Kentucky Bancshares (KTYB) 10-Q 2012 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2012

or

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

For the transition period from                     to                   

Commission File Number:  000-52598

KENTUCKY BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

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

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

Registrant’s telephone number, including area code:  (859) 987-1795

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer o	Accelerated filer o
Non-accelerated filer x	Smaller reporting company o
(Do not check if a smaller reporting company)

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

Number of shares of Common Stock outstanding as of July 31, 2012:  2,719,674.

KENTUCKY BANCSHARES, INC.

Table of Contents

Part I - Financial Information
Item 1.	Financial Statements
	Consolidated Balance Sheets	3
	Consolidated Statements of Income and Comprehensive Income	4
	Consolidated Statement of Changes in Stockholders’ Equity	6
	Consolidated Statements of Cash Flows	7
	Notes to Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	33
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	44
Item 4.	Controls and Procedures	46
Part II - Other Information		46
Item 6.	Exhibits	48
Signatures		48

2

Item 1 - Financial Statements

KENTUCKY BANCSHARES, INC.

CONSOLIDATED BALANCE SHEETS (unaudited)

(in thousands)

	6/30/2012			12/31/2011
Assets
Cash and due from banks	$	15,204		$	17,129
Federal funds sold	110			528
Cash and cash equivalents	15,314			17,657
Securities available for sale	184,962			180,419
Mortgage loans held for sale	92			624
Loans	421,399			411,867
Allowance for loan losses	(5,789		)	(5,842		)
Net loans	415,610			406,025
Federal Home Loan Bank stock	6,731			6,731
Real estate owned, net	8,644			8,296
Bank premises and equipment, net	16,705			16,702
Interest receivable	3,688			4,052
Mortgage servicing rights	995			835
Goodwill	13,117			13,117
Other intangible assets	649			765
Other assets	4,036			4,230
Total assets	$	670,543		$	659,453
Liabilities and Stockholders’ Equity Deposits
Non-interest bearing	$	137,711		$	130,999
Time deposits, $100,000 and over	88,452			93,127
Other interest bearing	316,968			318,798
Total deposits	543,131			542,924
Repurchase agreements and other borrowings	5,592			4,523
Federal Funds Purchased	2,691			—
Federal Home Loan Bank advances	33,307			30,326
Subordinated debentures	7,217			7,217
Interest payable	732			963
Other liabilities	5,508			4,547
Total liabilities	598,178			590,500
Stockholders’ equity
Preferred stock, 300,000 shares authorized and unissued	—			—
Common stock, no par value; 10,000,000 shares authorized; 2,722,481 and 2,716,805 shares issued and outstanding on June 30, 2012 and December 31, 2011	12,470			12,448
Retained earnings	54,848			52,735
Accumulated other comprehensive income	5,047			3,770
Total stockholders’ equity	72,365			68,953
Total liabilities & stockholders’ equity	$	670,543		$	659,453

See Accompanying Notes

3

KENTUCKY BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited)

(in thousands, except per share amounts)

	Six Months Ending
	6/30/2012		6/30/2011
INTEREST INCOME:
Loans, including fees	$	11,859	$	11,944
Securities
Taxable	924		1,508
Tax exempt	1,536		1,529
Other	164		158
Total interest income	14,483		15,139
INTEREST EXPENSE:
Deposits	1,322		2,247
Repurchase agreements and other borrowings	25		43
Federal Home Loan Bank advances	544		696
Subordinated debentures	123		117
Total interest expense	2,014		3,103
Net interest income	12,469		12,036
Loan loss provision	1,000		1,450
Net interest income after provision	11,469		10,586
NON-INTEREST INCOME:
Service charges	2,182		2,155
Loan service fee income	83		86
Trust department income	344		351
Securities available for sale gains	271		224
Gain on sale of mortgage loans	848		283
Brokerage Income	121		72
Debit Card Interchange Income	927		819
Other	202		111
Total other income	4,978		4,101
NON-INTEREST EXPENSE:
Salaries and employee benefits	6,153		5,876
Occupancy expenses	1,486		1,511
Repossession expenses (net)	520		294
FDIC Insurance	286		453
Legal and professional fees	372		367
Data processing	610		482
Debit Card Expenses	421		349
Amortization	117		124
Advertising and marketing	352		305
Taxes other than payroll, property and income	428		371
Telephone	158		271
Postage	148		149
Loan fees	211		60
Other	1,031		949
Total other expenses	12,293		11,561
Income before taxes	4,154		3,126
Income taxes	758		443
Net income	$	3,396	$	2,683
Other Comprehensive Income, net of tax:
Change in Unrealized Gains on Securities	1,277		3,102
Comprehensive Income	$	4,673	$	5,785
Earnings per share
Basic	$	1.25	$	0.98
Diluted	1.25		0.98
Dividends per share	0.46		0.44

See Accompanying Notes

4

KENTUCKY BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited)

(in thousands, except per share amounts)

	Three Months Ending
	6/30/2012			6/30/2011
INTEREST INCOME:
Loans, including fees	$	5,997		$	6,126
Securities
Taxable	475			712
Tax exempt	768			766
Other	81			77
Total interest income	7,321			7,681
INTEREST EXPENSE:
Deposits	637			1,055
Repurchase agreements and other borrowings	12			22
Federal Home Loan Bank advances	252			329
Subordinated debentures	61			59
Total interest expense	962			1,465
Net interest income	6,359			6,216
Loan loss provision	550			700
Net interest income after provision	5,809			5,516
NON-INTEREST INCOME:
Service charges	1,112			1,152
Loan service fee income	(4		)	42
Trust department income	188			185
Securities available for sale gains	111			221
Gain on sale of mortgage loans	370			135
Brokerage Income	70			33
Debit Card Interchange Income	482			427
Other	153			79
Total other income	2,482			2,274
NON-INTEREST EXPENSE:
Salaries and employee benefits	3,072			3,160
Occupancy expenses	777			756
Repossession expenses (net)	191			215
FDIC Insurance	145			224
Legal and professional fees	172			197
Data processing	295			265
Debit Card Expenses	221			179
Amortization	59			60
Advertising and marketing	176			153
Taxes other than payroll, property and income	214			161
Telephone	84			109
Postage	75			72
Loan fees	94			30
Other	510			550
Total other expenses	6,085			6,131
Income before taxes	2,206			1,659
Income taxes	428			238
Net income	$	1,778		$	1,421
Other Comprehensive Income, net of tax:
Change in Unrealized Gains on Securities	1,768			1,808
Comprehensive Income	$	3,546		$	3,229
Earnings per share
Basic	$	0.65		$	0.52
Diluted	0.65			0.52
Dividends per share	0.23			0.22

See Accompanying Notes

5

KENTUCKY BANCSHARES, INC.

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (unaudited)

(in thousands, except share information)

									Accumulated
									Other		Total
	—Common Stock(1)—					Retained			Comprehensive		Stockholders’
	Shares		Amount			Earnings			Income/(Loss)		Equity
Balances, January 1, 2012	2,716,805		$	12,448		$	52,735		$	3,770	$	68,953
Common stock issued, including tax benefit, net	5,614		1			—			—		1
Stock based compensation expense	—		46			—			—		46
Common stock purchased and retired	(2,745	)	(25		)	(31		)	—		(56		)
Net change in unrealized gain (loss) on securities available for sale, net of tax and reclassifications	—		—			—			1,277		1,277
Net income	—		—			3,396			—		3,396
Dividends declared - $0.46 per share	—		—			(1,252		)	—		(1,252		)
Balances, June 30, 2012	2,719,674		$	12,470		$	54,848		$	5,047	$	72,365

(1)Common Stock has no par value; amount includes Additional Paid-in Capital

See Accompanying Notes

6

KENTUCKY BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

(in thousands)

	Six Months Ended
	6/30/2012			6/30/2011
Cash Flows From Operating Activities
Net Income	$	3,396		$	2,683
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	827			812
Securities amortization (accretion), net	654			31
Stock based compensation expense	46			52
Provision for loan losses	1,000			1,450
Securities gains, net	(271		)	(224		)
Originations of loans held for sale	(28,707		)	(9,430		)
Proceeds from sale of loans	30,087			9,199
Gains (losses) on sale of fixed assets	14			(54		)
Losses (gains) on other real estate	69			99
Gain on sale of mortgage loans	(848		)	(283		)
Changes in:
Interest receivable	364			814
Real estate owned, net	19			68
Other assets	(268		)	(100		)
Interest payable	(231		)	102
Other liabilities	303			435
Net cash from operating activities	6,454			5,654
Cash Flows From Investing Activities
Purchases of securities	(44,891		)	(30,681		)
Proceeds from principal payments, sales, maturities and calls of securities	41,900			38,830
Net change in loans	(12,186		)	(1,093		)
Purchases of bank premises and equipment	(627		)	(429		)
Proceeds from the sale of bank premises	17			200
Proceeds from the sale of other real estate	1,349			2,283
Net cash from investing activities	(14,438		)	9,110
Cash Flows From Financing Activities:
Net change in deposits	207			(20,408		)
Net change in repurchase agreements and other borrowings	4,160			10,399
Advances from Federal Home Loan Bank	25,000			10,000
Payments on Federal Home Loan Bank advances	(22,019		)	(16,984		)
Payments on note payable	(400		)	(400		)
Proceeds from issuance of common stock	1			—
Purchase of common stock	(56		)	(138		)
Dividends paid	(1,252		)	(1,205		)
Net cash from financing activities	5,641			(18,736		)
Net change in cash and cash equivalents	(2,343		)	(3,972		)
Cash and cash equivalents at beginning of period	17,657			17,625
Cash and cash equivalents at end of period	$	15,314		$	13,653
Supplemental disclosures of cash flow information
Cash paid during the year for:
Interest expense	$	2,245		$	3,010
Income taxes	300			300
Supplemental disclosures of non-cash investing activities
Real estate acquired through foreclosure	$	1,689		$	3,674

See Accompanying Notes

7

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The financial information presented as of any date other than December 31 has been prepared from the Company’s books and records without audit.  The accompanying consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Certain financial information that is normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America, but is not required for interim reporting purposes, has been condensed or omitted.  In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of such financial statements, have been included.  The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year.

