EX-13 3 exhibit13.htm EXHIBIT 13






EXHIBIT 13



LCNB Corp. 2005 Annual Report



President's Letter to Shareholders (pages 2 - 3 of Annual Report):


Dear Shareholders:


The theme of this year’s annual report revolves around “Relationships”. We are not in business to simply sell a loan or deposit account. We are not looking for just an insurance customer or only a trust or brokerage client.  What we do better than anyone else, is build a total financial relationship with each of our customers. This is a relationship based on trust, integrity, and service; a relationship that not only crosses product lines but also endures throughout time. The relationships we have developed since 1876 have not only lasted lifetimes, but through generations.


Today’s common wisdom is that a community bank must specialize and be very strong in one aspect of financial service at the expense of other financial services. We disagree with this philosophy. It is not that we want to be all things to all people. We just want to be all things to you when it comes to your financial needs.


The relationships we have developed through the years paid off in 2005. It was a very difficult year for many financial institutions. Declining interest rate margins, increasing regulatory burden, and increased competition, especially from government subsidized competitors, proved to be formidable challenges for our industry.  Through all of these issues we were able to post higher earnings, increase return on equity, set a new record on earnings per share, and grow our assets under management by 5.56%.


Net income for 2005 was $6.7 million, representing a 1.25% return on average assets and a 12.80% return on average shareholders equity. Earnings per share were $2.03 compared to $1.97 in 2004. Total assets at year end were $540 million compared to $522 million at year end 2004. Total capital on December 31, 2005 was $52 million. Our capital position remains strong and it is our intention to maintain the FDIC “well capitalized” designation.


For the 20th consecutive year, your Board of Directors increased the dividend paid to shareholders. The total dividend paid in 2005 was $1.16 per share compared to $1.115 per share in 2004, for a 4.04% increase. Under the current tax laws, we feel that maintaining a strong dividend payout is in the best interest of our shareholders.


Loan growth was a crucial component of our success in 2005. Our loan portfolio grew by $23 million or 6.94%.  This level of loan growth increased our loan to deposit ratio and was extremely important to our net interest margin. Our asset quality remained high with lower than budgeted loan losses and a year end delinquency rate of .92%.


Total deposits grew by $18 million or 3.79% during 2005.  Free checking products, public fund deposits, and corporate checking accounts were all strong growth areas for our bank. We continue to maintain a competitive advantage with next-day availability and unmatched service in these areas.



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Another key factor in our success was the growth we experienced in non-interest income. Our relationship strategy paid off in 2005 as we grew non- interest income by 3.47%. With continued pressure on interest income growth, this area was important in 2005 and will be essential to our future. Along with our commercial bank, the trust department, brokerage unit, and insurance subsidiary all made positive contributions to our noninterest income.


The following financial highlight shows total assets under management as of December 31, 2005 and 2004 and the percent change in each category.

Assets Under Management ($000’s) 2005 2004 % Change


Assets Under Management

                   2005        2004     % Change

LCNB Corp. total assets                 $539,501     522,251      3.30%

Trust and investments *                  196,386     180,122      9.03%

Mortgage loans serviced                   46,244      46,345     -0.22%

Business cash management                  26,242      26,554     -1.17%

Brokerage accounts *                      36,196      24,826     45.80%

Total assets managed                    $844,569     800,098      5.56%


*  at fair market value


In addition to this illustration of assets under management, our Dakin subsidiary has also experienced continued growth. The measurement for growth in the insurance industry is not assets under management, but premiums written. Dakin, since joining LCNB Corp. on April 11, 2000, has grown from $4.5 million to $8.7 million. The generations of relationships Dakin has developed since 1876 provides another example of how our relationship strategy benefits our financial institution and our customers.


Additional statistical data and information on our financial performance for 2005 are available in the management discussion and analysis (MD&A) document.  The MD&A document is enclosed with the initial mailing of this annual report to shareholders and is also available in the LCNB Corp. annual report on Form 10-K. This report is filed annually with the Securities and Exchange Commission and is available upon request or from the shareholders information section of our website, www.LCNB.com.


Up to this point in my annual letter to you, I have concentrated on financial performance. Our financial results in 2005 would not have been possible without the hard work and dedication of our 253 employees.  They are the ones who maintain relationships, cross sell additional products, and handle millions of transactions each year. They answer the phones (we still do that, you know), greet our customers by name, and do all of the many things behind the scenes that insure the integrity and confidentiality of your financial transactions. We are in a people business and we have the best people in the business.


