allow for any anticipated recovery in fairvalue.   The fair value of debt securities is expectedto recover as the securities approach their maturity date.

 

Unrealized losses on mortgage-backed securitiesand agencies have not been recognized into income as the decline in fair value  is largely due to increases in market interestrates.  The fair value is expected torecover as the bonds approach their maturity date  and/or market rates decline.

 

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**NOTE 5 - LOANS AND ALLOWANCE FOR LOAN LOSSES**

 

 
| ** **                        | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
|                              |       |                        |       |                        |       |
| Commercial and industrial loans   |       | $                           | 149,074    |                        | $          | 154,717 |   |
| Agricultural production financing |       | 23,871                      |       | 22,647                      |       |
| Farm real estate                  |       | 38,833                      |       | 38,281                      |       |
| Commercial real estate            |       | 160,061                     |       | 133,360                     |       |
| Hotel                             |       | 47,939                      |       | 80,234                      |       |
| Residential real estate           |       | 368,953                     |       | 353,515                     |       |
| Construction and development      |       | 45,783                      |       | 37,821                      |       |
| Consumer                          |       | 123,481                     |       | 108,430                     |       |
| Total loans                       |       | 957,995                     |       | 929,005                     |       |
| Allowance for loan lossess        |       | (10,441                     | )          | (11,698                     | )          |
| Net loans                         |       | $                           | 947,554    |                        | $          | 917,307 |   |

 

Activity in the allowance for loan losses wasas follows:
| **December 31**                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                |       |     |       |     |       |     |       |
| Allowance for loan losses           |       |     |       |     |       |     |       |
| Balances, January 1            |       | $        | 11,698     |     | $          | 11,509   |       | $ | 9,517 |   |
| Addition resulting from acquisition |       | 1,002    |       | 1,775    |       | 2,078    |       |
| Provision for losses                |       | 1,040    |       | 600      |       | 1,325    |       |
| Recoveries on loans                 |       | 284      |       | 346      |       | 509      |       |
| Loans charged off                   |       | (3,583   | )          | (2,532   | )          | (1,920   | )          |
| Balances, December 31          |       | $        | 10,441     |     | $          | 11,698   |       | $ | 11,509 |   |

 

Impaired loans were as follows:
| **December 31**                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                               |       |     |       |     |       |     |       |
| Impaired loans with an allowance allocated         |       | $        | 5,888      |     | $          | 8,908    |       | $ | 6,954 |   |
| Impaired loans with no allocated allowances        |       | 4,239    |       | —   |       | —   |       |
| Total impaired loans                               |       | $        | 10,127     |     | $          | 8,908    |       | $ | 6,954 |   |
| Allowance allocated for impaired loans             |       | $        | 1,615      |     | $          | 1,578    |       | $ | 1,086 |   |
| Average balance of impaired loans during  the year |       | $        | 13,431     |     | $          | 6,758    |       | $ | 4,997 |   |
| Interest income recognized on impaired  loans      |       | —   |       | —   |       | —   |       |
| Cash basis interest included above                 |       | —   |       | —   |       | —   |       |

 

Nonperforming loans were asfollows:
| **December 31**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|
| Loans past due 90 days or more still on  accrual |       | $        | 233        |     | $          | 431 |   |
| Nonaccrual loans                                 |       | 9,984    |       | 13,611   |       |
|                                             |       | $        | 10,217     |     | $          | 14,042 |   |

 

Nonperformingloans include both smaller balance homogeneous loans that are collectivelyevaluated for impairment and individually classified impaired loans.

 

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**NOTE 6 -PREMISES AND EQUIPMENT**

 
| **December 31**     | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
|                     |       |     |       |     |       |
| Land                     |       | $        | 4,762      |     | $          | 4,604 |   |
| Buildings                |       | 27,314   |       | 24,086   |       |
| Furniture and equipment  |       | 25,260   |       | 23,860   |       |
| Total cost               |       | 57,336   |       | 52,550   |       |
| Accumulated depreciation |       | (29,473  | )          | (26,784  | )          |
| Net                      |       | $        | 27,863     |     | $          | 25,766 |   |

 

Depreciationexpense was $3,087, $2,962, and $2,629 in 2005, 2004 and 2003.

 

40

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**NOTE 7 - GOODWILL AND INTANGIBLE ASSETS**

 

**Goodwill**

 

Thechange in carrying amount of goodwill is as follows:

 
| ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Beginning of year                          |       | $        | 40,642     |     | $          | 36,047 |   |
| Goodwill from acquisition during the year  |       | 11,990   |       | 4,595    |       |
| Goodwill reduced from disposal of business |       | (1,331   | )          | —   |       |
| End of year                                |       | $        | 51,301     |     | $          | 40,642 |   |

 

**Acquired Intangible Assets**
| ** **                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Core deposit intangibles      |       | $        | 16,096     |     | $          | 11,945 |   |
| Accumulated amortization      |       | (6,822   | )          | (5,516   | )          |
| Core deposit intangibles, net |       | $        | 9,274      |     | $          | 6,429 |   |

 

Aggregateamortization expense was $1,306, $1,059, and $909 for 2005, 2004, and 2003.

 

Estimatedamortization expense for each of the next five years follows:

 
| 2006 |   | $     | 1,638  |   |
|------|--------|-------|--------|--------|
| 2007 |   | 1,603 |   |
| 2008 |   | 1,471 |   |
| 2009 |   | 945   |   |
| 2010 |   | 820   |   |

 

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**NOTE 8 - DEPOSITS**

 
| ** **                              | ** ** | **December 31  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| Non-interest-bearing demand             |       | $                          | 161,568    |                        | $          | 145,999 |   |
| Interest-bearing demand                 |       | 330,592                    |       | 310,306                     |       |
| Savings                                 |       | 321,661                    |       | 304,230                     |       |
| Certificates of deposit of $100 or more |       | 173,656                    |       | 117,361                     |       |
| Other certificates and time deposits    |       | 365,220                    |       | 348,471                     |       |
| Total deposits                          |       | $                          | 1,352,697  |                        | $          | 1,226,367 |   |

 

Certificatesand other time deposits mature as follows:
| 2006       |   |   | $       | 336,679 |   |
|------------|--------|--------|---------|---------|--------|
| 2007       |   |   | 115,560 |    |
| 2008       |   |   | 46,067  |    |
| 2009       |   |   | 28,717  |    |
| 2010       |   |   | 2,322   |    |
| Thereafter |   |   | 9,531   |    |
| Total      |   |   | 538,876 |    |

 

42

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**NOTE 9 - SHORT TERM BORROWINGS**

 
| **December 31**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------|------------|----------|------------|----------|------------|
| Short term borrowings consisted of the  following at year-end: |       |     |       |     |       |
| Securities sold under repurchase agreements                    |       | $        | 26,516     |     | $          | 27,275 |   |
| Federal funds purchased                                        |       | —   |       | 26,900   |       |
| Line of credit                                                 |       | —   |       | 3,000    |       |
| Total short-term borrowings                                    |       | $        | 26,516     |     | $          | 57,175 |   |

 

Securitiessold under repurchase agreements (“agreements”) consist of obligations securedby Federal agency securities, and a safekeeping agent holds suchcollateral.  The maximum amount ofoutstanding repurchase agreements at any month-end during 2005, 2004, and 2003totaled $28,581, $28,782, and $20,048. The daily average of such agreements during 2005, 2004, and 2003 totaled$21,661, $22,166, and $16,680.   Theweighted average rate was 2.36%, 1.34%, and 0.71% at December 31, 2005,2004, and 2003 while the weighted average rate during 2005, 2004, and 2003 was approximately 1.98%, 0.96%,and 0.88% respectively.  Themajority  of the agreements at December 31,2005 mature within 30 days.