For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

Basis of Presentation:  The consolidated financial statements include the accounts of Kentucky Bancshares, Inc. (the “Company”, “we”, “our” or “us”), its wholly-owned subsidiary, Kentucky Bank (the “Bank”), and the Bank’s wholly-owned subsidiary, KB Special Assets Unit, LLC.  Intercompany transactions and balances have been eliminated in consolidation.

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

Estimates in the Financial Statements:  The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.  The allowance for loan losses, mortgage servicing rights, real estate owned, goodwill and fair value of financial instruments are particularly subject to change.

8

Loss Contingencies:  Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated.  The Company terminated its Defined Benefit Plan (the Plan) effective December 31, 2008.  The termination was filed with the Pension Benefit Guaranty Corporation (PBGC) in April 2009.  The 60-day PBGC comment period passed without comment from PBGC.  Benefits were distributed according to the actuarial calculations in 2009.  The Internal Revenue Service (IRS) issued a favorable determination as to the Plan termination in July 2010.  Subsequent to termination and distribution, the Plan was selected for audit by the PBGC.  The PBGC asserts a plan amendment was applied errantly resulting in lower benefits. A preliminary estimate provided by the Plan actuary indicates the potential exposure related to this matter is $1.3 million.  The Company believes it has meritorious defenses and formally rebutted the PBGC assertion in June 2011 requesting a reconsideration of the PBGC conclusion and intends to continue to vigorously defend the position.  As such, the Company does not believe a loss is probable and has not recorded a liability relating to the PBGC assertion.

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

9

2.     SECURITIES AVAILABLE FOR SALE

INVESTMENT SECURITIES

Period-end securities are as follows:

(in thousands)

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Available for Sale
June 30, 2012
U.S. government agencies	$	17,641	$	89	$	—		$	17,730
States and political subdivisions	80,180		5,449		(15		)	85,614
Mortgage-backed - residential	79,225		2,086		—			81,311
Equity securities	270		37		—			307
Total	$	177,316	$	7,661	$	(15	)	$	184,962
December 31, 2011
U.S. government agencies	$	23,363	$	10	$	(19	)	$	23,354
States and political subdivisions	81,697		4,938		(28		)	86,607
Mortgage-backed - residential	69,378		786		(9		)	70,155
Equity securities	270		33		—			303
Total	$	174,708	$	5,767	$	(56	)	$	180,419

The amortized cost and fair value of securities at June 30, 2012 by contractual maturity are shown below.  Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  Securities not due at a single maturity are shown separately.

(in thousands)

	Amortized		Fair
	Cost		Value
Due in one year or less	$	50	$	50
Due after one year through five years	6,472		6,598
Due after five years through ten years	38,165		39,727
Due after ten years	53,134		56,969
	97,821		103,344
Mortgage-backed - residential	79,225		81,311
Equity	270		307
Total	$	177,316	$	184,962

Proceeds from sales of securities during the first six months of 2012 and 2011 were $27.2 million and $21.2 million.  Gross gains of $271 thousand and $224 thousand and gross losses of $0 and $0 thousand were realized on those sales, respectively.  The tax provision related to these realized gains and losses was $92 thousand and $76 thousand, respectively.

10

Proceeds from sales of securities during the three months ending June 30, 2012 and June 30, 2011 were $14.4 million and $21.2 million.  Gross gains of $111 thousand and $221 thousand, respectively, and no gross losses were realized on those sales.  The tax provision related to these realized gains was $38 thousand and $75 thousand, respectively.

Securities with unrealized losses at June 30, 2012 and at December 31, 2011 not recognized in income are as follows:

June 30, 2012

	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
Description of Securities	Value		Loss			Value		Loss			Value		Loss
U.S. Government agencies	$	—	$	—		$	—	$	—		$	—	$	—
States and municipals	1,655		(13		)	509		(2		)	2,164		(15		)
Mortgage-backed - residential	—		—			—		—			—		—
Total temporarily impaired	$	1,655	$	(13	)	$	509	$	(2	)	$	2,164	$	(15	)

December 31, 2011

	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
Description of Securities	Value		Loss			Value		Loss			Value		Loss
U.S. Government agencies	$	10,984	$	(19	)	$	—	$	—		$	10,984	$	(19	)
States and municipals	2,006		(27		)	1,028		(1		)	3,034		(28		)
Mortgage-backed - residential	3,159		(9		)	—		—			3,159		(9		)
Total temporarily impaired	$	16,149	$	(55	)	$	1,028	$	(1	)	$	17,177	$	(56	)

The Company evaluates securities for other than temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.  In analyzing an issuer’s financial condition, we may consider many factors including, (1) whether the securities are issued by the federal government or its agencies, (2) whether downgrades by bond rating agencies have occurred, (3) the results of reviews of the issuer’s financial condition and near-term prospects, (4) the length of time and the extent to which the fair value has been less than cost, and (5) whether we intend to sell the investment security or more likely than not will be required to sell the investment security before its anticipated recovery.

Unrealized losses on securities included in the tables above have not been recognized into income because (1) all rated securities are investment grade and are of high credit quality, (2) management does not intend to sell and it is more likely than not that management would not be required to sell the securities prior to their anticipated recovery, (3) management believes the decline in fair value is largely due to changes in interest rates and (4) management believes the declines in fair value are temporary.  The Company believes the fair value is expected to recover as the securities approach maturity.

11

3.       LOANS

Loans at period-end are as follows:

(in thousands)

	6/30/12		12/31/11
Commercial	$	32,481	$	28,892
Real estate construction	10,136		13,261
Real estate mortgage:
1-4 family residential	166,102		160,645
Multi-family residential	11,704		13,305
Non-farm & non-residential	109,552		100,047
Agricultural	73,721		77,820
Consumer	17,496		17,572
Other	207		325
Total	$	421,399	$	411,867

Activity in the allowance for loan losses for the six and three month periods indicated was as follows:

	Six Months Ended June 30, 2012
	(in thousands)
	Beginning									Ending
	Balance		Charge-offs		Recoveries		Provision			Balance
Commercial	$	192	$	—	$	—	$	6		$	198
Real estate Construction	1,008		73		—		(171		)	764
Real estate mortgage:
1-4 family residential	2,257		612		8		561			2,214
Multi-family residential	336		52		1		(11		)	274
Non-farm & non-residential	410		64		—		352			698
Agricultural	721		15		4		81			791
Consumer	524		213		25		199			535
Other	50		254		192		49			37
Unallocated	344		—		—		(66		)	278
	$	5,842	$	1,283	$	230	$	1,000		$	5,789

	Three Months Ended June 30, 2012
	(in thousands)
	Beginning									Ending
	Balance		Charge-offs		Recoveries		Provision			Balance
Commercial	$	206	$	—	$	—	$	(8	)	$	198
Real estate Construction	1,015		73		—		(178		)	764
Real estate mortgage:
1-4 family residential	2,380		468		4		298			2,214
Multi-family residential	318		52		—		8			274
Non-farm & non-residential	425		64		—		337			698
Agricultural	812		—		2		(23		)	791
Consumer	526		85		19		75			535
Other	25		108		70		50			37
Unallocated	287		—		—		(9		)	278
	$	5,994	$	850	$	95	$	550		$	5,789

12

Activity in the allowance for loan losses for the six and three month periods indicated was as follows:

	Six Months Ended June 30, 2011
	(in thousands)
	Beginning									Ending
	Balance		Charge-offs		Recoveries		Provision			Balance
Commercial	$	235	$	34	$	74	$	(70	)	$	205
Real estate Construction	721		124		—		77			674
Real estate mortgage:
1-4 family residential	1,827		211		5		682			2,303
Multi-family residential	148		94		144		136			334
Non-farm & non-residential	889		329		14		122			696
Agricultural	265		—		12		406			683
Consumer	582		119		11		95			569
Other	58		361		279		50			26
Unallocated	200		—		—		(48		)	152
	$	4,925	$	1,272	$	539	$	1,450		$	5,642

	Three Months Ended June 30, 2011
	(in thousands)
	Beginning									Ending
	Balance		Charge-offs		Recoveries		Provision			Balance
Commercial	$	223	$	16	$	74	$	(76	)	$	205
Real estate Construction	671		124		—		127			674
Real estate mortgage:
1-4 family residential	2,289		121		1		134			2,303
Multi-family residential	265		94		—		163			334
Non-farm & non-residential	904		314		—		106			696
Agricultural	239		—		1		443			683
Consumer	585		66		5		45			569
Other	37		139		94		34			26
Unallocated	428		—		—		(276		)	152
	$	5,641	$	874	$	175	$	700		$	5,642

13

The following tables present the balance in the allowance for loan losses and the recorded investment (excluding accrued interest receivable amounting to $2.5 million as of June 30, 2012 and $2.9 million at December 31, 2011) in loans by portfolio segment and based on impairment method as of June 30, 2012 and December 31 2010:

As of June 30, 2012

(in thousands)

	Individually		Collectively
	Evaluated for		Evaluated for
	Impairment		Impairment		Total
Allowance for Loan Losses:
Commercial	$	—	$	198	$	198
Real estate construction	503		261		764
Real estate mortgage:
1-4 family residential	95		2,119		2,214
Multi-family residential	25		249		274
Non-farm & non-residential	229		469		698
Agricultural	488		303		791
Consumer	—		535		535
Other	—		37		37
Unallocated	—		278		278
	$	1,340	$	4,449	$	5,789
Loans:
Commercial	$	—	$	32,481	$	32,481
Real estate construction	2,334		7,802		10,136
Real estate mortgage:
1-4 family residential	3,933		162,169		166,102
Multi-family residential	605		11,099		11,704
Non-farm & non-residential	5,561		103,991		109,552
Agricultural	6,409		67,312		73,721
Consumer	—		17,496		17,496
Other	—		207		207
	$	18,842	$	402,557	$	421,399

As of December 31, 2011

(in thousands)