During 2005 we opened two specialty branch offices. Our Warrior Branch, inside the Lebanon High School, opened in the first quarter. In the fourth quarter we opened our second retirement village office inside Mason Christian Village. We now operate from 21 offices in our five county primary service area. We will continue to look for other expansion opportunities as we move forward in a new year.








- 2 -



Our strategic initiatives continue to revolve around our strong capital position and our need to employ that capital for the benefit of our shareholders. We continued to move forward with five programs in this area. The first is the continuation of our stock buyback programs to increase shareholder value. The second is to continue an aggressive dividend payout program. The third is to spend capital to position our bank for internal growth. The fourth is to be more aggressive in acquiring facilities, deposits and loans, or entire bank partners. The fifth and final initiative is our willingness to invest more capital in our insurance operation for growth through acquisition.


2005 also saw a continuation of LCNB Corp.’s commitment to the communities we serve. In addition to various corporate donations and other corporate support, our directors, officers, and employees provided personal support to over 74 organizations that work to improve the quality of life in the areas we serve. We were pleased to again receive an outstanding CRA rating in 2005 from the Office of the Comptroller of the Currency.


The annual meeting for LCNB Corp. will be Tuesday, April 11, 2006, at 10:00a.m. at our Main Office located at 2 North Broadway, Lebanon, Ohio. Proxy material is included with this mailing. Again this year you will notice a significant event in the history of Lebanon Citizens National Bank and LCNB Corp. when you review the proxy material. Robert C. Cropper is not standing for re-election to the Board of Directors. Rob Cropper’s relationship with LCNB is another example of one that spans generations. Not only has Rob served as a director, shareholder, and a customer, he was even an employee in his early career.  We can trace Rob’s family connection back to the 1920’s when Leondias Simonton was instrumental in the merger between Lebanon National Bank and Citizens National Bank.  Rob’s grandfather was Charlie Waggoner, a beloved president and director of Lebanon Citizens National Bank. Mr. Waggoner served in that dual capacity from 1951 to 1959. The good news is that this family relationship will not end with Rob, as our nominating committee has named Rob’s son, Spencer S. Cropper, to run for the open seat on the board. Spence will be an outstanding director and he will make a meaningful and immediate impact on the board. Spence is a CPA and qualifies as a “financial expert” under the Sarbanes Oxley definition of that important designation. Robert C. Cropper has made a tremendous contribution to the success of LCNB. Spencer S. Cropper will carry on the tradition.


Please review, sign and return the proxy in the envelope provided. We would be pleased to have you attend our annual meeting in person. Thank you for your continued support.


Stephen P. Wilson

President and CEO




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Financial Statements and Supplementary Data (pages 12 - 23 of Annual Report):



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the Board of Directors and Shareholders

LCNB Corp. and subsidiaries

Lebanon, Ohio



We have audited the accompanying consolidated balance sheets of LCNB Corp. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2005.  These financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these financial statements based on our audits.


We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.


In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of LCNB Corp. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.


We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of LCNB Corp. and subsidiaries’ internal control over financial reporting as of December 31, 2005, based on criteria established in “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 16, 2006 expressed an unqualified opinion on management’s assessment of internal control over financial reporting and an unqualified opinion on the effectiveness of internal control over financial reporting.




 

/s/ J.D. Cloud & Co. L.L.P.

 

Certified Public Accountants

  

Cincinnati, Ohio

 

February 16, 2006

 



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LCNB CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

At December 31,

(Dollars in thousands)

 
 
   

2005

   

2004

 

ASSETS:

        

   Cash and due from banks

 

$

13,415 

   

10,715  

 

   Federal funds sold and interest-bearing demand deposits

  

1,909 

   

32,400  

 

        Total cash and cash equivalents

  

15,324 

   

43,115  

 
         

   Securities available for sale, at market value

  

133,505 

   

113,437  

 

   Federal Reserve Bank and Federal Home Loan

     Bank stock, at cost

  


3,181 

   


3,058  

 

   Loans, net

  

357,651 

   

334,440  

 

   Premises and equipment, net

  

12,571 

   

12,233  

 

   Intangibles, net

  

1,575 

   

2,173  

 

   Bank owned life insurance

  

10,515 

   

   10,028 

 

   Other assets

  

5,179 

   

3,767  

 

            TOTAL ASSETS

 

$

539,501 

   

522,251  

 
         

LIABILITIES:

        

   Deposits -

        

    Noninterest-bearing

 

$

82,030 

   

73,417  

 

    Interest-bearing

  

399,445 

   

390,483  

 

        Total deposits

  

481,475 

   

463,900  

 