 

TheCompany has a revolving credit facility for $30,000 as a standby for fundingneeds which matures July 1, 2007.  The interest rate is 120 basis points above the 3-month LIBOR rate whichresulted in a rate of 5.72% at year-end 2005.  There was no outstanding balance as of December 31, 2005.  The line is secured by the stock ofMainSource Bank.

 

Asof December 31, 2004, the Company had a revolving credit facility for$3,000 which matured June 5, 2005.

 

43

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

 

FederalHome Loan Bank (“FHLB”) advances at year end were:
| ** **                                                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Maturities March 2006 through  August 2012, primarily fixed rates from 2.4% to 6.3%, averaging 4.4% |       | $        | 41,547     |     | $          | — |   |
|                                                                                                          |       |     |       |     |       |
| Maturities June 2005 through  August 2012, primarily fixed rates from 2.4% to 6.6%, averaging 3.8%  |       | —   |       | 90,981   |       |
|                                                                                                          |       | $        | 41,547     |     | $          | 90,981 |   |

 

Themajority of the FHLB advances are secured by first mortgage loans totalingapproximately 150% of the advance under a blanket security agreement.  Approximately $132 of advances are secured bycash. The advances are subject to restrictions or penalties in the event ofprepayment.

 

Maturitiesover the next five years are:
| 2006       |   | 132    |   |
|------------|--------|--------|--------|
| 2007       |   | 15,305 |   |
| 2008       |   | — |   |
| 2009       |   | — |   |
| 2010       |   | 5,581  |   |
| Thereafter |   | 20,529 |   |

 

44

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**NOTE 11 – NOTES PAYABLE**

 

Notespayable at December 31, 2004 include a term note with a balance of $9,100secured by the common stock of MainSource Bank. The note required semi annual principal payments of $1,300 plusquarterly interest payments. Interest accrued at LIBOR plus 120 basispoints.  This note was paid off in fullin June of 2005.

 

45

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**NOTE 12 – SUBORDINATED DEBENTURES**

 

The Company formed threeseparate trusts in 2002 and 2003 that issued floating rate trust preferredsecurities as part of pooled offerings. The Company issued subordinated debentures to the trusts in exchange forthe proceeds of the offerings, which debentures represent the sole asset of thetrusts.  Under FAS Interpretation No. 46,the trusts are no longer consolidated with the Company.  Other than the items detailed below, theterms of the subordinated debentures are generally the same.  Interest payments are payable quarterly inarrears and the Company has the option to defer interest payments from time totime for a period not to exceed 20 consecutive quarters.  The subordinated debentures mature in 30years from issuance and can be called anytime after five years at par.   The following table summarizes the other termsof each issuance.

 
| ** ** | ** ** | **Issuance** | ** ** | **Amount** | ** ** | **Variable  Rate** | ** **  | **Rate as of  12/31/05** | ** ** | **Maturity** | ** ** |
|------------|------------|--------------|------------|------------|------------|--------------------|-------------|--------------------------|------------|--------------|------------|
| Trust 1    |       | 2002         |       | $          | 8,248      |               | LIBOR +3.25 | %                        | 7.77       | %            | 2032       |   |
| Trust 2    |       | 2003         |       | 14,433     |       | LIBOR +3.25        | %           | 7.78                     | %          | 2033         |       |
| Trust 3    |       | 2003         |       | 7,217      |       | LIBOR +3.15        | %           | 7.64                     | %          | 2033         |       |
|            |            |              |            |            |            |                    |             |                          |            |              |            |  |

 

During2003, the Company entered into an interest rate swap and cap to mitigate overallrisk to changes in interest rates.  Boththe interest rate swap and the cap have a 60 month term and a notionalprincipal amount of $14,000.  Thenotional amount of the interest rate swaps do not represent amounts exchangedby the parties.  The amount exchanged isdetermined by reference to the notional amounts and other terms of thecontract.  The interest rate swap and capwere designated as cash flow hedges against a portion of the subordinateddebentures.  As such, the aggregate fairvalue of the swaps are recorded as other assets or other liabilities withchanges in the fair value recorded in other comprehensive income and no amountof ineffectiveness was included in net income. Under the interest rate swap agreement, the Company made fixed rate paymentsat 6.65%, and received variable payments based on LIBOR.  Net settlement expense or benefit is includedin interest expense.  A payment of $23was due to the Company at December 31, 2005.  The interest rate cap requires thecounter-party to pay the Company the excess of 3 month LIBOR over 12%.  The fair value for the interest rate swap andcap was $426 at December 31, 2005 and was included in other assets.  The fair value was $52 at December 31,2004 and was included in other assets. Both the interest rate swap and cap expire in April 2008.

 

46

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**NOTE 13- LOAN SERVICING**

 

Loans serviced forothers are not included in the accompanying consolidated balance sheets. Theunpaid principal balances of loans serviced for others totaled $509,211 and$500,797 at December 31, 2005 and 2004. Mortgage servicing rights areincluded in other assets on the consolidated balance sheets.  The fair value of capitalized mortgageservicing assets is based on comparable market values and expected cash flows,with impairment assessed based on portfolio characteristics including producttype and interest rates.  No valuationallowance was necessary during 2005 or 2004. The fair market value ofcapitalized mortgage servicing rights was $4,861 and $4,789 at year end 2005and 2004.

 
| ** **                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
|                             |       |     |       |     |       |
| Mortgage servicing assets        |       |     |       |     |       |
| Balances, January 1         |       | $        | 2,888      |     | $          | 2,618 |   |
| Servicing assets capitalized     |       | 828      |       | 1,226    |       |
| Amortization of servicing assets |       | (558     | )          | (956     | )          |
| Balance, December 31        |       | $        | 3,158      |     | $          | 2,888 |   |

 

47

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**NOTE 14- INCOME TAX**

 

Income tax expense(benefit) was as follows:
| **Year Ended December 31** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                            |       |     |       |     |       |     |       |
| Income tax expense              |       |     |       |     |       |     |       |
| Currently payable               |       | $        | 2,972      |     | $          | 4,154    |       | $ | 4,749 |   |
| Deferred                        |       | 2,200    |       | 2,119    |       | 1,848    |       |
| Total income tax expense        |       | $        | 5,172      |     | $          | 6,273    |       | $ | 6,597 |   |

 

Effective tax rates differ from the federalstatutory rate of 35% applied to income before income taxes due to thefollowing:
| Federal statutory income tax rate   |   | 35     | %      | 35     | %      | 35    | %      |
|-------------------------------------|--------|--------|--------|--------|--------|-------|--------|
| Federal statutory income tax        |   | $      | 7,477  |   | $      | 8,073 |   | $ | 7,666 |   |
| Tax exempt interest                 |   | (1,612 | )      | (1,231 | )      | (893  | )      |
| Effect of state income taxes        |   | 25     |   | 63     |   | 397   |   |
| Non-deductible expenses             |   | 36     |   | 50     |   | 52    |   |
| Tax exempt income on life insurance |   | (472   | )      | (356   | )      | (219  | )      |
| Low income housing credits          |   | (132   | )      | (132   | )      | (175  | )      |
| Other                               |   | (150   | )      | (194   | )      | (231  | )      |
| Income tax expense                  |   | $      | 5,172  |   | $      | 6,273 |   | $ | 6,597 |   |

 