	Individually		Collectively
	Evaluated for		Evaluated for
	Impairment		Impairment		Total
Allowance for Loan Losses:
Commercial	$	—	$	192	$	192
Real estate construction	703		305		1,008
Real estate mortgage:
1-4 family residential	325		1,932		2,257
Multi-family residential	52		284		336
Non-farm & non-residential	119		291		410
Agricultural	427		294		721
Consumer	—		524		524
Other	—		50		50
Unallocated	—		344		344
	$	1,626	$	4,216	$	5,842
Loans:
Commercial	$	—	$	28,892	$	28,892
Real estate construction	3,975		9,286		13,261
Real estate mortgage:
1-4 family residential	1,873		158,772		160,645
Multi-family residential	207		13,098		13,305
Non-farm & non-residential	2,667		97,380		100,047
Agricultural	6,416		71,404		77,820
Consumer	—		17,572		17,572
Other	—		325		325
	$	15,138	$	396,729	$	411,867

14

The following table presents individually impaired average loan balances by class for the six months periods ended June 30, 2012 and June 30, 2011:

	June 30, 2012		June 30, 2011
(in thousands)	Six Month Average		Six Month Average
Commercial	$	—	$	—
Real Estate construction	4,721		5,475
Real estate mortgage:
1-4 family residential	2,918		3,855
Multi-family residential	340		1,984
Non-farm & non-residential	4.565		5,875
Agricultural	7,393		4,166
Installment	—		—
Other	—		—
Total	$	19,937	$	21,355

The following table presents individually impaired average loan balances by class for the three months periods ended June 30, 2012 and June 30, 2011:

	June 30, 2012		June 30, 2011
(in thousands)	Three Month Average		Three Month Average
Commercial	$	—	$	—
Real Estate construction	3,144		5,069
Real estate mortgage:
1-4 family residential	3,005		3,840
Multi-family residential	406		1,734
Non-farm & non-residential	3,936		5,639
Agricultural	6,410		5,852
Installment	—		—
Other	—		—
Total	$	16,901	$	22,134

Interest income and cash-basis interest income recognized during impairment for the six and three months ending June 30, 2012 and June 30, 2011 is shown below.  Interest income and cash-basis interest income recognized during impairment for the six and three months ending June 30, 2012 and June 30, 2011 were the same amounts.

	Six Months Ended		Three Months Ended
(in thousands)	June 30, 2012		June 30, 2012
Commercial	$	—	$	—
Real estate construction	37		37
Real estate mortgage:
1-4 family residential	57		27
Multi-family residential	—		—
Non-farm & non-residential	1		—
Agricultural	8		7
Consumer	3		—
Other	—		—
Total	$	106	$	71

	Six Months Ended		Three Months Ended
(in thousands)	June 30, 2011		June 30, 2011
Commercial	$	—	$	—
Real estate construction	—		—
Real estate mortgage:
1-4 family residential	22		17
Multi-family residential	—		—
Non-farm & non-residential	—		—
Agricultural	105		76
Consumer	1		1
Other	—		—
Total	$	128	$	94

15

The following table presents loans individually evaluated for impairment by class of loans as of June 30, 2012 (in thousands):

	Unpaid				Allowance for		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest
	Balance		Investment		Allocated		Investment		Recognized		Recognized
With no related allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	—	$	—
Real estate construction	—		—		—		1,067		37		37
Real estate mortgage:
1-4 family residential	3,469		3,449		—		1,447		57		57
Multi-family residential	207		155		—		69		—		—
Non-farm & non-residential	2,852		2,151		—		2,002		1		1
Agricultural	1,562		1,562		—		1,501		8		8
Consumer	—		—		—		—		3		3
Other	—		—		—		—		—		—
With an allowance recorded:
Commercial	—		—		—		—		—		—
Real estate construction	3,035		3,035		503		2,354		—
Real estate mortgage:
1-4 family residential	484		484		95		1,181		—		—
Multi-family residential	450		450		25		271		—		—
Non-farm & non-residential	2,709		2,709		229		1,512		—		—
Agricultural	4,847		4,847		488		4,910		—		—
Consumer	—		—		—		—		—		—
Other	—		—		—		—				—
Total	$	19,615	$	18,842	$	1,340	$	16,314	$	106	$	106

The recorded investment in loans excludes accrued interest receivable and loan origination fees, net due to immateriality.  For purposes of this disclosure, the unpaid principal balance is not adjusted for net charge-offs.

16

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2011 (in thousands):

	Unpaid				Allowance for		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest
	Balance		Investment		Allocated		Investment		Recognized		Recognized
With no related allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	1	$	1
Real estate construction	1,600		940		—		1,732		113		113
Real estate mortgage:
1-4 family residential	595		595		—		1,003		39		39
Multi-family residential	—		—		—		493		—		—
Non-farm & non-residential	1,578		1,578		—		3,908		—		—
Agricultural	1,474		1,474		—		1,931		123		123
Consumer	—		—		—		—		5		5
Other	—		—		—		—		—		—
With an allowance recorded:
Commercial	—		—		—		—		—		—
Real estate construction	3,035		3,035		703		3,274		—
Real estate mortgage:
1-4 family residential	1,298		1,278		325		2,167		—		—
Multi-family residential	207		207		52		739		—		—
Non-farm & non-residential	1,089		1,089		119		1,007		—		—
Agricultural	4,942		4,942		427		3,004		—		—
Consumer	—		—		—		—		—		—
Other	—		—		—		—				—
Total	$	15,818	$	15,138	$	1,626	$	19,258	$	281	$	281

The recorded investment in loans excludes accrued interest receivable and loan origination fees, net due to immateriality.  For purposes of this disclosure, the unpaid principal balance is not adjusted for net charge-offs.

17

The following tables present the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of June 30, 2012 and December 31, 2011:

As of June 30, 2012

(in thousands)

			Loans Past Due Over 90 Days Still		Troubled Debt
	Nonaccrual		Accruing		Restructurings
Commercial	$	—	$	—	$	—
Real estate construction	3,035		—		—
Real estate mortgage:
1-4 family residential	1,449		470		511
Multi-family residential	155		—		—
Non-farm & non-residential	1,540		—		1,947
Agricultural	389		—		5,432
Consumer	72		1		—
Total	$	6,640	$	471	$	7,890

As of December 31, 2011

(in thousands)

			Loans Past Due Over 90 Days Still		Troubled Debt
	Nonaccrual		Accruing		Restructurings
Commercial	$	—	$	—	$	—
Real estate construction	1,138		—		—
Real estate mortgage:
1-4 family residential	2,573		372		519
Multi-family residential	207		—		—
Non-farm & non-residential	1,421		—		—
Agricultural	610		—		585
Consumer	68		26		—
Total	$	6,017	$	398	$	1,104

Nonaccrual loans secured by real estate make up 99.0% of the total nonaccruals at June 30, 2012.

Nonaccrual loans are included in impaired loans.  A loan is impaired when full payment under the contractual terms is not expected.

Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.

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A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement.  All amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement.  Nonaccrual loans are loans for which payments in full of principal or interest is not expected or which principal or interest has been in default for a period of 90 days or more unless the asset is both well secured and in the process of collection.  Impaired loans may be loans showing signs of weakness or interruptions in cash flow, but ultimately are current or less than 90 days past due with respect to principal and interest and for which we anticipate full payment of principal and interest.

Additional factors considered by management in determining impairment and non-accrual status include payment status, collateral value, availability of current financial information, and the probability of collecting all contractual principal and interest payments.

During the first six months of 2012, $1.7 million of impaired loans were transferred to other real estate owned and $1.1 million recorded in charge offs.

The following tables present the aging of the recorded investment in past due and non-accrual loans as of June 30, 2012 and December 31, 2011 by class of loans:

As of June 30, 2012

(in thousands)

	30–59		60–89		Loans Past Due				Total
	Days		Days		Over 90 Days				Past Due &		Loans Not
	Past Due		Past Due		Still Accruing		Non-accrual		Non-accrual		Past Due
Commercial	$	141	$	—	$	—	$	—	$	141	$	32,340
Real estate construction	—		—		—		3,035		3,035		7,101
Real estate mortgage:
1-4 family residential	2,203		57		470		1,449		4,179		162,822
Multi-family residential	450		—		—		155		605		11,099
Non-farm & non-residential	97		—		—		1,540		1,637		107,016
Agricultural	772		—		—		389		1,161		72,560
Consumer	93		26		1		72		192		17,304
Other	—		—		—		—		—		207
Total	$	3,756	$	83	$	471	$	6,640	$	10,950	$	410,449

As of December 31, 2011

(in thousands)

	30–59		60–89		Loans Past Due				Total
	Days		Days		Over 90 Days				Past Due &		Loans Not
	Past Due		Past Due		Still Accruing		Non-accrual		Non-accrual		Past Due
Commercial	$	71	$	—	$	—	$	—	$	71	$	28,821
Real estate construction	—		—		—		1,138		1,138		12,123
Real estate mortgage:
1-4 family residential	1,859		232		372		2,573		5,036		155,609
Multi-family residential	164		—		—		207		371		12,934
Non-farm & non-residential	153		—		—		1,421		1,574		98,473
Agricultural	468		35		—		610		1,113		76,707
Consumer	130		38		26		68		262		17,310
Other	—		—		—		—		—		324
Total	$	2,845	$	305	$	398	$	6,017	$	9,565	$	402,301

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Troubled Debt Restructurings:

The Company has allocated $709 thousand in specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of June 30, 2012.  No specific reserves were allocated to customers whose loan terms had been modified in troubled debt restructuring as of December 31, 2011.  The Company has not committed to lend additional amounts as of June 30, 2012 and December 31, 2011 to customers with outstanding loans that are classified as troubled debt restructurings.

Two loans were modified as troubled debt restructurings during the six months and three months ending June, 30, 2012 and two additional notes were modified prior to January 1, 2012.  The modification of the terms of such loans were to interest only payments for a 1 year term and lower interest rates.