   Long-term debt

  

2,073 

   

2,137  

 

   Accrued interest and other liabilities

  

3,931 

   

3,918  

 

            TOTAL LIABILITIES

  

487,479 

   

469,955  

 
         

SHAREHOLDERS' EQUITY:

        

    Preferred stock-no par value, authorized 1,000,000

      shares at December 31, 2005, none outstanding

        

   Common stock-no par value, authorized 8,000,000 and

     4,000,000 shares at December 31, 2005 and 2004,

     respectively; issued and outstanding 3,551,884 shares

  



10,560 

   



10,560  

 

   Surplus

  

10,562 

   

10,553  

 

   Retained earnings

  

39,612 

   

36,735  

 

   Treasury shares at cost, 274,676 and 223,585 shares

     at December 31, 2005 and 2004, respectively

  


(8,011)

   


36,735  

 

   Accumulated other comprehensive income (loss),

     net of taxes

  


(701)

   


  526  

 

            TOTAL SHAREHOLDERS' EQUITY

  

52,022 

   

52,296  

 
         

            TOTAL LIABILITES AND

               SHAREHOLDERS' EQUITY

 


$


539,501 

   


522,251  

 
         

The accompanying notes to consolidated financial statements are an integral part of these statements.

         

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LCNB CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

For the years ended December 31,

(Dollars in thousands, except per share data)

 
 
  

2005

 

2004

 

2003

INTEREST INCOME:

      

   Interest and fees on loans

$

22,278 

 

20,517

 

21,991

   Dividends on Federal Reserve Bank

     and Federal Home Loan Bank stock

 


162 

 


136

 


129

   Interest on investment securities-

 

 

    

       Taxable

 

2,685 

 

2,792

 

3,040

       Non-taxable

 

2,102 

 

1,954

 

2,100

   Other short-term investments

 

375 

 

249

 

177

        TOTAL INTEREST INCOME

 

27,602 

 

25,648

 

27,437

       

INTEREST EXPENSE:

      

   Interest on deposits

 

8,865 

 

 7,157

 

 8,395

   Interest on short-term borrowings

 

49 

 

 6

 

 6

   Interest on long-term debt

 

118 

 

205

 

279

        TOTAL INTEREST EXPENSE

 

9,032 

 

 7,368

 

 8,680

        NET INTEREST INCOME

 

18,570 

 

18,280

 

18,757

PROVISION FOR LOAN LOSSES

 

338 

 

489

 

658

       

        NET INTEREST INCOME AFTER

          PROVISION FOR LOAN LOSSES

 


18,232 

 


17,791

 


18,099

       

NON-INTEREST INCOME:

      

   Trust income

 

1,639 

 

1,544

 

1,308

   Service charges and fees

 

4,018 

 

3,836

 

3,126

   Net gain (loss) on sales of securities

 

(8)

 

  306

 

  9

   Insurance agency income

 

1,451 

 

1,359

 

1,464

   Bank owned life insurance income

 

487 

 

29

 

-

   Gains from sales of mortgage loans

 

98 

 

 52

 

758

   Gain from sale of credit card portfolio

 

- 

 

403

 

-

   Other operating income

 

240 

 

130

 

132

        TOTAL NON-INTEREST INCOME

 

7,925 

 

7,659

 

6,797

       

NON-INTEREST EXPENSE:

      

   Salaries and wages

 

7,495 

 

6,955

 

6,808

   Pension and other employee benefits

 

1,843 

 

1,875

 

1,737

   Equipment expenses

 

1,064 

 

1,030

 

1,021

   Occupancy expense, net

 

1,279 

 

1,178

 

1,115

   State franchise tax

 

613 

 

581

 

552

   Marketing

 

417 

 

436

 

385

   Intangible amortization

 

591 

 

598

 

609

   ATM expense

 

371 

 

310

 

292

   Computer maintenance and supplies

 

384 

 

402

 

364

   Other non-interest expense

 

3,155 

 

3,039

 

2,842

        TOTAL NON-INTEREST EXPENSE

 

17,212 

 

16,404

 

15,725

       

        INCOME BEFORE INCOME TAXES

 

8,945 

 

9,046

 

9,171

PROVISION FOR INCOME TAXES

 

2,240 

 

2,450

 

2,434

        NET INCOME

$

6,705 

 

6,596

 

6,737

       

Earnings per common share:

      

   Basic

$

2.03 

 

1.97

 

1.97

   Diluted

 

2.03 

 

1.97

 

1.97

       

Weighted average shares outstanding:

      

   Basic

 

3,304,157 

 

3,351,146

 

3,417,254

   Diluted

 

3,305,462 

 

3,352,297

 

3,417,652

       
       
       

The accompanying notes to consolidated financial statements are an integral part of these statements.