Thecomponents of the net deferred tax asset (liability) are as follows:
| **December 31**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
| Assets                                             |       |     |       |     |       |
| Allowance for loan losses                          |       | $        | 3,653      |     | $          | 4,585 |   |
| Deferred compensation                              |       | 435      |       | 439      |       |
| Fair value adjustments on assets acquired          |       | 336      |       | 707      |       |
| Accrued expenses                                   |       | 343      |       | 226      |       |
| Unrealized loss on securities AFS                  |       | 1,845    |       | —   |       |
| Other                                              |       | 136      |       | 325      |       |
| Total assets                                       |       | $        | 6,748      |     | $          | 6,282 |   |
|                                               |       |     |       |     |       |
| Liabilities                                        |       |     |       |     |       |
| Accretion on securities                            |       | (56      | )          | (28      | )          |
| Depreciation                                       |       | (1,228   | )          | (1,530   | )          |
| Intangibles                                        |       | (3,004   | )          | (2,900   | )          |
| Mortgage servicing rights                          |       | (1,105   | )          | (1,151   | )          |
| Deferred loan fees/costs                           |       | (285     | )          | (195     | )          |
| FHLB stock dividends                               |       | (336     | )          | (303     | )          |
| Unrealized gain on securities AFS                  |       | —   |       | (35      | )          |
| Net unrealized appreciation on interest  rate swap |       | (149     | )          | (21      | )          |
| Other                                              |       | (1,224   | )          | (710     | )          |
| Total liabilities                                  |       | $        | (7,387     | )        | $          | (6,873 | ) |
|                                               |       |     |       |     |       |
| Net deferred tax asset/(liability)                 |       | $        | (639       | )        | $          | (591 | ) |

 

The Company has a state operating loss carryforward of $5,200, whichbegins to expire in 2019.

 

Retainedearnings of MainSource Bank include approximately $2,162 for which no deferredincome tax liability has been recognized. This amount represents an allocation of income to bad debt deductions asof  December 31, 1987 for taxpurposes only.  Reduction of amounts soallocated for purposes other than tax bad debt losses including redemption ofMainSource Bank stock or excess dividends, or loss of “bank” status forMainSource Bank would create income for tax purposes only, which  would be subject to the then-current corporateincome tax rate.  The unrecorded deferredincome tax liability on the above amount for MainSource at December 31,2005 was approximately $757.

 

48

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**NOTE 15 - OTHER COMPREHENSIVE INCOME**

 
| **Year Ended December 31, 2005**                                | ** ** | **Before-Tax  Amount** | ** ** | **Tax (Expense)/  Benefit** | ** ** | **Net-of-Tax  Amount** | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|-----------------------------|------------|------------------------|------------|
|                                                                 |       |                   |       |                        |       |                   |       |
| Unrealized holding losses on available for  sale securities          |       | $                      | (7,626     | )                           | $          | 2,788                  |       | $ | (4,838 | ) |
| Unrealized holding gains on interest rate  swap and cap              |       | 374                    |       | (149                        | )          | 225                    |       |
| Less: reclassification adjustment for  losses realized in net income |       | (2,179                 | )          | 796                         |       | (1,383                 | )          |
| Other comprehensive loss                                             |       | $                      | (5,073     | )                           | $          | 1,843                  |       | $ | (3,230 | ) |

 
| **Year  Ended December 31, 2004**                              | ** ** | **Before-Tax  Amount** | ** ** | **Tax  (Expense)/  Benefit** | ** ** | **Net-of-Tax  Amount** | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|------------------------------|------------|------------------------|------------|
|                                                                |       |                   |       |                         |       |                   |       |
| Unrealized holding losses on available for  sale securities         |       | $                      | (1,019     | )                            | $          | 380                    |       | $ | (639 | ) |
| Unrealized holding gains on interest rate  swap and cap             |       | 247                    |       | (99                          | )          | 148                    |       |
| Less: reclassification adjustment for gains  realized in net income |       | 991                    |       | (364                         | )          | 627                    |       |
| Other comprehensive loss                                            |       | $                      | (1,763     | )                            | $          | 645                    |       | $ | (1,118 | ) |

 
| **Year  Ended December 31, 2003**                              | ** ** | **Before-Tax  Amount** | ** ** | **Tax  (Expense)/  Benefit** | ** ** | **Net-of-Tax  Amount** | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|------------------------------|------------|------------------------|------------|
|                                                                |       |                   |       |                         |       |                   |       |
| Unrealized holding losses on available for  sale securities         |       | $                      | (3,580     | )                            | $          | 1,260                  |       | $ | (2,320 | ) |
| Unrealized holding losses on interest rate  swap and cap            |       | $                      | (195       | )                            | $          | 78                     |       | $ | (117 | ) |
| Less: reclassification adjustment for gains  realized in net income |       | 1,300                  |       | (455                         | )          | 845                    |       |
| Other comprehensive loss                                            |       | $                      | (5,075     | )                            | $          | 1,793                  |       | $ | (3,282 | ) |

 

49

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**NOTE 16 - COMMITMENTS**

 

Somefinancial instruments, such as loan commitments, credit lines, letters ofcredit,  and overdraft protection, areissued to meet customer financing needs. These are  agreements to providecredit or to support the credit of others, as long as conditions  established in the contract are met, andusually have expiration dates. Commitments  may expire withoutbeing used.  Off-balance-sheet risk tocredit loss exists up to the  face amountof these instruments, although material losses are not anticipated.  The same credit policies are used to make such commitments as are used forloans,  including obtaining collateral atexercise of the commitment.

 

Financialinstruments whose contract amount represents credit risk as of December 31were as follows:

 
| ** **                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
| Commitments to extend credit |       | $        | 222,373    |     | $          | 155,280 |   |
| Commercial letters of credit |       | 14,404   |       | 17,925   |       |
|                              |            |          |            |          |            |  |  |

 

Commitmentsare predominantly short-term or variable in rate.

 

50

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**NOTE 17 – STOCK DIVIDENDS AND SPLITS**

 

On November 29, 2004, the Company announced a 5% stock dividend tobe paid on January 15, 2005 to shareholders of record as of December 31,2004.  The stock dividend was recorded in2004, and all share and per share amounts have been retroactively adjusted forall prior years to reflect this stock dividend.

 

On March 16, 2004, the Company announced a 3-for-2 stock split tobe distributed on April 16, 2004 to shareholders of record as of March 31,2004.  The stock split was recorded in2004, and all share and per share amounts have been retroactively adjusted forall prior years to reflect this stock split.

 

On November 26, 2003, the Company announced a 5% stock dividend tobe paid on January 9, 2004 to shareholders of record as of December 22,2003.  The stock dividend was recorded in2003, and all share and per share amounts have been retroactively adjusted forall prior years to reflect this stock dividend.

 

51

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**NOTE 18 - DIVIDENDS**

 

Without prior approval, the Banks are restricted by state and federalregulations as to the maximum amount of dividends they can pay to the holdingcompany in any calendar year.  The Banksmay dividend their retained net profits (as defined) for that year and the twopreceding years.  From time to time, theholding company may seek the approval of the appropriate regulatory authoritiesto allow the banks to pay additional dividends to the holding company in excessof the aforementioned amount.  At December 31,2005, total shareholders’ equity of the Banks was $171,516 of which $170,238was restricted or limited from dividend distribution to the holding company.

 

**NOTE 19 – DIVIDEND REINVESTMENT PLAN**

 

The Company maintains an Automatic Dividend Reinvestment Plan.  The plan enables shareholders to elect tohave their cash dividends on all or a portion of shares held automaticallyreinvested in additional shares of the Company’s common stock. The stock ispurchased by the Company’s transfer agent on the open market and credited toparticipant accounts at fair market value. Dividends are reinvested on a quarterly basis.