The following table presents loans by class modified as troubled debt restructurings outstanding as of June 30, 2012:

		Pre-Modification		Post-Modification
		Outstanding		Outstanding
	Number	Recorded		Recorded
	of Loans	Investment		Investment
Troubled Debt Restructurings:
Real estate mortgage:
1-4 family residential	1	$	474	$	511
Agricultural	2	5,240		5,432
Non-Farm & non-residential	1	1,926		1,947
Total	4	$	7,640	$	7,890

The troubled debt restructurings described above increased the allowance for loan losses by $221 and resulted in charge offs of $0 during the period ending June 30, 2012. The post-modification balances increased primarily for amounts advanced to pay interest and taxes.  Loans past due 60 days are normally considered in default.  No loans modified in the last 12 months are in default.

No other loans were modified during the six months and three months ending June 30, 2012 that did not meet the definition of a troubled debt restructuring.

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as:  current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors.  The Company analyzes loans individually by classifying the loans as to credit risk.  This analysis is performed on a quarterly basis.  The Company uses the following definitions for risk ratings:

Special Mention.  Loans classified as special mention have a potential weakness that deserves management’s close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.

20

Substandard.  Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any.  Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful.  Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

As of June 30, 2012 and December 31, 2011, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:

As of June 30, 2012

(in thousands)

			Special
	Pass		Mention		Substandard		Doubtful
Commercial	$	30,764	$	1,426	$	291	$	—
Real estate construction	4,192		2,910		3,035		—
Real estate mortgage:
1-4 family residential	144,383		9,623		11,945		151
Multi-family residential	9,756		1,703		244		—
Non-farm & non-residential	94,445		11,637		3,470		—
Agricultural	60,685		5,131		7,902		3
Total	$	344,225	$	32,430	$	26,887	$	154

As of December 31, 2011

(in thousands)

			Special
	Pass		Mention		Substandard		Doubtful
Commercial	$	27,294	$	1,342	$	256	$	—
Real estate construction	6,957		2,017		4,287		—
Real estate mortgage:
1-4 family residential	141,403		9,603		9,613		26
Multi-family residential	9,871		2,965		469		—
Non-farm & non-residential	91,957		5,317		2,773		—
Agricultural	63,391		6,663		7,751		15
Total	$	340,873	$	27,907	$	25,149	$	41

For consumer loans, the Company evaluates the credit quality based on the aging of the recorded investment in loans, which was previously presented.  Non-performing consumer loans are loans which are greater than 90 days past due or on non-accrual status, and total $73 thousand at June 30, 2012 and $94 thousand at December 31, 2011.

21

4.     REAL ESTATE OWNED

Activity in real estate owned was as follows:

	Six Months Ended
	2012			2011
	(in thousands)
Beginning of year	$	8,296		$	8,424
Additions	1,689			3,674
Sales	(1,418		)	(2,567		)
Additions to valuation allowance, net	(19		)	(68		)
Recovery from sale in valuation allowance	96			183
End of period	$	8,644		$	9,646

Activity in the valuation allowance was as follows:

	Six Months Ended
	2012			2011
	(in thousands)
Beginning of year	$	1,332		$	799
Additions charged to expense, net	19			68
Recovery from sale	(96		)	(183		)
End of period	$	1,255		$	684

Expenses related to foreclosed assets include:

	Six Months Ended
	2012		2011
	(in thousands)
Net loss (gain) on sales	$	69	$	99
Provision for unrealized losses, net	19		68
Operating expenses (receipts), net of rental income	501		226
End of period	$	589	$	393

22

5.     EARNINGS PER SHARE

Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period.  Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options.

The factors used in the earnings per share computation follow:

	Six Months Ended
	June 30
	2012		2011
	(in thousands)
Basic Earnings Per Share
Net Income	$	3,396	$	2,683
Weighted average common shares outstanding	2,706		2,728
Basic earnings per share	$	1.25	$	0.98
Diluted Earnings Per Share
Net Income	$	3,396	$	2,683
Weighted average common shares outstanding	2,706		2,728
Add dilutive effects of assumed vesting of stock grants	3		1
Weighted average common and dilutive potential common shares outstanding	2,709		2,729
Diluted earnings per share	$	1.25	$	0.98

	Three Months Ended
	June 30
	2012		2011
	(in thousands)
Basic Earnings Per Share
Net Income	$	1,778	$	1,421
Weighted average common shares outstanding	2,706		2,730
Basic earnings per share	$	0.65	$	0.52
Diluted Earnings Per Share
Net Income	$	1,778	$	1,421
Weighted average common shares outstanding	2,706		2,730
Add dilutive effects of assumed vesting of stock grants	3		1
Weighted average common and dilutive potential common shares outstanding	2,709		2,731
Diluted earnings per share	$	0.65	$	0.52

Stock options for 29,160 shares of common stock for the six and three months ended June 30, 2012 and 23,610 shares of common stock for the six and three months ended June 30, 2011 were excluded from diluted earnings per share because their impact was antidilutive.  Restricted stock grants of 14,354 shares of common stock for the six and three months ended June 30, 2012 and 23,610 shares of common stock for the six and three months ended June 30, 2011 were excluded from diluted earnings per share because their impact was antidilutive.

23

6.     STOCK COMPENSATION

We have four share based compensation plans as described below.

Two Stock Option Plans

Under our now expired 1999 Employee Stock Option Plan (the “1999 Plan”), we granted certain officers and key employees stock option awards which vest and become fully exercisable at the end of five years and provide for issuance of up to 100,000 options.  Under the now expired 1993 Non-Employee Directors Stock Ownership Incentive Plan (together with the 1999 Plan, the “Stock Option Plans”), we also granted certain directors stock option awards which vest and become fully exercisable immediately and provide for issuance of up to 20,000 options.  For each Stock Option Plan, the exercise price of each option, which has a ten year life, was equal to the market price of our stock on the date of grant.

The combined summary of activity for 2012 in the expired Stock Option Plans follows:

					Weighted
			Weighted		Average
			Average		Remaining	Aggregate
			Exercise		Contractual	Intrinsic
	Shares		Price		Term	Value
Outstanding, beginning of year	30,660		$	29.68
Granted	—		—
Forfeited or expired	(1,500	)	26.47
Exercised	—		—
Outstanding, end of period	29,160		$	29.86	26.2 months	$	—
Vested and expected to vest	29,160		$	29.86	26.2 months	$	—
Exercisable, end of period	29,160		$	29.86	26.2 months	$	—

As of June 30, 2012, there was $0 of total unrecognized compensation cost related to nonvested stock options granted under either Stock Option Plan.  Since both Stock Option Plans have expired, as of June 30, 2012 no additional options can be granted under either of these plans.

2005 Restricted Stock Grant Plan

On May 10, 2005, our stockholders approved a restricted stock grant plan.  Total shares issuable under the plan are 50,000.  There were 5,615 shares issued during 2012 and 5,955 shares issued during 2011.  There were 30 shares forfeited during the first six months of 2012 and 65 shares forfeited during the first six months of 2011.  As of June 30, 2012, the restricted stock grant plan allows for additional restricted stock share awards of up to 18,310 shares.

24

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

			Weighted-Average			Fair
			Grant-Date			Value
Nonvested Shares	Shares		Fair Value			Per Share
Nonvested at January 1, 2012	13,434		$	253,366		$	18.86
Granted	5,615		106,741			19.01
Vested	(4,080	)	(88,629		)	21.72
Forfeited	(30	)	(570		)	19.00
Nonvested at June 30, 2012	14,939		$	270,908		$	18.13

As of June 30, 2012, there was $271,198 of total unrecognized compensation cost related to nonvested shares granted under the restricted stock grant plan.  The cost is expected to be recognized over a weighted-average period of 5 years.

2009 Stock Award Plan

On May 13, 2009, our stockholders approved a stock award plan that provides for the granting of both incentive and nonqualified stock options and other share based awards.  Total shares issuable under the plan are 150,000.  As of June 30, 2012 no awards have been granted under the plan and 150,000 shares are still available.

7.  OTHER BORROWINGS

Promissory note payable of $900,000 at June 30, 2012 and $1,300,000 at December 31, 2011, matures July 29, 2012, and has principal due at maturity and interest payable quarterly at prime, and is secured by 100% of the common stock of the bank.  The original 2009 loan agreement contains certain covenants and performance terms.  The Bank was not in compliance with the non-performing asset covenant at June 30, 2012.  However, a debt covenant waiver was obtained from the lending institution.  The loan is in the process of being renewed on similar terms for an additional 1 year term.

8.  FAIR VALUE MEASUREMENTS

ASC Topic 820, “Fair Value Measurements and Disclosures”, defines fair value, establishes a framework for measuring fair value, and sets forth disclosures about fair value measurements.  ASC Topic 825, “Financial Instruments”, allows entities to choose to measure certain financial assets and liabilities at fair value.  The Company has not elected the fair value option for any financial assets or liabilities.

ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  It also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  This Topic describes three levels of inputs that may be used to measure fair value:

Level 1 — Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

25

Level 2 — Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3 — Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

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

Investment Securities:  The fair values for available for sale investment securities are determined by quoted market prices, if available (Level 1).  For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2).  For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3).

Impaired Loans:  The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent third party real estate appraisals.  These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available.  Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Other Real Estate Owned:  Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned (OREO) are measured at fair value, less costs to sell.  Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification.  In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

Mortgage Servicing Rights:  Fair value is based on market prices for comparable mortgage servicing contracts, when available, or alternatively based on a valuation model that calculates the present value of estimated future net servicing income, resulting in a Level 3 classification.

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Assets and Liabilities Measured on a Recurring Basis

Available for sale investment securities are the Company’s only balance sheet item that meet the disclosure requirements for instruments measured at fair value on a recurring basis.  Disclosures are as follows in the tables below.