       

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LCNB CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

For the years ended December 31,

(Dollars in thousands, except per share amounts)

 
 
          

Accumulated

       
          

Other

  

Total

    
  

Common

   

Retained

 

Treasury

 

Comprehensive

 

Shareholders'

Comprehensive

  

Shares

 

Surplus

 

Earnings

 

Shares

 

Income (Loss)

  

Equity

  

Income

 
                     

Balance January 1, 2003

$

10,560

 

10,553

 

30,768 

 

(2,193)

  

2,242

    

51,930 

    
                     

Net income

     

6,737 

         

6,737 

  

6,737 

 
                     

Net unrealized loss on available-for-

  sale securities (net of taxes of $215)

          


 (417)

    


 (417)

  


 (417)

 
                     

Reclassification adjustment for net

  realized gain on sale of available-

  for-sale securities included in net

  income (net of taxes of $3)

          




(6)

    




(6)

  




(6)

 
                     

Total comprehensive income

                  

6,314 

 
                     

Treasury shares purchased

       

(2,163)

       

(2,163)

    
                     

Cash dividends declared,

  $1.0625 per share

     


(3,633)

         


(3,633)

    
                     

Balance, December 31, 2003

 

10,560

 

10,553

 

33,872 

 

(4,356)

  

1,819 

    

52,448 

    
                     

Net income

     

6,596 

         

6,596 

  

6,596 

 
                     

Net unrealized loss on available-for-

  sale securities (net of taxes of $562)

          


(1,091)

    


(1,091)

  


(1,091)

 
                     

Reclassification adjustment for net

  realized gain on sale of available-

  for-sale securities included in net

  income (net of taxes of $104)

          




(202)

    




(202)

  




(202)

 
                     

Total comprehensive income

                  

5,303 

 
                     

Treasury shares purchased

       

(1,722)

       

(1,722)

    
                     

Cash dividends declared,

  $1.115 per share

     


(3,733)

         


(3,733)

    
                    

Balance, December 31, 2004

 

10,560

 

10,553

 

36,735 

 

(6,078)

  

  526 

    

52,296 

    
                     

Net income

     

6,705 

         

6,705 

  

6,705 

 
                     

Net unrealized loss on available-for-

  sale securities (net of taxes of $635)

          


(1,232)

    


(1,232)

  


(1,232)

 
                     

Reclassification adjustment for net

  realized loss on sale of available-

  for-sale securities included in net

  income (net of taxes of $3)

          




        5

    




        5

  




5 

 
                     

Total comprehensive income

                  

5,478 

 
                     

Compensation expense relating to

  stock options

   


9

           


         9

    
                     

Treasury shares purchased

       

(1,933)

       

(1,933)

    
                     

Cash dividends declared,

  $1.16 per share

     


(3,828)

         


(3,828)

    
                     

Balance, December 31, 2005

$

10,560

 

10,562

 

39,612 

 

(8,011)

  

(701)

    

52,022 

    
                     

The accompanying notes to consolidated financial statements are an integral part of these statements.

                     

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LCNB CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the years ended December 31,

(Dollars in thousands)

       
  

2005

 

2004

 

2003

CASH FLOWS FROM OPERATING ACTIVITIES:

      

   Net income

$

    6,705

 

    6,596

 

6,737 

   Adjustments to reconcile net income to net cash

    flows from operating activities-

      

      Depreciation, amortization and accretion

 

     2,580

 

     2,974

 

3,209 

      Provision for loan losses

 

        338

 

       489

 

658 

      Partial charge-off of real estate acquired

        through foreclosure

 


         13

 


           -

 


           -

      Deferred income tax provision (benefit)

 

(75)

 

(14)

 

         83

      Federal Home Loan Bank stock dividends

 

(123)

 

(96)

 

(91)

      Increase in cash surrender value of bank owned

        life insurance

 


(487)

 


(29)

 


           -

      Realized (gain) loss on sales of securities available

        for sale

 


           8

 


(306)

 


(9)

      Realized gain on sale of credit card portfolio

 

           -

 

(403)

 

           -

      Realized (gain) loss on sale of premises and equipment

 

(88)

 

           -

 

           7

      Origination of mortgage loans for sale

 

(5,791)

 

(2,237)

 

(35,060)

      Realized gains from sales of mortgage loans

 

(97)

 

(52)

 

(758)