 

52

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**NOTE 20 - REGULATORY CAPITAL**

 

Banksand bank holding companies are subject to various regulatory capitalrequirements administered by the federal banking agencies and are assigned to acapital category. The assigned capital category is largely determined by threeratios that are calculated according to the regulations. The ratios areintended to measure capital relative to assets and credit risk associated withthose assets and off-balance sheet exposures. The capital category assigned toan entity can also be affected by qualitative judgments made by regulatoryagencies about the risk inherent in the entity’s activities that are not partof the calculated ratios.

 

Thereare five capital categories defined in the regulations, ranging from wellcapitalized to critically undercapitalized. Classification in any of theundercapitalized categories can result in actions by regulators that could havea material effect on operations. At December 31, 2005 and 2004, the mostrecent regulatory notifications categorized the banks as well capitalized underthe regulatory framework for prompt corrective actions.  There are no conditions or events since thatnotification that management believes have changed the institutions’ category.

 

Actualand required capital amounts and ratios are presented below.

 
| ** **                               | ** ** | **Actual** |       | ** ** | **Required for  Adequate Capital** |       | ** ** | **To Be Well  Capitalized** | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------------------------------|------------|------------|-----------------------------|------------|
| **December 31, 2005**               | ** ** | **Amount** | ** ** | **Ratio**  | ** **                         | ** ** | **Amount** | ** **                  | **Ratio**  | ** ** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                     |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| MainSource Financial Group               |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |       | $          | 143,068    |       | 13.5                               | %          |       | $                           | 84,537     |   | 8.0 | % |   | N/A |   | N/A |   |
| Tier 1 capital (to risk-weighted assets) |       | 132,627    |       | 12.6       |                               |       | 42,268     |                        | 4.0        |   |   | N/A |   | N/A |   |
| Tier 1 capital (to average assets)       |       | 132,627    |       | 8.4        |                               |       | 63,284     |                        | 4.0        |   |   | N/A |   | N/A |   |
|                                     |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| MainSource Bank                          |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |       | $          | 112,673    |       | 12.0                               | %          |       | $                           | 75,301     |   | 8.0 | % |   | $ | 94,126 |   | 10.0 | % |
| Tier 1 capital (to risk-weighted assets) |       | 102,969    |       | 10.9       |                               |       | 37,650     |                        | 4.0        |   |   | 56,475 |   | 6.0 |   |
| Tier 1 capital (to average assets)       |       | 102,969    |       | 7.5        |                               |       | 55,194     |                        | 4.0        |   |   | 68,993 |   | 5.0 |   |
|                                     |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| MainSource Bank of Illinois              |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |       | $          | 13,166     |       | 12.3                               | %          |       | $                           | 8,596      |   | 8.0 | % |   | $ | 10,745 |   | 10.0 | % |
| Tier 1 capital (to risk-weighted assets) |       | 12,429     |       | 11.6       |                               |       | 4,298      |                        | 4.0        |   |   | 6,447 |   | 6.0 |   |
| Tier 1 capital (to average assets)       |       | 12,429     |       | 6.8        |                               |       | 7,370      |                        | 4.0        |   |   | 9,212 |   | 5.0 |   |

 
| ** **                                                     | ** ** | **Actual** |       | ** ** | **Required for  Adequate Capital** |       | ** ** | **To Be Well  Capitalized** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|------------|------------------------------------|------------|------------|-----------------------------|------------|
| **December 31, 2004**                                     | ** ** | **Amount** | ** ** | **Ratio**  | ** **                         | ** ** | **Amount** | ** **                  | **Ratio**  | ** ** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                                           |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| MainSource Financial Group                                     |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)                        |       | $          | 116,851    |       | 11.8                               | %          |       | $                           | 79,061     |   | 8.0 | % |   | N/A |   | N/A |   |
| Tier 1 capital (to risk-weighted assets)                       |       | 105,153    |       | 10.6       |                               |       | 39,530     |                        | 4.0        |   |   | N/A |   | N/A |   |
| Tier 1 capital (to average assets)                             |       | 105,153    |       | 7.0        |                               |       | 60,271     |                        | 4.0        |   |   | N/A |   | N/A |   |
|                                                           |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| MainSource Bank (includes Regional and  Peoples Trust Company) |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)                        |       | $          | 105,685    |       | 11.9                               | %          |       | $                           | 71,130     |   | 8.0 | % |   | $ | 88,912 |   | 10.0 | % |
| Tier 1 capital (to risk-weighted assets)                       |       | 95,327     |       | 10.7       |                               |       | 35,565     |                        | 4.0        |   |   | 53,347 |   | 6.0 |   |
| Tier 1 capital (to average assets)                             |       | 95,327     |       | 7.3        |                               |       | 52,158     |                        | 4.0        |   |   | 65,198 |   | 5.0 |   |
|                                                           |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| MainSource Bank of Illinois                                    |       |       |       |       |                               |       |       |                        |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)                        |       | $          | 14,290     |       | 15.2                               | %          |       | $                           | 7,531      |   | 8.0 | % |   | $ | 9,414 |   | 10.0 | % |
| Tier 1 capital (to risk-weighted assets)                       |       | 13,463     |       | 14.3       |                               |       | 3,765      |                        | 4.0        |   |   | 5,648 |   | 6.0 |   |
| Tier 1 capital (to average assets)                             |       | 13,463     |       | 7.0        |                               |       | 7,713      |                        | 4.0        |   |   | 9,642 |   | 5.0 |   |

 

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**NOTE 21 – EMPLOYEE BENEFIT PLANS**

 

The Company has a defined-contributionretirement plan in which substantially all employees may participate. TheCompany matches a portion of employees’ contributions and makes additionalcontributions based on employee compensation. Expense was $1,309 in 2005,$1,621 in 2004, and $1,284 in 2003.

 

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**NOTE 22 - RELATED PARTY TRANSACTIONS**

 

TheCompany has entered into transactions with certain directors, executiveofficers, significant stockholders and their affiliates or associates (relatedparties). Such transactions were made in the ordinary course of business anddid not, in the opinion of management, involve more than normal credit risk orpresent other unfavorable features.

 

Theaggregate amount of loans, as defined, to such related parties were as follows:

 
| Balances, January 1, 2005             |   | $      | 9,847  |   |
|--------------------------------------------|--------|--------|--------|--------|
| Changes in composition of related parties  |   | (231   | )      |
| New loans, including renewals and advances |   | 10,871 |   |
| Payments, including renewals               |   | (9,679 | )      |
| Balances, December 31, 2005           |   | $      | 10,808 |   |

 

Depositsfrom related parties held by the Company at December 31, 2005 and 2004totaled $2,847 and $4,462.

 

55

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**NOTE 23 - STOCK OPTION PLANS**

 

Optionsto buy stock were granted to directors and employees of the Company under theCompany’s Stock Option Plan, which was adopted in 2003 and provides for theissuance of up to 578,813 options, of which 390,333 are still available for granting at year-end 2005. 