	Fair Value Measurements at June 30, 2012 Using:
			Quoted Prices
			In Active
			Markets for		Significant Other		Significant
			Identical		Observable		Unobservable
(In thousands)	Fair		Assets		Inputs		Inputs
Description	Value		(Level 1)		(Level 2)		(Level 3)
U. S. government agencies	$	17,730	$	—	$	17,730	$	—
States and municipals	85,614		—		85,614		—
Mortgage-backed - residential	81,311		—		81,311		—
Equity securities	307		307		—		—
Total	$	184,962	$	307	$	184,655	$	—

	Fair Value Measurements at December 31, 2011 Using:
			Quoted Prices
			In Active
			Markets for		Significant Other		Significant
			Identical		Observable		Unobservable
(In thousands)	Fair		Assets		Inputs		Inputs
Description	Value		(Level 1)		(Level 2)		(Level 3)
U. S. government agencies	$	23,354	$	—	$	23,354	$	—
States and municipals	86,607		—		86,607		—
Mortgage-backed - residential	70,155		—		70,155		—
Equity securities	303		303		—		—
Total	$	180,419	$	303	$	180,116	$	—

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

	Fair Value Measurements at June 30, 2012 Using:
			Quoted Prices
			In Active				Other
			Markets for		Significant		Significant
			Identical		Observable		Unobservable
(In thousands)	Fair		Assets		Inputs		Inputs
Description	Value		(Level 1)		(Level 2)		(Level 3)
Impaired loans:
Real estate construction	$	2,532	$	—	$	—	$	2,532
Real Estate Mortgage:
1-4 family residential	388		—		—		388
Multi-family residential	425		—		—		425
Non-farm & non-residential	243		—		—		243
Other real estate owned:
Residential	4,248		—		—		4,248
Loan servicing rights	686		—		—		686

	Fair Value Measurements at December 31, 2011 Using:
			Quoted Prices
			In Active				Other
			Markets for		Significant		Significant
			Identical		Observable		Unobservable
(In thousands)	Fair		Assets		Inputs		Inputs
Description	Value		(Level 1)		(Level 2)		(Level 3)
Impaired loans:
Real estate construction	$	2,332	$	—	$	—	$	2,332
Real Estate Mortgage:
1-4 family residential	953		—		—		953
Multi-family residential	155		—		—		155
Non-farm & non-residential	970		—		—		970
Agricultural	4,515		—		—		4,515
Other real estate owned:
Residential	5,542		—		—		5,542
Commercial real estate	42		—		—		42
Loan servicing rights	380		—		—		380

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Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $3.6 million, which includes a valuation allowance of $631 thousand at June 30, 2012. The allowance for specific impaired loans decreased $286 thousand for the six months ending June 30, 2012 and $335 thousand for the three months ending June 30, 2012.  The loan loss provision for the six months ending June 30, 2012 is $1.0 million and $550 thousand for the three months ending June 30, 2012.  The loan loss provision for the six months ending June 30, 2011 was $1.5 million and $700 thousand for the three months ending June 30, 2011.

Other real estate owned which is measured at fair value less costs to sell, had a net carrying amount of $4.2 million, which is made up of the outstanding balance of $5.5 million, net of a valuation allowance of $1.3 million at June 30, 2012.  The net write-down of Other Real Estate Owned properties totaled $19 thousand for the six months ending June 30, 2012.  The net write-down consists of $80 thousand in write downs and $61 thousand in the recovery of a prior write-down. Write-downs of Other Real Estate Owned properties totaled $23 thousand for the three months ending June 30, 2012.  The write-down of Other Real Estate Owned properties totaled $68 thousand for the six months ending June 30, 2011.

Loan servicing rights, which are carried at lower of cost or fair value, were carried at their fair value of $686 thousand, which is made up of the outstanding balance of $895 thousand, net of a valuation allowance of $209 thousand at June 30, 2012, resulting in a recovery of $40 thousand for the six months ending June 30, 2012 and a write-down of $23 thousand for the three months ending June 30, 2012.  The valuation adjustment to the loan servicing right was a recovery of $41 thousand for the six months ending June 30, 2011 and a recovery of $21 thousand for the three months ending June 30, 2011.  At December 31, 2011, loan servicing rights were carried at their fair value of $380 thousand, which is made up of the outstanding balance of $630 thousand, net of a valuation allowance of $250 thousand at December 31, 2011.

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The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at June 30, 2012:

					Range
	Fair		Valuation	Unobservable	(Weighted
(In thousands)	Value		Technique(s)	Input(s)	Average)
Impaired loans
Real estate construction	$	2,532	sales comparison	adjustment for differences between the comparable sales	23%-30% (27%)
Real estate mortgage:
1-4 family residential	388		sales comparison	adjustment for differences between the comparable sales	0%-44% (11%)
Multi-family residential	425		sales comparison	adjustment for differences between the comparable sales	2%-23% (14%)
Non-farm & non-residential	243		sales comparison	adjustment for differences between the comparable sales	7%-11% (9%)
Other real estate owned:
Residential	4,248		sales comparison	adjustment for differences between the comparable sales	1%-84% (12%)
			income approach	capitalization rate	8%-10% (8%)
Loan Servicing Rights	686		discounted cash flow	constant prepayment rates	8%-35% (19%)

Fair Value of Financial Instruments

The carrying amounts and estimated fair values of financial instruments, at June 30, 2012 and December 31, 2011 are as follows:

Fair Value Measurements at

June 30, 2012 Using:

	Carrying
(in thousands)	Value		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	15,314	$	15,314	$	—	$	—	$	15,314
Securities	184,962		307		184,655		—		184,962
Mortgage loans held for sale	92		—		95		—		95
Loans, net	415,610		—		—		417,320		417,320
FHLB Stock	6,731		—		—		—		N/A
Interest receivable	3,688		—		1,220		2,468		3,688
Financial liabilities
Deposits	$	543,131	$	352,570	$	192,615	$	—	$	545,185
Securities sold under agreements to repurchase and other borrowings	5,592		—		5,592		—		5,592
Federal Funds Purchased	2,691		2,691						2,691
FHLB advances	33,307		—		34,831		—		34,831
Subordinated Debentures	7,217		—		—		6,795		6,795
Interest payable	732		—		723		9		732

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December 31, 2011:

	December 31, 2011
	Carrying
	Amount		Fair Value
Financial assets
Cash and cash equivalents	$	17,657	$	17,657
Securities	180,419		180,419
Mortgage loans held for sale	624		624
Loans, net	406,025		407,872
FHLB stock	6,731		N/A
Interest receivable	4,052		4,052
Financial liabilities
Deposits	$	542,924	$	545,467
Securities sold under agreements to repurchase and other borrowings	4,523		4,523
FHLB advances	30,326		32,227
Subordinated debentures	7,217		6,339
Interest payable	963		963

The methods and assumptions, not previously presented, used to estimate fair values are described as follows:

Cash and Cash Equivalents - The carrying amounts of cash and short-term instruments approximate fair values and are classified as Level 1.

FHLB Stock - It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

Loans - Fair values of loans, excluding loans held for sale, are estimated as follows:  For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification.  Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification.  Impaired loans are valued at the lower of cost or fair value as described previously.  The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.

Deposits - The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 1 classification.  The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date resulting in a Level 1 classification.  Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

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Securities Sold Under Agreements to Repurchase and Other Borrowings - The carrying amounts of borrowings under repurchase agreements approximate their fair values resulting in a Level 2 classification.

The carrying amount of the Company’s variable rate borrowings approximate their fair values resulting in a Level 2 classification.

Federal Funds Purchased - The carrying amounts of federal funds purchased approximate fair values and are classified as Level 1.

FHLB Advances and Subordinated Debentures - The fair values of the Company’s FHLB advances are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

The fair values of the Company’s Subordinated Debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

Accrued Interest Receivable/Payable - The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification based on the level of the related asset/liability.

Off-balance Sheet Instruments - Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.  The fair value of off-balance sheet instruments is not material.

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Item 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

This discussion contains forward-looking statements under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. These statements are not historical facts, but rather statements based on our current expectations regarding our business strategies and their intended results and our future performance.  Forward-looking statements are preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions.

Although we believe that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate.  Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to:  economic conditions (both generally and more specifically in the markets, including the tobacco market and the thoroughbred horse industry, in which we and our bank operate); competition for our subsidiary’s customers from other providers of financial and mortgage services; government legislation, regulation and monetary policy (which changes from time to time and over which we have no control); changes in interest rates (both generally and more specifically mortgage interest rates); material unforeseen changes in the liquidity, results of operations, or financial condition of our subsidiary’s customers; adequacy of the allowance for losses on loans and the level of future provisions for losses on loans; and other risks detailed in our filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond our control.

You are cautioned not to place undue reliance on any forward-looking statements made by us or on our behalf.  We undertake no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Summary

The Company recorded net income of $3.4 million, or $1.25 basic earnings and diluted earnings per share for the first six months ending June 30, 2012 compared to $2.7 million or $0.98 basic earnings and diluted earnings per share for the six month period ending June 30, 2011.  The first six months earnings reflects an increase of 26.6% compared to the same time period in 2011, due primarily to an increase in the gain on sold mortgage loans of $565 thousand, an increase in net interest income of $433 thousand and a decrease of $450 thousand in the provision for loan losses.  These positive changes to net income during 2012 were partially offset by an increase of $277 thousand in employee salaries and benefits and an increase of $226 thousand in repossession expenses.  The earnings for the three months ending June 30, 2012 were $1.8 million, or $0.65 basic and diluted earnings per share compared to $1.4 million or $0.52 basic and diluted earnings per share for the three month period ending June 30, 2011.  The earnings for the three month period in 2012 reflect a 25.1% increase compared to the same time period in 2011.

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Return on average assets was 1.00% for the six months ended June 30, 2012 and 0.82% for the six month period ended June 30, 2011.  Return on average assets was 1.05% for the three months ended June 30, 2012 and 0.87% for the three months ended June 30, 2011.  Return on average equity was 9.6% for the six month period ended June 30, 2012 and 8.6% for the same period in 2011.  Return on average equity was 10.0% for the three months ended June 30, 2012 and 8.9% for the same time period in 2011.  Gross Loans increased $9.5 million from $411.9 million on December 31, 2011 to $421.4 million on June 30, 2012.  The overall increase is attributed mostly to an increase of $8.6 million in non-farm and non-residential real estate loans, an increase of $6.4 million in 1-4 family residential real estate loans and an increase of $3.6 million in commercial loans.  Decreases in the loan portfolio from December 31, 2011 to June 30, 2012 included a decrease of $4.1 million in agricultural loans, a decrease of $3.1 million in real estate construction loans and a decrease of $1.6 million in multi-family residential real estate loans.