      Proceeds from sales of mortgage loans

 

     5,822

 

     2,264

 

35,448 

      Compensation expense related to stock options

 

          9 

 

           -

 

           -

      (Increase) decrease in income receivable

 

(461)

 

       642

 

(72)

      (Increase) decrease in other assets

 

(234)

 

       366

 

(245)

      Increase (decrease) in other liabilities

 

       326

 

         32

 

       106

         TOTAL ADJUSTMENTS

 

    1,740

 

     3,630

 

3,276 

       

           NET CASH FLOWS FROM OPERATING

             ACTIVITIES

 


    8,445

 


   10,226

 


10,013 

       

CASH FLOWS FROM INVESTING ACTIVITIES:

      

   Proceeds from sales of securities available for sale

 

  10,988

 

   36,315

 

1,775 

   Proceeds from maturities of securities available for sale

 

  38,027

 

   36,620

 

46,959 

   Purchases of securities available for sale

 

(71,494)

 

(38,007)

 

(65,429)

   Purchases of bank owned life insurance

 

          -

 

(10,000)

 

           -

   Proceeds from sale of credit card portfolio

 

          -

 

    2,927

 

           -

   Net decrease (increase) in loans

 

(23,906)

 

(22,059)

 

6,283 

   Purchases of premises and equipment

 

(1,690)

 

(1,306)

 

(1,394)

   Proceeds from sales of premises and equipment

 

      327

 

          2

 

        26

            NET CASH FLOWS FROM INVESTING

              ACTIVITIES

 


(47,748)

 


   4,492

 


(11,780)

       

CASH FLOWS FROM FINANCING ACTIVITIES:

      

   Net change in deposits

 

   17,575

 

       867

 

   20,813 

   Net change in short-term borrowings

 

(238)

 

       636

 

    (2,389)

   Principal payments on long-term debt

 

(64)

 

(2,060)

 

(2,056)

   Cash dividends paid

 

(3,828)

 

(3,733)

 

(3,633)

   Purchases of treasury shares

 

(1,933)

 

(1,722)

 

(2,163)

            NET CASH FLOWS FROM FINANCING

              ACTIVITIES

 


  11,512

 


(6,012)

 


10,572 

       

            NET CHANGE IN CASH AND CASH

               EQUIVALENTS

 


(27,791)

 


    8,706

 


     8,805

       
       

CASH AND CASH EQUIVALENTS AT BEGINNING

   OF YEAR

 


   43,115

 


   34,409

 


25,604 

       

CASH AND CASH EQUIVALENTS AT END OF

   YEAR


$


   15,324 

 


   43,115

 


34,409 

       

SUPPLEMENTAL CASH FLOW INFORMATION:

      

CASH PAID DURING THE YEAR FOR:

      

   Interest

$

    8,940 

 

    7,388

 

 8,778 

   Income taxes

 

    2,367 

 

    2,416

 

2,245 

       

SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING ACTIVITY:

      

   Transfer from loans to real estate acquired through

     foreclosure

 


        98

 

         

       86

 

         

           -

       

The accompanying notes to consolidated financial statements are an integral part of these statements.

       

- 8 -







LCNB CORP. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS

December 31, 2004



NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


LCNB Corp. (the "Company"), an Ohio corporation formed in December 1998, is a financial holding company whose principal activities are the ownership of Lebanon Citizens National Bank (the "Bank") and Dakin Insurance Agency, Inc. ("Dakin").  The Bank was founded in 1877 and provides full banking services, including trust and brokerage services, to customers primarily in the Southwestern Ohio area of Warren, Hamilton, Clermont, Clinton and Butler counties. Dakin is an independent insurance agency founded in 1876 and offers a wide range of insurance products for businesses and individuals in the Bank's primary market area.


BASIS OF PRESENTATION-

The consolidated financial statements include the accounts of the Company and its subsidiaries. Significant intercompany accounts and transactions are eliminated in consolidation.  The accounting and reporting policies of the Company conform with U.S. generally accepted accounting principles (“GAAP”) and with general practices in the banking industry.  


USE OF ESTIMATES-

The preparation of financial statements in conformity with U.S. generally accepted accounting principles 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.


CASH AND CASH EQUIVALENTS

For purposes of reporting cash flows, cash and cash equivalents include cash, balances due from banks, and federal funds sold and interest-bearing demand deposits with original maturities of three months or less.  Deposits with other banks routinely have balances greater than FDIC insured limits.  Management considers risk of loss to be very low.