 

Exerciseprice is the market price at date of grant, so there is no compensation expense  recognized in the consolidated statements ofincome.  The maximum option term is tenyears, and options vest immediately for the directors’ grant and over fouryears for the employees’ grants.  Theweighted average remaining contractual life is 8.3 years at December 31,2005.  A summary of the activity in theplan is as follows:

 
| ** **                                        | ** ** | **2005**   | ** ** | **2004**              | ** ** | **2003**   | ** ** |
|---------------------------------------------------|------------|------------|------------|-----------------------|------------|------------|------------|
| ** **                                        | ** ** | ** ** | ** ** | **Weighted  Average** | ** ** | ** ** | ** ** | **Weighted  Average** | ** ** | ** ** | ** ** | **Weighted  Average** | ** ** |
| **Year Ended December 31**                   | ** ** | **Shares** | ** ** | **Exercise Price**    | ** ** | **Shares** | ** ** | **Exercise Price** | ** ** | **Shares** | ** ** | **Exercise Price** | ** ** |
| Options (restated for stock dividends and splits) | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding, beginning of year                    |       | 116,825    |       | $                     | 18.36      |       | 57,054     |   | $ | 14.03 |   | — |   | $ | — |   |
| Granted                                           |       | 70,000     |       | 21.45                 |       | 61,425     |       | 22.26 |   | 57,054 |   | 14.03 |   |
| Exercised                                         |       | (3,142     | )          | 14.03                 |       | (1,654     | )          | 14.03 |   | — |   | — |   |
| Forfeited or expired                              |       | (9,777     | )          | 17.84                 |       | —     |       | — |   | — |   | — |   |
| Outstanding, end of year                          |       | 173,906    |       | $                     | 19.71      |       | 116,825    |   | $ | 18.36 |   | 57,054 |   | $ | 14.03 |   |
| Options exercisable at year end                   |       | 155,662    |       | $                     | 20.30      |       | 39,371     |   | $ | 17.09 |   | 17,612 |   | $ | 14.03 |   |

 

Options outstanding at year-end 2005 were asfollows.

 
| ** **           | ** ** | **Outstanding** | ** ** | **Exercisable**                          | ** ** |
|----------------------|------------|-----------------|------------|------------------------------------------|------------|
| **Exercise  Prices** | ** ** | **Number**      | ** ** | **Remaining  Contractual  Life (years)** | ** ** | **Number** | ** ** |
| $14.03               |       | 47,131          |       | 7.3                                      |       | 31,587 |   |
| $18.13               |       | 3,000           |       | 9.8                                      |       | 300 |   |
| 21.60 *              |       | 65,500          |       | 9.2                                      |       | 65,500 |   |
| 22.26 *              |       | 58,275          |       | 8.2                                      |       | 58,275 |   |
| Total at year-end    |       | 173,906         |       |                                     |       | 155,662 |   |

 

----

*Stock options for which vesting was accelerated in 2005.

 

56

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**NOTE 24 - EARNINGS PER SHARE**

 

Earningsper share were computed as follows:

 
| ** **                                                           | ** ** | **Net  Income** | ** ** | **Weighted  Average  Shares** | ** ** | **Per - Share  Amount** | ** ** |
|----------------------------------------------------------------------|------------|-----------------|------------|-------------------------------|------------|-------------------------|------------|
| **Year Ended December 31, 2005**                                |       |            |       |                          |       |                    |       |
| **Basic Earnings Per Share**                                         |       |            |       |                          |       |                    |       |
| Net income available to common shareholders                          |       | $               | 16,192     |                          | 12,549,964 |                    | $          | 1.29 |   |
| Effect of dilutive stock options                                     |       |            |       | 13,496                        |       |                    |       |
|                                                                 |       |            |       |                          |       |                    |       |
| **Diluted Earnings Per Share**                                       |       |            |       |                          |       |                    |       |
| Net income available to common shareholders  and assumed conversions |       | $               | 16,192     |                          | 12,563,460 |                    | $          | 1.29 |   |
|                                                                 |       |            |       |                          |       |                    |       |
| **Year Ended December 31, 2004**                                |       |            |       |                          |       |                    |       |
| **Basic Earnings Per Share**                                         |       |            |       |                          |       |                    |       |
| Net income available to common shareholders                          |       | $               | 16,793     |                          | 11,355,665 |                    | $          | 1.48 |   |
| Effect of dilutive stock options                                     |       |            |       | 16,329                        |       |                    |       |
|                                                                 |       |            |       |                          |       |                    |       |
| **Diluted Earnings Per Share**                                       |       |            |       |                          |       |                    |       |
| Net income available to common shareholders  and assumed conversions |       | $               | 16,793     |                          | 11,371,994 |                    | $          | 1.48 |   |
|                                                                 |       |            |       |                          |       |                    |       |
| **Year Ended December 31, 2003**                                |       |            |       |                          |       |                    |       |
| **Basic Earnings Per Share**                                         |       |            |       |                          |       |                    |       |
| Net income available to common shareholders                          |       | $               | 15,305     |                          | 11,157,943 |                    | $          | 1.37 |   |
| Effect of dilutive stock options                                     |       |            |       | 3,290                         |       |                    |       |
|                                                                 |       |            |       |                          |       |                    |       |
| **Diluted Earnings Per Share**                                       |       |            |       |                          |       |                    |       |
| Net income available to common shareholders  and assumed conversions |       | $               | 15,305     |                          | 11,161,233 |                    | $          | 1.37 |   |

 

Stockoptions for 123,775 and 61,425 shares of common stock were not considered incomputing diluted earnings per  commonshare for 2005 and 2004 because they were antidilutive.  All stock options were dilutive in 2003.

 

57

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**NOTE 25 - FAIR VALUES OF FINANCIAL INSTRUMENTS**

 
| ** **                               | ** ** | **2005**             | ** ** | **2004**        | ** ** |
|------------------------------------------|------------|----------------------|------------|-----------------|------------|
| **December 31**                     | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| Assets                                   |       |                 |       |            |       |   |   |   |   |
| Cash and cash equivalents                |       | $                    | 86,205     |            | $          | 86,205 |   | $ | 76,269 |   | $ | 76,269 |   |
| Interest-bearing time deposits           |       | 210                  |       | 210             |       | 304 |   | 304 |   |
| Securities available for sale            |       | 450,814              |       | 450,814         |       | 425,443 |   | 425,443 |   |
| Securities held to maturity              |       | —               |       | —          |       | 3,243 |   | 3,414 |   |
| Loans including loans held for sale, net |       | 950,120              |       | 948,150         |       | 918,131 |   | 913,866 |   |
| Restricted stock                         |       | 10,940               |       | 10,940          |       | 7,902 |   | 7,902 |   |
| Interest receivable                      |       | 8,400                |       | 8,400           |       | 7,123 |   | 7,123 |   |
| Interest rate swap and cap               |       | 426                  |       | 426             |       | 52 |   | 52 |   |
|                                     |       |                 |       |            |       |   |   |   |   |
| Liabilities                              |       |                 |       |            |       |   |   |   |   |
| Deposits                                 |       | (1,352,697           | )          | (1,340,150      | )          | (1,226,367 | ) | (1,222,053 | ) |
| Borrowings                               |       |                 |       |            |       |   |   |   |   |
| Short-term                               |       | (26,516              | )          | (26,516         | )          | (57,175 | ) | (57,175 | ) |
| FHLB advances                            |       | (41,547              | )          | (40,951         | )          | (90,981 | ) | (91,603 | ) |
| Notes payable                            |       | —               |       | —          |       | (9,100 | ) | (9,100 | ) |
| Interest payable                         |       | (3,373               | )          | (3,373          | )          | (2,391 | ) | (2,391 | ) |
| Subordinated debentures                  |       | (29,898              | )          | (31,090         | )          | (29,898 | ) | (29,898 | ) |
|                                          |            |                      |            |                 |            |  |  |  |  |  |  |  |  |

 

Themethods and assumptions used to estimate fair value are described as follows.

 

Carryingamount is the estimated fair value of cash and cash equivalents,interest-bearing time deposits, restricted stock, accrued interest receivableand payable, demand and all other transactional deposits, short-termborrowings, variable rate notes payable and subordinated debentures, andvariable rate loans or deposits that reprice frequently and fully.   Security fair values are based on marketprices or dealer quotes, and if no such information is available, on the rateand term of the security and information about the issuer.  For fixed rate loans or deposits and forvariable rate loans or deposits with infrequent repricing or repricing limits,fair value is based on discounted  cashflows using current market rates applied to the estimated life and creditrisk.  Fair values for impaired loans areestimated using discounted cash flow analysis or underlying collateralvalues.  Fair value of loans held forsale is based on market quotes.  Fairvalue of FHLB advances is based on current rates for similar financing. Thefair value of off-balance-sheet items is based on the current fees or cost thatwould be charged to  enter into orterminate such arrangements, and are not considered significant.  The fair value of interest rate swaps isbased on market prices or dealer quotes.