Total deposits increased from $542.9 million on December 31, 2011 to $543.1 million on June 30, 2012, an increase of $200 thousand.  Non-interest bearing demand deposit accounts increased $6.7 million from December 31, 2011 to June 30, 2012.  This increase is not all attributable to additional deposits being placed with the bank as part of the increase is from deposit accounts changing from time deposits to non-interest bearing demand deposit accounts.  Time deposits $100 thousand and over decreased $4.7 million and other interest bearing deposit accounts decreased $1.8 million.

Net Interest Income

Net interest income is the difference between interest income earned on interest-earning assets and the interest expense paid on interest-bearing liabilities.

Net interest income was $12.5 million for the six months ended June 30, 2012 compared to $12.0 million for the six months ended June 30, 2011, an increase of 3.6%.  The interest spread of 4.00% for the first six months of 2012 is slightly down from 4.02% reported for the same period in 2011, a decrease of 2 basis points.  Rates have remained fairly low in the past year.  For the first six months ending June 30, 2012, the cost of total deposits was 0.47% compared to 0.84% for the same time period in 2011.  Increasing non-interest bearing deposit accounts and lower rates on certificates of deposit accounts have helped to lower the cost of deposits.  Net interest income was $6.4 million for the three months ending June 30, 2012 compared to $6.2 million for the three months ending June 30, 2011, an increase of 2.3%.  The interest spread was 4.06% for the three month period ending June 30, 2012 compared to 4.19% for the three month period in 2011, a decrease of 13 basis points.

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For the first six months, the yield on assets decreased from 5.07% in 2011 to 4.68% in 2012.  The yield on loans decreased 15 basis points in the first six months of 2012 compared to 2011 from 5.89% to 5.74%.  The yield on securities decreased 69 basis points in the first six months of 2012 compared to 2011 from 3.48% in 2011 to 2.79% in 2012.  The cost of liabilities decreased from 1.06% in 2011 to 0.67% in 2012.  Year to date average loans increased $5.3 million, or 1.3% from June 30, 2011 to June 30, 2012.  Loan interest income decreased $85 thousand for the first six months of 2012 compared to the first six months of 2011.  Year to date average deposits increased from June 30, 2011 to June 30, 2012, up $20.1 million or 3.7%.  The increase is largely attributed to an increase in public funds.  Year to date average interest bearing deposits increased $6.3 million, or 1.5%, from June 30, 2011 to June 30, 2012.  Deposit interest expense has decreased $925 thousand for the first six months of 2012 compared to the same period in 2011.  Year to date average borrowings decreased $11.5 million, or 21.5% from June 30, 2011 to June 30, 2012.  The decrease is mostly attributed to paying off Federal Home Loan Bank advances as they mature.  Interest expense on borrowed funds has decreased $164 thousand for the first six months of 2012 compared to the same period in 2011.

The volume rate analysis for 2012 that follows indicates that $1.2 million of the decrease in interest income is attributable to a decrease in interest rates, while the change in volume contributed to an increase of $506 thousand in interest income.  Even more affected by volume and rate changes was the liability side of the balance sheet.  The average rate of the Company’s total outstanding deposits and borrowing liabilities decreased from 1.06% in 2011 to 0.67% in 2012.  Based on the volume rate analysis that follows, the lower level of interest rates contributed to a decrease of $852 thousand in interest expense, while the change in volume was responsible for a $237 thousand decrease in interest expense.  As a result, the increase in net interest income for the first six months in 2012 is mostly attributed to increases in volume in the loan and security portfolios and reduced rates on deposits.

The accompanying analysis of changes in net interest income in the following table shows the relationships of the volume and rate portions of these changes in 2012.  Changes in interest income and expenses due to both rate and volume are allocated on a pro rata basis.

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Changes in Interest Income and Expense

	2012 vs. 2011
	Increase (Decrease) Due to Change in
(in thousands)	Volume			Rate			Net Change
INTEREST INCOME
Loans	$	318		$	(404	)	$	(86	)
Investment Securities	175			(752		)	(577		)
Other	13			(6		)	7
Total Interest Income	506			(1,162		)	(656		)
INTEREST EXPENSE
Deposits
Demand	174			(377		)	(203		)
Savings	11			(14		)	(3		)
Negotiable Certificates of Deposit and Other Time Deposits	(171		)	(548		)	(719		)
Securities sold under agreements to repurchase and other borrowings	(37		)	26			(11		)
Federal Home Loan
Bank advances	(214		)	61			(153		)
Total Interest Expense	(237		)	(852		)	(1,089		)
Net Interest Income	$	743		$	(310	)	$	433

Non-Interest Income

Non-interest income increased $877 thousand for the six months ended June 30, 2012, compared to the same period in 2011, to $5.0 million. The increase was due primarily to an increase of $565 thousand in gains recognized on sold mortgage loans, an increase of $108 thousand in debit card interchange income and an increase of $91 thousand in other non-interest income.  Increases to non-interest income for the first six months of 2012 compared to the first six months of 2011 also included an increase of $47 thousand in recognized gains on sold securities, an increase of $49 thousand in brokerage income and an increase of $27 thousand in service charges.  Non-interest income increased $208 thousand for the three months ended June 30, 2012 compared to the three months ended June 30, 2011.  The increase was mostly the result of an increase of $235 thousand in gains recognized on the sale of mortgage loans, an increase of $55 thousand in debit card interchange income and an increase of $74 thousand in other non-interest income.  Increases to non-interest income for the three month period ending June 30, 2012 compared to the three months ending June 30, 2011 also includes a decrease of $110 thousand in gains recognized on sold securities, a decrease of $46 thousand in loan service fee income and a decrease of $40 thousand in service charges.

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The gain on the sale of mortgage loans increased from $283 thousand in the first six months of 2011 to $848 thousand during the first six months of 2012, an increase of $565 thousand.  For the three months ending June 30, 2012 compared to the same time period in 2011, the gain on the sale of mortgage loans increased $235 thousand.  The volume of loans originated to sell during the first six months of 2012 increased $19.3 million compared to the same time period in 2011.  The volume of mortgage loan originations and sales is generally inverse to rate changes.  A change in the mortgage loan rate environment can have a significant impact on the related gain on sale of mortgage loans.  Loan service fee income, net of amortization expense, was $83 thousand for the six months ending June 30, 2012 compared to $86 thousand for the six months ending June 30, 2011, a decrease of $3 thousand.  For the three month period ending June 30, 2012, loan service fee income, net of amortization expense, was a loss of $4 thousand compared to positive income of $42 thousand for the same time period one year ago.  During the first six months of 2012, the carrying value of the mortgage servicing right was written up a net amount of $40 thousand, as the fair value of this asset recovered.  Of this, a positive adjustment of $63 thousand was recorded in the first quarter of 2012 and a write-down of $23 thousand was recorded during the second quarter of 2012.  For the six months ending June 30, 2011, the carrying value of the mortgage servicing right had a positive valuation adjustment in the amount of $41 thousand with a $ 20 thousand positive adjustment recorded during the first quarter of 2011 and a $21 thousand positive adjustment recorded during the second quarter of 2011.

Non-Interest Expense

Total non-interest expenses increased $732 thousand for the six month period ended June 30, 2012 compared to the same period in 2011.  For the three month period ended June 30, 2012 compared to the three months ending June 30, 2011, total non-interest expense decreased $46 thousand.

For the comparable six month periods, salaries and benefits increased $277 thousand, an increase of 4.7%.  The increase is attributed largely to additional employees being hired throughout 2011 and 2012 and normal pay increases at the beginning of 2012.  The number of full time equivalent employees at June 30, 2012 was 197 compared to 188 one year ago and 184 at December 31, 2010.  Salaries and employee benefits decreased $88 thousand for the three month period ending June 30, 2012 compared to the same time period in 2011.

Occupancy expenses decreased $25 thousand to $1.5 million for the first six months of 2012 compared to the same time period in 2011.  Occupancy expenses increased $21 thousand for the three month period ended June 30, 2012 compared to the same time period in 2011.

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Legal and professional fees increased $5 thousand for the first six months ended June 30, 2012 compared to the same time period in 2011.  Legal and professional fees decreased $25 thousand for the three month period ending June 30, 2012 compared to the same time period in 2011.  Repossession expenses increased $226 thousand for the first six months ending June 30, 2012 compared to the same time period in 2011 and decreased $24 thousand for the three months period ending June 30, 2012 compared to the same period one year ago.  Repossession expenses are reported net of income earned on the repossessed properties.  Repossession expenses were higher during the first six months of 2012 when compared to the same time period in 2011 due to maintaining additional other real estate owned properties in 2012. In addition, the rents earned on other real estate properties, including new property added, decreased $106 thousand to $169 thousand for the six months ending June 30, 2012 compared to the same period last year.  FDIC insurance expense decreased $167 thousand for the six months ending June 30, 2012 and $79 thousand for the three months ending June 30, 2012, compared to the same time period in 2011.  The decrease is mostly attributed to a change in the calculation the FDIC uses to assess insurance premiums.

Income Taxes

The effective tax rate for the six months ended June 30, 2012 was 18.2% compared to 14.2% in 2011.  The effective tax rate for the three months ended June 30, 2012 was 19.4% compared to 14.3% for the three months ended June 30, 2011.  These rates are less than the statutory rate as a result of the tax-free securities and loans and tax credits generated by certain investments held by the Company.  The rates for 2012 are higher due to the higher level of income for 2012.  Tax-exempt interest income decreased $20 thousand for the first six months of 2012 compared to the first six months of 2011.

As part of normal business, Kentucky Bank typically makes tax free loans to select municipalities in our market and invests in selected tax free securities, primarily in the Commonwealth of Kentucky.  In making these investments, the Company considers the overall impact to managing our net interest margin, credit worthiness of the underlying issuer and the favorable impact on our tax position.  For the six months ended June 30, 2012, the Company averaged $81.2 million in tax free securities and $17.6 million in tax free loans.  As of June 30, 2012, the weighted average remaining maturity for the tax free securities is 140 months, while the weighted average remaining maturity for the tax free loans is 151 months.