- 9 -







NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Continued)


INVESTMENT SECURITIES-

All of the Company's debt securities are classified as available for sale and are reported at fair value with unrealized holding gains and losses reported net of income taxes as Accumulated Other Comprehensive Income, a separate component of shareholders' equity. Amortization of premiums and accretion of discounts are recognized as adjustments to interest income using the level-yield method.  Realized gains or losses from the sale of securities are computed using the specific identification method.  Declines in the fair value of available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses.  In estimating other than temporary impairment losses, management considers the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.


Federal Home Loan Bank ("FHLB") stock is an equity interest in the Federal Home Loan Bank of Cincinnati.  It can be sold only at its par value of $100 per share and only to the FHLB or to another member institution.  In addition, the equity ownership rights are more limited than would be the case for a public company because of the oversight role exercised by the Federal Housing Finance Board in the process of budgeting and approving dividends.  Federal Reserve Bank stock is similarly restricted in marketability and value.  Both investments are carried at cost, which is their par value.


LOANS AND ALLOWANCE FOR LOAN LOSSES-

Loans are stated at the principal amount outstanding, net of unearned income, deferred origination fees and costs, and the allowance for loan losses.  Interest income is accrued on the unpaid principal balance.  Generally, a loan is placed on non-accrual status when there is an indication that the borrower’s cash flow may not be sufficient to meet payments as they come due, unless the loan is well secured and in the process of collection.  Subsequent cash receipts on non-accrual loans are recorded as a reduction of principal, and interest income is recorded once principal recovery is reasonably assured.  The current year's accrued interest on loans placed on non-accrual status is charged against earnings.  Previous years' accrued interest is charged against the allowance for loan losses.


Loan origination fees and certain direct loan origination costs are deferred and the net amount amortized as an adjustment of loan yields.  These amounts are being amortized over the lives of the related loans.




- 10 -







NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Continued)


Loans are considered impaired when management believes, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Impaired loans are measured by the present value of expected future cash flows using the loan's effective interest rate.  Impaired collateral-dependent loans may be measured based on collateral value.  Smaller-balance homogenous loans, including residential mortgage and consumer installment loans, are collectively evaluated for impairment.


The allowance for loan losses is established through a provision for loan losses charged to expense.  Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely.  The allowance is an amount that management believes will be adequate to absorb possible losses on loans that may become uncollectible, based on evaluations of the collectibility of loans and prior loan loss experience.  The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers' ability to pay.  


The allowance consists of specific, general, and unallocated components.  The specific component relates to loans that are classified as either doubtful, substandard, or special mention.  For such loans that are also classified as impaired, an allowance is established when the discounted cash flows or collateral value or observable market price of the impaired loan is lower than the carrying value of that loan.  The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors.  An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses.  The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.


PREMISES AND EQUIPMENT-

Premises and equipment are stated at cost less accumulated depreciation.  Depreciation is computed on both the straight-line and accelerated methods over the estimated useful lives of the assets, generally 15 to 40 years for premises and 3 to 10 years for equipment.  Costs incurred for maintenance and repairs are expensed currently.


REAL ESTATE ACQUIRED THROUGH FORECLOSURE-

Real estate acquired through foreclosure is recorded at the lower of cost or fair value, less estimated selling costs.  The allowance for loan losses is charged for any write down of the loan’s carrying value to fair value at the date of acquisition.  Any subsequent reductions in fair value are recorded to other non-interest expense.  Expenses incurred from holding foreclosed real estate are charged to other non-interest expense as incurred.  




- 11 -







NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Continued)


INTANGIBLE ASSETS-

The Company's intangible assets at December 31, 2005 and 2004 primarily represent the unamortized intangible related to the Company's 1997 acquisition of three branch offices from another bank.  Management determined its 1997 branch office acquisition did not meet the definition of a business combination and continues to amortize the intangible over ten years, subject to periodic review for impairment in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144.  At December 31, 2005, the carrying amount of this intangible was $1.3 million, net of accumulated amortization of $4.8 million.


Mortgage servicing rights on originated mortgage loans that have been sold are capitalized by allocating the total cost of the loans between mortgage servicing rights and the loans based on their estimated fair values.  Capitalized mortgage servicing rights are amortized to loan servicing income in proportion to and over the period of estimated servicing income.  Such assets are periodically evaluated as to the recoverability of their carrying value.


Annual estimates of intangible amortization expense, including amortization of the mortgage servicing rights asset, for the years 2006 through 2010 are $649,000, $579,000, $258,000, $33,000, and $23,000, respectively.