 

58

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**NOTE 26 - QUARTERLY FINANCIAL DATA (UNAUDITED)**

 
| ** **     | ** ** | **Interest  Income** | ** ** | **Net Interest  Income** | ** ** | **Net  Income** | ** ** | **Earnings per Share** | ** ** |
|----------------|------------|----------------------|------------|--------------------------|------------|-----------------|------------|------------------------|------------|
| **Basic**      | ** ** | **Fully Diluted**    | ** ** |
| 2005           |       |                 |       |                     |       |            |       |                   |       |   |   |
| First quarter  |       | $                    | 18,693     |                     | $          | 12,705          |       | $                      | 3,790      |   | $ | 0.33 |   | $ | 0.33 |   |
| Second quarter |       | 19,533               |       | 13,185                   |       | 4,326           |       | 0.37                   |       | 0.37 |   |
| Third quarter  |       | 20,598               |       | 13,629                   |       | 4,532           |       | 0.34                   |       | 0.34 |   |
| Fourth quarter |       | 21,651               |       | 14,129                   |       | 3,544           |       | 0.26                   |       | 0.26 |   |
|           |       |                 |       |                     |       |            |       |                   |       |   |   |
| 2004           |       |                 |       |                     |       |            |       |                   |       |   |   |
| First quarter  |       | $                    | 16,764     |                     | $          | 11,472          |       | $                      | 3,635      |   | $ | 0.33 |   | $ | 0.33 |   |
| Second quarter |       | 17,474               |       | 12,284                   |       | 4,319           |       | 0.38                   |       | 0.38 |   |
| Third quarter  |       | 18,985               |       | 13,500                   |       | 4,606           |       | 0.40                   |       | 0.40 |   |
| Fourth quarter |       | 18,618               |       | 12,746                   |       | 4,233           |       | 0.37                   |       | 0.37 |   |

 

59

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**NOTE 27 - PARENT ONLY CONDENSED FINANCIAL STATEMENTS**

 

**Parent Only Condensed Balance Sheets**

 
| **December 31**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Assets                                          |       |     |       |     |       |
| Cash and cash equivalents                       |       | $        | 9,457      |     | $          | 1,787 |   |
| Investment securities available for sale        |       | 3,111    |       | 3,099    |       |
| Investment in subsidiaries                      |       | 174,471  |       | 157,320  |       |
| Other assets                                    |       | 5,713    |       | 4,687    |       |
| Total assets                                    |       | $        | 192,752    |     | $          | 166,893 |   |
|                                            |       |     |       |     |       |
| Liabilities                                     |       |     |       |     |       |
| Subordinated debentures                         |       | $        | 29,898     |     | $          | 29,898 |   |
| Notes payable                                   |       | —   |       | 9,100    |       |
| Short-term borrowings                           |       | —   |       | 3,000    |       |
| Other liabilities                               |       | 1,785    |       | 1,575    |       |
| Total liabilities                               |       | 31,683   |       | 43,573   |       |
| Shareholders’ equity                       |       | 161,069  |       | 123,320  |       |
| Total liabilities and shareholders’ equity |       | $        | 192,752    |     | $          | 166,893 |   |

 

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**Parent Only Condensed Statements of Income**

 
| **Year Ended December 31**                                                       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Income                                                                                |       |     |       |     |       |     |       |
| Dividends from subsidiaries                                                           |       | $        | 27,797     |     | $          | 17,850   |       | $ | 14,250 |   |
| Fees from subsidiaries                                                                |       | 10,345   |       | 9,197    |       | 7,813    |       |
| Other Income                                                                          |       | 132      |       | 95       |       | 207      |       |
| Total income                                                                          |       | 38,274   |       | 27,142   |       | 22,270   |       |
| Expenses                                                                              |       |     |       |     |       |     |       |
| Interest expense                                                                      |       | 2,192    |       | 1,993    |       | 1,898    |       |
| Salaries and benefits                                                                 |       | 6,115    |       | 5,280    |       | 4,869    |       |
| Professional fees                                                                     |       | 932      |       | 689      |       | 582      |       |
| Other expenses                                                                        |       | 5,805    |       | 4,962    |       | 5,085    |       |
| Total expenses                                                                        |       | 15,044   |       | 12,924   |       | 12,434   |       |
| Income (loss) before income taxes and  equity in undistributed income of subsidiaries |       | 23,230   |       | 14,218   |       | 9,836    |       |
| Income tax expense (benefit)                                                          |       | (1,980   | )          | (1,588   | )          | (1,877   | )          |
| Income (loss) before equity in  undistributed income of subsidiaries                  |       | 25,210   |       | 15,806   |       | 11,713   |       |
| Equity in undistributed income of  subsidiaries                                       |       | (9,018   | )          | 987      |       | 3,592    |       |
| Net income                                                                            |       | $        | 16,192     |     | $          | 16,793   |       | $ | 15,305 |   |

 

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**Condensed Statements of Cash Flows Parent Only**

 
| **Year Ended December 31**                       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Operating Activities**                              |       |     |       |     |       |     |       |
| Net income                                            |       | $        | 16,192     |     | $          | 16,793   |       | $ | 15,305 |   |
| Undistributed income of subidiaries                   |       | 9,018    |       | (987     | )          | (3,592   | )          |
| Changes in other assets and liabilities               |       | 1,172    |       | 183      |       | 3,228    |       |
| Net cash provided by operating activities             |       | 26,382   |       | 15,989   |       | 14,941   |       |
|                                                  |       |     |       |     |       |     |       |
| **Investing Activities**                              |       |     |       |     |       |     |       |
| Capital contributed to subsidiary                     |       | (735     | )          | (1,300   | )          | (5,600   | )          |
| Cash paid for acquisition                             |       | (30,267  | )          | (4,662   | )          | (24,283  | )          |
| Purchases of equipment                                |       | (1,777   | )          | (948     | )          | (705     | )          |
| Proceeds from sales of securities available  for sale |       | —   |       | 165      |       | —   |       |
| Purchase of securities available for sale             |       | —   |       | (2,096   | )          | —   |       |
| Net cash used by investing activities                 |       | (32,779  | )          | (8,841   | )          | (30,588  | )          |
|                                                  |       |     |       |     |       |     |       |
| **Financing Activities**                              |       |     |       |     |       |     |       |
| Payments on note payable                              |       | (9,100   | )          | (3,400   | )          | (2,900   | )          |
| Payments on subordinated debentures                   |       | —   |       | —   |       | (23,119  | )          |
| Proceeds from issuance of subordinated  debentures    |       | —   |       | —   |       | 21,650   |       |
| Proceeds from issuance of long-term debt              |       | —   |       | —   |       | 13,000   |       |
| Net change in short-term borrowings                   |       | (3,000   | )          | 3,000    |       | —   |       |
| Purchase of treasury shares                           |       | (27      | )          | (1,312   | )          | (1,497   | )          |
| Proceeds from exercise of stock options               |       | 48       |       | 28       |       | —   |       |
| Proceeds from stock issuance                          |       | 32,660   |       |     |       |     |       |
| Cash dividends and fractional shares                  |       | (6,514   | )          | (5,421   | )          | (4,874   | )          |
| Net cash provided (used) by financing  activities     |       | 14,067   |       | (7,105   | )          | 2,260    |       |
| Net change in cash and cash equivalents               |       | 7,670    |       | 43       |       | (13,387  | )          |
| Cash and cash equivalents, beginning of  year         |       | 1,787    |       | 1,744    |       | 15,131   |       |
| Cash and cash equivalents, end of year                |       | $        | 9,457      |     | $          | 1,787    |       | $ | 1,744 |   |

 

62

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**ITEM 9.****    CHANGES IN AND DISAGREEMENTSWITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

In connection with its audits for the three most recent fiscal yearsended December 31, 2005, there have been no disagreements with the Company’sindependent registered public accounting firm on any matter of accountingprinciples or practices, financial statement disclosure or auditing scope orprocedure.