Liquidity and Funding

Liquidity is the ability to meet current and future financial obligations.  The Company’s primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of investment securities and FHLB borrowings.

Liquidity risk is the possibility that we may not be able to meet our cash requirements.  Management of liquidity risk includes maintenance of adequate cash and sources of cash to fund operations and to meet the needs of borrowers, depositors and creditors.  Excess liquidity has a negative impact on earnings as a result of the lower yields on short-term assets.

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Cash and cash equivalents were $15.3 million as of June 30, 2012 compared to $17.7 million at December 31, 2011.  The decrease in cash and cash equivalents is attributed to a decrease of $1.9 million in cash and due from banks and a decrease of $418 thousand in federal funds sold.  In addition to cash and cash equivalents, the securities portfolio provides an important source of liquidity.  Securities available for sale totaled $185.0 million at June 30, 2012 compared to $180.4 million at December 31, 2011.  The available for sale securities are available to meet liquidity needs on a continuing basis.  However, we expect our customers’ deposits to be adequate to meet our funding demands.

Generally, we rely upon net cash inflows from financing activities, supplemented by net cash inflows from operating activities, to provide cash used in our investing activities.  As is typical of many financial institutions, significant financing activities include deposit gathering and the use of short-term borrowings, such as federal funds purchased and securities sold under repurchase agreements along with long-term debt.  Our primary investing activities include purchasing investment securities and loan originations.

For the first six months of 2012, deposits increased $207 thousand. The Company’s investment portfolio increased $4.5 million and the Company’s loan portfolio increased $9.5 million.  The borrowed funds the Company have with the Federal Home Loan Bank increased $3.0 million.  The Company paid down FHLB advances by $25.0 million during the first six months of 2012 but replaced some of those maturing advances with new short-term borrowings.  Federal Funds purchased increased $2.7 million from $0 at December 31, 2011 to $2.7 million at June 30, 2012.

The Company has a promissory note payable that matures July 29, 2012, and has principal due at maturity and interest payable quarterly at prime, and is secured by 100% of the common stock of the bank.  The loan agreement contains certain covenants and performance terms.  The Bank was not in compliance with the non-performing asset covenant at June 30, 2012.  However, a debt covenant waiver was obtained from the lending institution.  The loan is in the process of being renewed on similar terms for an additional 1 year term.

Management is aware of the challenge of funding sustained loan growth.  Therefore, in addition to deposits, other sources of funds, such as Federal Home Loan Bank (FHLB) advances, may be used.  We rely on FHLB advances for both liquidity and asset/liability management purposes.  These advances are used primarily to fund long-term fixed rate residential mortgage loans.  As of June 30, 2012, we have sufficient collateral to borrow an additional $58 million from the Federal Home Loan Bank.  In addition, as of June 30, 2012, $21 million is available in overnight borrowing through various correspondent banks and the Company has access to $232 million in brokered deposits.  In light of this, management believes there is sufficient liquidity to meet all reasonable borrower, depositor and creditor needs in the present economic environment.

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Capital Requirements

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices.  The Company and Bank capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital to average assets (as defined).  Management believes, as of June 30, 2012 and December 31, 2011, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

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

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

	Actual				For Capital Adequacy Purposes				To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio
	(Dollars in Thousands)
June 30, 2012
Consolidated
Total Capital (to Risk-Weighted Assets)	$	66,246	14.3	%	$	37,002	8	%	$	N/A	N/A
Tier I Capital (to Risk-Weighted Assets)	60,446		13.1		18,501		4		N/A		N/A
Tier I Capital (to Average Assets)	60,446		9.1		26,643		4		N/A		N/A
Bank Only
Total Capital (to Risk-Weighted Assets)	$	66,633	14.4	%	$	36,983	8	%	$	46,629	10	%
Tier I Capital (to Risk-Weighted Assets)	60,836		13.2		18,492		4		27,737		6
Tier I Capital (to Average Assets)	60,836		9.1		26,633		4		33,291		5
December 31, 2011
Consolidated
Total Capital (to Risk-Weighted Assets)	$	64,279	14.0	%	$	36,718	8	%	N/A		N/A
Tier I Capital (to Risk-Weighted Assets)	58,525		12.8		18,359		4		N/A		N/A
Tier I Capital (to Average Assets)	58,525		9.2		25,405		4		N/A		N/A
Bank Only
Total Capital (to Risk-Weighted Assets)	$	65,229	14.2	%	$	36,705	8	%	$	45,882	10	%
Tier I Capital (to Risk-Weighted Assets)	59,476		13.0		18,353		4		27,529		6
Tier I Capital (to Average Assets)	59,476		9.4		25,405		4		31,756		5

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Non-Performing Assets

As of June 30, 2012, our non-performing assets totaled $23.6 million or 3.56% of assets compared to $15.8 million or 2.40% of assets at December 31, 2011 (See table below.)  The Company experienced an increase of $623 thousand in non-accrual loans from December 31, 2011 to June 30, 2012.  As of June 30, 2012, non-accrual loans include $3.0 million in loans secured by real estate construction, $389 thousand in loans secured by farmland, $1.5 million in loans secured by 1-4 family residential properties, $1.5 million in loans secured by non-farm & non-residential real estate and $155 thousand in loans secured by multi-family residential real estate.  Real estate loans composed 99.0% of the non-performing loans as of June 30, 2012 and 99.3% as of December 31, 2011.  Forgone interest income on non-accrual loans totaled $180 thousand for the first six months of 2012 compared to forgone interest of $276 thousand for the same time period in 2011.  Accruing loans that are contractually 90 days or more past due as of June 30, 2012 totaled $471 thousand compared to $398 thousand at December 31, 2011, an increase of $73 thousand.  The total nonperforming and restructured loans increased $7.5 million from December 31, 2011 to June 30, 2012, resulting in an increase in the ratio of nonperforming loans to loans of 173 basis points to 3.56%.  In addition, the amount the Company has booked as “Other Real Estate” has increased $348 thousand from December 31, 2011 to June 30, 2012.  As of June 30, 2012, the amount recorded as “Other Real Estate” totaled $8.6 million compared to $8.3 million at December 31, 2011.  The overall increase to total “Other Real Estate” properties is largely attributed to one property which was recorded into other real estate during 2012 and has a carrying value of $478 thousand.  The property is classified as non-farm and non-residential.  The allowance as a percentage of non-performing and restructured loans and Other Real Estate Owned decreased from 37% at December 31, 2011 to 24% at June 30, 2012.

Nonperforming Assets

	6/30/12			12/31/11
	(in thousands)
Non-accrual Loans	$	6,640		$	6,017
Accruing Loans which are Contractually past due 90 days or more	471			398
Troubled Debt Restructurings	7,890			1,104
Total Nonperforming Loans	15,001			7,519
Other Real Estate	8,644			8,296
Total Nonperforming Loans and Other Real Estate	$	23,645		$	15,815
Nonperforming Loans as a Percentage of Loans	3.56		%	1.83		%
Nonperforming Loans and Other Real Estate as a Percentage of Total Assets	3.53		%	2.40		%
Allowance as a Percentage of Period-end Loans	1.37		%	1.42		%
Allowance as a Percentage of Non-performing Loans and Other Real Estate	24		%	37		%

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We maintain a “watch list” of agricultural, commercial, real estate mortgage, and real estate construction loans and review those loans on a regular basis.  Generally, assets are designated as “watch list” loans to ensure more frequent monitoring.  If we determine that there is serious doubt as to performance in accordance with original terms of the contract, then the loan is generally downgraded and often placed on non-accrual status.  We review and evaluate nonaccrual loans, past due loans, and loans graded substandard or worse on a regular basis to determine if specific allocations are needed.

Provision for Loan Losses

The loan loss provision for the first six months was $1.0 million for 2012 and $1.5 million for 2011.  Management evaluates the loan portfolio by reviewing the historical loss rate for each respective loan type and assigns risk multiples to certain categories to account for qualitative factors including current economic conditions.  The average loss rates are reviewed for trends in the analysis, as well as comparisons to peer group loss rates.  Management makes allocations within the allowance for loan losses for specifically classified loans regardless of loan amount, collateral or loan type.  Loan categories are evaluated utilizing subjective factors in addition to the historical loss calculations to determine a loss allocation for each of those types.  As this analysis, or any similar analysis, is an imprecise measure of loss, the allowance is subject to ongoing adjustments.  Therefore, management will often take into account other significant factors that may be necessary or prudent in order to reflect probable incurred losses in the total loan portfolio.

Nonperforming loans and restructured loans increased $7.5 million since December 31, 2011 to $15.0 million as of June 30, 2012.  Other real estate increased $348 thousand over this same time period as some nonperforming loans moved to other real estate.

The June 30, 2012 unallocated allowance of $278 thousand decreased from the December 31, 2011 balance of $344 thousand.

Net charge-offs for the six month period ended June 30, 2012 were $1.1 million compared to net charge-offs of $733 thousand for the same period in 2011.  Future levels of charge-offs will be determined by the particular facts and circumstances surrounding individual loans.  Based on the above information, management believes the current loan loss allowance is sufficient to meet probable incurred loan losses.