BANK OWNED LIFE INSURANCE-

The Company has purchased life insurance policies on certain officers of the Company.  The Company is the beneficiary of these policies and has recorded the estimated cash surrender value in other assets in the consolidated balance sheet.  Income on the policies, based on the increase in cash surrender value, is included in other non-interest income in the consolidated statements of income.


MARKETING EXPENSE-

Marketing costs are expensed as incurred.


EMPLOYEE BENEFITS-

The Company has a noncontributory pension plan covering full-time employees. The retirement plan cost is made up of several components that reflect different aspects of the Company's financial arrangements as well as the cost of benefits earned by employees. These components are determined using the projected unit credit actuarial cost method and are based on certain actuarial assumptions.






- 12 -







NOTE 1 -

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  (Continued)


STOCK OPTIONS-

The Company has an Ownership Incentive Plan (the "Plan").  Effective January 1, 2005, LCNB adopted the fair value method of accounting for stock options as described in Statement of  Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123 (revised)”). SFAS No. 123 (revised) generally requires an entity to recognize expense for the grant-date fair value of share-based compensation, where the original SFAS No. 123, Accounting for Stock-Based Compensation, encouraged but did not require an entity to recognize expense for such transactions.  The estimated cost of share-based compensation is recognized over the period during which an employee is required to provide service in exchange for the award, usually the vesting period or five years.  Compensation expense recognized in the consolidated statements of income for all stock options granted prior to January 1, 2005 is determined using the modified prospective approach as allowed by SFAS No. 123 (revised).  


INCOME TAXES-

Deferred income taxes are determined using the liability method of accounting.  Under this method, the net deferred tax asset or liability is determined based on the tax effects of temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.


EARNINGS PER SHARE-

Basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding during the period.  Diluted earnings per share is adjusted for the dilutive effects of stock options.  The diluted average number of common shares outstanding has been increased for the assumed exercise of stock options with proceeds used to purchase treasury shares at the average market price for the period.


RECLASSIFICATIONS-

Certain prior period data presented in the financial statements has been reclassified to conform with the current year presentation.


RECENT ACCOUNTING PRONOUNCEMENTS-

Financial Accounting Standards Board (“FASB”) Staff Position Numbers 115-1 and 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”, (the “FSP”) was released in November, 2005.   The FSP provides guidance for determining when an investment is considered impaired, whether impairment is other-than-temporary, and measurement of an impairment loss.  LCNB does not expect the guidance in the FSP to have a material affect in its consolidated financial position, results of operations, or cash flows.


SFAS No. 154, “Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3”, was issued in May, 2005.  It primarily applies to voluntary changes in accounting principles, but it also includes changes in accounting estimates and corrections of errors in previously issued financial statements.  SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.


- 13 -







NOTE 2 -

EARNINGS PER SHARE


Earnings per share for the years ended December 31, 2005, 2004, and 2003 were calculated as follows ($000’s except per share data):


  

2005

 

2004

 

2003

       

Net income (loss)

$

6,705

 

6,596

 

6,737

       

Weighted average number of shares

  outstanding used in the calculation of

  basic earnings per common share

 



3,304,157

 



3,351,146

 



3,417,254

       

Add - Dilutive effect of stock options

 

1,305

 

1,151

 

398

       

Adjusted weighted average number of

  shares outstanding used in the

  calculation of diluted earnings per

  common share

 




3,305,462

 




3,352,297

 




3,417,652

       

Basic earnings per common share

$

2.03

 

1.97

 

1.97

       

Diluted earnings per common share

 

2.03

 

1.97

 

1.97




NOTE 3 -

INVESTMENT SECURITIES


The amortized cost and estimated market value of available-for-sale investment securities at December 31 are summarized as follows (000’s):


 

2005

 

Amortized

Unrealized

Unrealized

 

Market

  

Cost

  

Gains

 

Losses

 

Value

            

U.S. Treasury notes

$

4,181

  

-

  

55

  

4,126

U.S. Agency notes

 

47,669

  

1

  

471

  

47,199

U.S. Agency mortgage-

   backed securities

 


21,480

  


7

  


629

  


20,858

Municipal securities:

           

     Non-taxable

 

55,637

  

484

  

295

  

55,826

     Taxable

 

5,600

  

4

  

108

  

5,496

 

$

134,567

  

496

  

1,558

  

133,505




- 14 -








NOTE 3 -

INVESTMENT SECURITIES (Continued)


 

2004

 

Amortized

Unrealized

Unrealized

 

Market

  

Cost

  

Gains

 

Losses

 

Value

            

U.S. Treasury notes

$

1,193

  

1

  

-

  

1,194

U.S. Agency notes

 

23,940

  

 45

  

196

  

23,789

U.S. Agency mortgage-

   backed securities

 


28,659

  


98

  


254

  


28,503

Municipal securities:

           

     Non-taxable

 

51,149

  

1,197

  

74

  

52,272

     Taxable

 

 7,699

  

 55

  

75

  

 7,679

 

$

112,640

  

1,396

  

599

  

113,437


Contractual maturities of debt securities at December 31, 2005 were as follows (000’s).  Actual maturities may differ from contractual maturities when issuers have the right to call or prepay obligations.