 

**ITEM 9A.****  CONTROLS &PROCEDURES**

 

**Disclosure Controls and Procedures**

 

As of the end of the period covered by this report, an evaluation wascarried out under the supervision and with the participation of the Company’smanagement, including our Chief Executive Officer and Chief Financial Officer,of the effectiveness of our disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934). Based on their evaluation, our Chief Executive Officerand Chief Financial Officer have concluded that the Company’s disclosurecontrols and procedures are, to the best of their knowledge, effective toensure that information required to be disclosed by the Company in reports thatit files or submits under the Exchange Act is recorded, processed, summarizedand reported within the time periods specified in Securities and ExchangeCommission rules and forms as of such date.

 

Our management has evaluated our internal control over financialreporting and there were no changes in our internal control over financialreporting that occurred during the most recent fiscal quarter that havematerially affected, or are reasonably likely to materially affect, the Company’sinternal control over financial reporting.

 

**Management’sReport on Internal Control Over Financial Reporting**

 

We, as management of theCompany, are responsible for establishing and maintaining effective internalcontrol over financial reporting that is designed to produce reliable financialstatements in conformity with Untied States generally accepted accountingprinciples. Because of its inherent limitations, internal control overfinancial reporting may not prevent or detect misstatements. Also, projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate. 

 

Management assessed theCompany’s system of internal control over financial reporting as of December31, 2005, in relation to criteria for effective internal control over financialreporting as described in “Internal Control – Integrated Framework” issued bythe Committee of Sponsoring Organizations of the Treadway Commission.  Based on this assessment, managementconcludes that as of December 31, 2005, its system of internal controls overfinancial reporting is effective and meets the criteria of the “InternalControl – Integrated Framework”.  CroweChizek and Company LLC, independent registered public accounting firm, hasissued an attestation report dated February 10, 2006 on management’s assessmentof the Company’s internal control over financial reporting. 

 

James L. Saner, Sr. 

President and Chief ExecutiveOfficer 

 

 

James M. Anderson 

Senior Vice President and ChiefFinancial Officer

 

63

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**Report Of Independent Registered Public Accounting Firm On InternalControls**

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

Member Horwath International |

 

Shareholdersand Board of Directors

MainSourceFinancial Group, Inc.

Greensburg,Indiana

 

We have audited management’s assessment, included in the accompanying *Report on Management’s Report on Internal ControlOver Financial Reporting*, that MainSource Financial Group, Inc. maintained effective internal controlover**financial reporting as ofDecember 31, 2005, based on criteria established in *Internal Control–Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO).   MainSource Financial Group, Inc.’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting.  Ourresponsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the Company’s internal control over financialreporting based on our audit.

 

We conducted our audit in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether effectiveinternal control over financial reporting was maintained in all materialrespects.  Our audit included obtainingan understanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with U.S. generally accepted accounting principles.  A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2)provide reasonable assurance that transactions are recorded as necessary topermit preparation of financial statements in accordance with U. S. generallyaccepted accounting principles, and that receipts and expenditures of thecompany are being made only in accordance with authorizations of management anddirectors of the company; and (3) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the company’s assets that could have a material effect on the financialstatements.

 

64

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Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that MainSource FinancialGroup, Inc. maintained effective internal control over financial reporting asof December 31, 2005, is fairly stated, in all material respects, based oncriteria established in *InternalControl–Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

 

Also in our opinion, MainSource Financial Group, Inc.  maintained, in all material respects,effective internal control over financial reporting as of December 31, 2005,based on criteria established in *InternalControl–Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

 

We have also audited, in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the consolidated balancesheets as of December 31, 2005 and 2004, and the related consolidated statementsof income, shareholders’ equity, and cash flows for each of the three years inthe period ended December 31, 2005 of MainSource Financial Group, Inc. and ourreport dated February 10, 2006 expressed an unqualified opinion.

 

 
|                  |   | Crowe Chizek and Company LLC |
|-----------------------|--------|------------------------------|
|                  |   |                         |
| Indianapolis, Indiana |   |                         |
| February 10, 2006     |   |                         |

 

**ITEM 9B.****    OTHER INFORMATION**

 

None

 

PART IV

 

65

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ITEM15—EXHIBITS, FINANCIAL STATEMENT SCHEDULES

 

(a)(1) Financial Statements.

 

Financial Statements filedas part of this Form 10-K are included under Part II, Item 8, above.

 

(a)(2) Financial statement schedules

 

All schedules are omittedbecause they are not applicable or not required, or because the requiredinformation is included in the consolidated financial statements or relatednotes in Part II, Item 8 above.

 

(a)(3) Exhibits:

 

3.1           Restated Articles of Incorporation (incorporated byreference to Exhibit 3.1 to the Annual Report on Form 10-K of the registrantfor the fiscal year ended December 31, 2003 filed March 12, 2004 with theCommission (Commission File No. 0-12422)).

 

3.2           Bylaws of MainSource Financial Group, Inc. dated September 19,2005 (incorporated by reference to Exhibit 3 to the Report on Form 8-K of theregistrant filed September 22, 2005 with the Commission (Commission FileNo. 0-12422)).

 

4.1           Indenture dated as of December 19, 2002 between theRegistrant, as issuer, and State Street Bank and Trust Company of Connecticut,N.A., as trustee, re: floating rate junior subordinated deferrable interest debenturesdue 2032 (incorporated by reference to Exhibit 4.6 to the Annual Report on Form10-K of the registrant for the fiscal year ended December 31, 2002 filed March28, 2003 with the Commission (Commission File No. 0-12422)).

 

4.2           Amended and Restated Declaration of Trust dated as ofDecember 19, 2002 among State Street Bank and Trust Company of Connecticut,N.A., as institutional trustee, the Registrant, as sponsor, and James L. SanerSr., Donald A. Benziger and James M. Anderson, as administrators (incorporatedby reference to Exhibit 4.7 to the Annual Report on Form 10-K of the registrantfor the fiscal year ended December 31, 2002 filed March 28, 2003 with theCommission (Commission File No. 0-12422)).

 

4.3           Guarantee Agreement dated as of December 19, 2002 betweenthe Registrant, and State Street Bank and Trust Company of Connecticut, N.A(incorporated by reference to Exhibit 4.8 to the Annual Report on Form 10-K ofthe registrant for the fiscal year ended December 31, 2002 filed March 28, 2003with the Commission (Commission File No. 0-12422)).

 

4.4           Indenture dated as of April 1, 2003 between the Registrant,as issuer, and U.S. Bank, N.A., as trustee, re: floating rate juniorsubordinated deferrable interest debentures due 2033 (incorporated by referenceto Exhibit 4.1 to the Quarterly Report on Form 10-Q of the registrant for thequarter ended June 30, 2003 filed August 14, 2003 with the Commission(Commission File No. 0-12422)).