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Loan Losses

	Six Months Ended June 30
	(in thousands)
	2012			2011
Balance at Beginning of Period	$	5,842		$	4,925
Amounts Charged-off:
Commercial	—			34
Real Estate Construction	73			124
1-4 family residential	612			211
Multi-family residential	52			94
Non-farm & non-residential	64			329
Agricultural	15			—
Consumer and other	467			480
Total Charged-off Loans	1,283			1,272
Recoveries on Amounts
Previously Charged-off:
Commercial	—			74
Real Estate Construction	—			—
1-4 family residential	8			5
Multi-family residential	1			144
Non-farm & non-residential	—			14
Agricultural	4			12
Consumer and other	217			290
Total Recoveries	230			539
Net Charge-offs	1,053			733
Provision for Loan Losses	1,000			1,450
Balance at End of Period	5,789			5,642
Loans
Average	414,085			408,794
At June 30	421,399			408,516
As a Percentage of Average Loans:
Net Charge-offs for the period	0.25		%	0.18		%
Provision for Loan Losses for the period	0.24		%	0.35		%
Allowance as a Multiple of Net Charge-offs (annualized)	2.7			3.8

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Loan Losses

	Three Months Ended June 30
	(in thousands)
	2012			2011
Balance at Beginning of Period	$	5,994		$	5,641
Amounts Charged-off:
Commercial	—			16
Real estate construction	73			124
1-4 family residential	468			121
Multi-family residential	52			94
Non-farm & non-residential	64			314
Real estate mortgage	—			—
Agricultural	—			—
Consumer and other	193			205
Total Charged-off Loans	850			874
Recoveries on Amounts
Previously Charged-off:
Commercial	—			74
Real estate construction	—			—
1-4 family residential	4			1
Multi-family residential	—			—
Non-farm & non-residential	—			—
Real estate mortgage	—			—
Agricultural	2			1
Consumer and other	89			99
Total Recoveries	95			175
Net Charge-offs	755			699
Provision for Loan Losses	550			700
Balance at End of Period	$	5,789		$	5,642
Loans
Average	$	417,369		$	408,139
At June 30	421,399			408,516
As a Percentage of Average Loans:
Net Charge-offs for the period	0.18		%	0.17		%
Provision for Loan Losses for the period	0.13		%	0.17		%
Allowance as a Multiple of Net Charge-offs (annualized)	1.9			2.0

Item 3 — QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset/Liability management control is designed to ensure safety and soundness, maintain liquidity and regulatory capital standards, and achieve acceptable net interest income.  Management considers interest rate risk to be the most significant market risk.  Our exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee.  Interest rate risk is the potential of economic losses due to future interest rate changes.  These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values.  The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk, while at the same time, maximize income.

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Management realizes certain risks are inherent and that the goal is to identify and minimize the risks.  The primary tools used by management are interest rate shock and economic value of equity (EVE) simulations.  We have no market risk sensitive instruments held for trading purposes. Using interest rate shock simulations, the following table depicts the change in net interest income resulting from 100 and 300 basis point changes in rates on the Company’s interest earning assets and interest bearing liabilities.  The projections are based on balance sheet growth assumptions and repricing opportunities for new, maturing and adjustable rate amounts.  As of June 30, 2012, the projected percentage changes are within the Board approved limits.  Although management does analyze and monitor the projected percentage change in a declining interest rate environment, due to the current rate environment many of the current deposit rates cannot decline an additional 100 basis points.  Therefore, management places more emphasis in the rising rate environment scenarios.  This period’s volatility is slightly higher in each rate shock simulation when compared to the same period a year ago.  The projected net interest income report summarizing our interest rate sensitivity as of June 30, 2012 is as follows:

PROJECTED NET INTEREST INCOME

(dollars in thousands)

							Level
Change in basis points:	- 300			- 100			Rates		+ 100			+ 300
Year One (7/12 - 6/13)
Net interest income	$	23,411		$	24,124		$	24,694	$	24,718		$	24,731
Net interest income dollar change	(1,283		)	(571		)	N/A		24			36
Net interest income percentage change	-5.2		%	-2.3		%	N/A		0.10		%	0.15		%
Board approved limit	>-10.0		%	>-4.0		%	N/A		>-4.0		%	>-10.0		%

The projected net interest income report summarizing the Company’s interest rate sensitivity as of June 30, 2011 is as follows:

PROJECTED NET INTEREST INCOME

(dollars in thousands)

							Level
Change in basis points:	- 300			- 100			Rates		+ 100			+ 300
Year One (7/11 - 6/12)
Net interest income	$	24,156		$	24,905		$	25,421	$	25,276		$	25,180
Net interest income dollar change	(1,265		)	(516		)	N/A		(145		)	(241		)
Net interest income percentage change	-5.0		%	-2.0		%	N/A		-0.6		%	-0.9		%
Board approved limit	>-10.0		%	>-4.0		%	N/A		>-4.0		%	>-10.0		%

Projections from June 30, 2012, year one reflected a decline in net interest income of 2.3% with a 100 basis point decline compared to the 2.0% decline in 2011.  The 100 basis point increase in rates reflected a 0.1% increase in net interest income in 2012 compared to a decrease of 0.6% in 2011.

EVE applies discounting techniques to future cash flows to determine the present value of assets, liabilities, and therefore equity.  Based upon applying these techniques to the June 30, 2012 balance sheet, a 100 basis point increase in rates results in a 7.5% decrease in EVE.  A 100 basis point decrease in rates results in a 1.6% decrease in EVE.  These are within the Board approved limits.

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Item 4 — CONTROLS AND PROCEDURES

As of the end of the period covered by this report, our management, including the Chief Executive Officer and the Chief Financial Officer, carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures.  Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.

We also conducted an evaluation of internal control over financial reporting to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on this evaluation, there has been no such change during the quarter covered by this report.

Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.

Part II - Other Information

Item 1.            Legal Proceedings

We are not a party to any material legal proceedings.

Item 1A.         Risk Factors

Enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), and the promulgation of regulations thereunder could significantly increase our compliance and operating costs or otherwise have a material and adverse effect on the Company’s financial position, results of operations, or cash flows.  The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States, establishes the new federal Bureau of Consumer Financial Protection (the “BCFP”), and will require the BCFP and other federal agencies to implement many new rules.  At this time, it is difficult to predict the extent to which the Dodd-Frank Act or the resulting regulations will impact the Company’s business.  However, compliance with these new laws and regulations will result in additional costs, which may adversely impact the Company’s results of operations, financial condition or liquidity, any of which may impact the market price of the Company’s common stock.

Our results of operations and financial condition may be negatively affected if we are unable to meet a debt covenant and, correspondingly, unable to obtain a waiver regarding the debt covenant from the lender.From time to time we may obtain financing from other lenders.  The loan documents reflecting the financing often require us to meet various debt covenants.  If we are unable to meet one or more of our debt covenants, then we will typically attempt to obtain a waiver from the lender.  For example, the Company has a promissory note payable that matures July 29, 2012 that we are attempting to renew for an additional one year term on similar terms.  The Bank was not in compliance with the non-performing asset covenant in the subject loan agreement at June 30, 2012 but the lender waived the noncompliance.  If a lender were not to agree to a waiver in such an instance in the future, then we would be in default under our borrowing obligation.  This default could affect our ability to fund various strategies that we may have implemented resulting in a negative impact in our results of operations and financial condition.

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Other than the additional risk factors mentioned above, there are no material changes from the risk factors set forth under Part I, Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011, which you are encouraged to carefully consider.

Item 2.            Unregistered Sales of Equity Securities and Use of Proceeds

ISSUER PURCHASES OF EQUITY SECURITIES

	(a)			(c) Total Number	(d) Maximum Number
	Total	(b)		of Shares (or Units)	(or Approximate Dollar
	Number of	Average		Purchased as Part	Value) of Shares (or
	Shares (or	Price Paid		of Publicly	Units) that May Yet Be
	Units)	Per Share		Announced Plans	Purchased Under the
Period	Purchased	(or Unit)		Or Programs	Plans or Programs
4/1/12 - 4/30/12	—	$	—	—	97,487 shares
5/1/12 - 5/31/12	—	—		—	97,487 shares
6/1/12 - 6/30/12	745	21.00		745	96,742 shares
Total	745			745	96,742 shares

On October 25, 2000, we announced that our Board of Directors approved a stock repurchase program and authorized the Company to purchase up to 100,000 shares of its outstanding common stock.  On November 11, 2002, the Board of Directors approved and authorized the Company’s repurchase of an additional 100,000 shares.  On May 20, 2008, the Board of Directors approved and authorized the Company to purchase an additional 100,000 shares.  On May 17, 2011, the Board of Directors approved and authorized the Company’s repurchase of an additional 100,000 shares.  Shares will be purchased from time to time in the open market depending on market prices and other considerations.  Through June 30, 2012, 303,258 shares have been purchased.

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Item 6.	Exhibits
	2.1	Agreement and Plan of Merger with Peoples Bancorp of Sandy Hook is incorporated by reference to Exhibit 2.1 of the Registrant’s Current Report of Form 8-K dated February 24, 2006
	3.1	Amended and Restated Articles of Incorporation of the Registrant are incorporated by reference to Exhibit 3.1 of the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ending March 31, 2000.
	3.2	Bylaws of the Registrant are incorporated by reference to Exhibit 3.1 of the Registrant’s Quarterly Report on Form 10-Q for the quarterly period ending June 30, 2000.
	3.3	Articles of Amendment to Amended and Restated Articles of Incorporation of the Registrant are incorporated by reference to Exhibit 3.3 of the Registrant’s Annual Report on Form 10-K for the period ending December 31, 2005.
	31.1	Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	31.2	Certifications of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	32	Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
	101*	The following financial information from Kentucky Bancshares, Inc. Quarterly Report on Form 10-Q for the period ended June 30, 2012, filed with the SEC on November 14, 2011, formatted in Extensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets at June 30, 2012 and December 31, 2011, (ii) Consolidated Statements of Income and Comprehensive Income for the three and six months ended June 30, 2012 and June 30, 2011, (iii) Consolidated Statement of Stockholders’ Equity for the six months ended June 30, 2012, (iv) Consolidated Statements of Cash Flows for the six months ended June 30, 2012 and June 30, 2011 and (v) Notes to Consolidated Financial Statements.

*Pursuant to Rule 406T of Regulation S-T, the XBRL related information in Exhibit 101 to this Quarterly Report on Form 10-Q shall not be deemed to be “filed” for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Exchange Act of 1934, or otherwise subject to the liability of those sections, and shall not be deemed part of a registration statement, prospectus or other document filed under the Securities Act of 1933 or the Exchange Act of 1934, except as shall be expressly set forth by specific reference in such filings.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

		KENTUCKY BANCSHARES, INC.
Date	8/13/12	/s/Louis Prichard
		Louis Prichard, President and C.E.O.
Date	8/13/12	/s/Gregory J. Dawson
		Gregory J. Dawson, Chief Financial Officer

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