 

66

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4.5           Amended and Restated Declaration of Trust dated as of April1, 2003 among U.S. Bank, N.A., as institutional trustee, the Registrant, assponsor, and James L. Saner Sr., Donald A. Benziger and James M. Anderson, asadministrators (incorporated by reference to Exhibit 4.2 to the QuarterlyReport on Form 10-Q of the registrant for the quarter ended June 30, 2003 filedAugust 14, 2003 with the Commission (Commission File No. 0-12422)).

 

4.6           Guarantee Agreement dated as of April 1, 2003 between theRegistrant, and U.S. Bank, N.A (incorporated by reference to Exhibit 4.3 to theQuarterly Report on Form 10-Q of the registrant for the quarter ended June 30,2003 filed August 14, 2003 with the Commission (Commission File No. 0-12422)).

 

4.7           Indenture dated as of June 12, 2003 between the Registrant,as issuer, and The Bank of New York, as trustee, re: rate junior subordinateddeferrable interest debentures due (incorporated by reference to Exhibit 4.4 tothe Quarterly Report on Form 10-Q of the registrant for the quarter ended June30, 2003 filed August 14, 2003 with the Commission (Commission File No.0-12422)).

 

4.8           Amended and Restated Declaration of Trust dated as of June12, 2003 among The Bank of New York, as institutional trustee, the Registrant,as sponsor, and James L. Saner Sr., Donald A. Benziger and James M. Anderson,as administrators (incorporated by reference to Exhibit 4.5 to the QuarterlyReport on Form 10-Q of the registrant for the quarter ended June 30, 2003 filedAugust 14, 2003 with the Commission (Commission File No. 0-12422)).

 

4.9           Guarantee Agreement dated as of June 12, 2003 between theRegistrant, and The Bank of New York (incorporated by reference to Exhibit 4.6to the Quarterly Report on Form 10-Q of the registrant for the quarter endedJune 30, 2003 filed August 14, 2003 with the Commission (Commission File No.0-12422)).

 

10.1         Registrant’s 2003 Stock Option Plan (incorporated byreference to Exhibit 10.1 to the Annual Report on Form 10-K of the registrantfor the fiscal year ended December 31, 2003 filed March 12, 2004 with theCommission (Commission File No. 0-12422)).*

 

10.2         Form of Stock Option Agreement Under 2003 Stock Option Planfor Directors of Registrant dated May 19, 2003 (incorporated by reference toExhibit 10.2 to the Annual Report on Form 10-K of the registrant for the fiscalyear ended December 31, 2003 filed March 12, 2004 with the Commission(Commission File No. 0-12422)).*

 

10.3         Form of Stock Option Agreement Under 2003 Stock Option Planfor Officers of Registrant (incorporated by reference to Exhibit 10.1 to theReport on Form 8-K of the registrant filed February 24, 2005 with theCommission (Commission File No. 0-12422)).*

 

10.4         Form of Executive Severance Agreement dated January 16, 2001between the Registrant and James L. Saner, Sr. (incorporated by reference toExhibit 10.2 to the Annual Report on Form 10-K of the registrant for the fiscalyear ended December 31, 2000 filed March 30, 2001 with the Commission(Commission File No. 0-12422)).*

 

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10.5         Form of Executive Severance Agreement dated January 16, 2001between the Registrant and John C. Parker (incorporated by reference to Exhibit10.4 to the Annual Report on Form 10-K of the registrant for the fiscal yearended December 31, 2002 filed March 28, 2003 with the Commission (CommissionFile No. 0-12422)).*

 

10.6         Form of Executive Severance Agreement dated January 16,2001 between Registrant and James M. Anderson.*

 

10.7         Form of Indemnification Agreement for Directors and CertainOfficers of Registrant (incorporated by reference to Exhibit 10.1 to the Reporton Form 8-K of the registrant filed February 24, 2005 with the Commission(Commission File No. 0-12422)).

 

14            Code of Ethical Conduct (incorporated by reference toExhibit 14 to the Annual Report on Form 10-K of the registrant for the fiscalyear ended December 31, 2003 filed March 12, 2004 with the Commission(Commission File No. 0-12422)).

 

21            List of subsidiaries of the Registrant.

 

23.1         Consent of Crowe Chizek and Company LLC

 

31.1         Certification pursuant to Section 302 of Sarbanes-Oxley Actof 2002 by Chief Executive Officer

 

31.2         Certification pursuant to Section 302 of Sarbanes-Oxley Actof 2002 by Chief Financial Officer

 

The following exhibitsaccompany this periodic report pursuant to Section 906 of the Sarbanes-OxleyAct of 2002 (the “2002 Act”). These exhibits shall be deemed only to accompanythis periodic report and are not part of this periodic report, shall not bedeemed filed for purposes of the Securities Exchange Act of 1934, and may notbe for any purpose other than compliance with the 2002 Act.

 

32.1         Certification pursuant to Section 906 of the Sarbanes-OxleyAct of 2002, by Chief Executive Officer

 

32.2         Certification pursuant to Section 906 of the Sarbanes-OxleyAct of 2002, by Chief Financial Officer

 

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* A management contract or compensatory planor agreement.

 

(b) Exhibits

 

Reference is made to Item15(a)(3) above.

 

(c) Schedules

 

None required

 

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Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned; thereunto duly authorized, on the10th day of March, 2006.

 
|   | MAINSOURCE FINANCIAL GROUP, INC.     |
|--------|--------------------------------------|
|   |                                 |
|   | /s/ James L. Saner, Sr.         |   |
|   | James L.  Saner, Sr., President |
|   | And Chief Executive Officer          |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report on Form 10-K has been signed by the following persons on behalfof the registrant and in the capacities with the Company and on the datesindicated.

 
| **Signature** | ** **               | **Capacity** | ** **                                                  | **Date** |
|---------------|--------------------------|--------------|-------------------------------------------------------------|----------|
|          |                     |         |                                                        |     |   |
| /s/           | William G. Barron        |         |                                                        |     |   |
|          | William G. Barron        |         | Director                                                    |     | March 10, 2006 |
|          |                     |         |                                                        |     |   |
| /s/           | Brian J. Crall           |         |                                                        |     |   |
|          | Brian J. Crall           |         | Director                                                    |     | March 10, 2006 |
|          |                     |         |                                                        |     |   |
| /s/           | Douglas I. Kunkel        |         |                                                        |     |   |
|          | Douglas I. Kunkel        |         | Director                                                    |     | March 10, 2006 |
|          |                     |         |                                                        |     |   |
| /s/           | Philip A. Frantz         |         |                                                        |     |   |
|          | Philip A. Frantz         |         | Director                                                    |     | March 10, 2006 |
|          |                     |         |                                                        |     |   |
| /s/           | Rick S. Hartman          |         |                                                        |     |   |
|          | Rick S. Hartman          |         | Director                                                    |     | March 10, 2006 |
|          |                     |         |                                                        |     |   |
| /s/           | D.J. Hines               |         |                                                        |     |   |
|          | D.J. Hines               |         | Director                                                    |     | March 10, 2006 |
|          |                     |         |                                                        |     |   |
| /s/           | Robert E. Hoptry         |         |                                                        |     |   |
|          | Robert E. Hoptry         |         | Director                                                    |     | March 10, 2006 |
|          |                     |         | Chairman of the  Board                                      |     |   |
|          |                     |         |                                                        |     |   |
| /s/           | James M. Anderson        |         |                                                        |     |   |
|          | James M. Anderson        |         | Senior Vice  President &  Chief Financial  Officer |     | March 10, 2006 |
|          |                     |         |                                                        |     |   |
| /s/           | James L. Saner, Sr. |         |                                                        |     |   |
|          | James L. Saner, Sr. |         | Director                                                    |     | March 10, 2006 |
|          |                     |         | President & Chief  Executive Officer               |     |   |

 

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