 

Amortized

 

Market

 
  

Cost

  

Value

 
       

Due within one year

$

40,539

  

40,401

 

Due from one to five years

 

54,223

  

53,704

 

Due from five to ten years

 

11,103

  

11,140

 

Due after ten years

 

7,222

  

7,402

 
  

113,087

  

112,647

 
       

U.S. Agency mortgage-backed securities

 

21,480

  

20,858

 
 

$

134,567

  

133,505

 


Information concerning securities with gross unrealized losses at December 31, 2005, aggregated by length of time that individual securities have been in a continuous loss position, is as follows (000’s):


  

Less than Twelve Months

 

More than Twelve Months

  

Fair

Value

 

Unrealized

Losses

 

Fair

Value

 

Unrealized

Losses

         

U.S. Treasury notes

$

-

 

-

 

4,126

 

55

U.S. Agency notes

 

30,690

 

189

 

13,996

 

282

U.S. Agency mortgage-

   backed securities

 


2,747

 


37

 


16,835

 


592

Municipal securities:

        

     Non-taxable

 

21,103

 

166

 

6,566

 

129

     Taxable

 

1,528

 

13

 

2,810

 

95

 

$

56,068

 

405

 

44,333

 

1,153


- 15 -







NOTE 3 -

INVESTMENT SECURITIES (Continued)


The decline in the fair values is primarily due to increases in market interest rates.  Because the Company has the ability and intent to hold these securities for a period of time sufficient to allow for any anticipated recovery in fair values, no individual declines are deemed to be other than temporary.


For the years ended December 31, 2005, 2004, and 2003, proceeds from sales of securities available for sale amounted to $10,988,000, $36,315,000, and $1,775,000, respectively.  Gross gains realized on sales were $1,000, $306,000, and $18,000 for 2005, 2004 and 2003, respectively.  Gross realized losses during 2005, 2004 and 2003 amounted to $9,000, $0 and $9,000, respectively.  


Investment securities with a market value of $88,316,000 and $56,733,000 at December 31, 2005 and 2004, respectively, were pledged to secure public deposits and for other purposes required or permitted by law.



NOTE 4 -

LOANS


Major classifications of loans at December 31 are as follows (000's):


  

2005

 

2004

 
      

Commercial and industrial

$

    34,607

 

32,931 

 

Commercial, secured by real estate

 

  124,823

 

107,138 

 

Residential real estate

 

  161,656

 

159,286 

 

Consumer

 

   35,879

 

34,672 

 

Agricultural

 

     1,978

 

1,653 

 

Other loans

 

        152

 

       167

 

Lease financing

 

          37

 

  253 

 
  

 359,132

 

336,100 

 

Deferred net origination costs

 

       669

 

490 

 
  

 359,801

 

336,590 

 

Allowance for loan losses

 

(2,150)

 

(2,150)

 

     Loans-net

$

 357,651

 

334,440 

 


Changes in the allowance for loan losses were as follows (000's):


  

2005

 

2004

 

2003

       

BALANCE - BEGINNING OF YEAR

$

2,150 

 

2,150 

 

2,000 

Provision for loan losses

 

  338

 

489 

 

658 

Charge-offs

 

(744)

 

(614)

 

(560)

Recoveries

 

  406

 

125 

 

52 

BALANCE - END OF YEAR

$

2,150

 

2,150 

 

2,150 


- 16 -







NOTE 4 -

LOANS (Continued)


Non-accrual, past-due, and restructured loans at December 31, 2005 and 2004 were as follows (000’s)


  

2005

 

2004

     

Non-accrual loans

$

785

 

  -

Past-due 90 days or more and still accruing

 

61

 

  165

Restructured loans

 

1,717

 

1,817

     Total

$

2,563

 

1,982


Non-accrual loans at December 31, 2005 consisted of two real estate mortgage loans.  Interest income that would have been recorded during 2005 if loans on non-accrual status at December 31, 2005 had been current and in accordance with their original terms was approximately $20,000.


Loans past-due 90 days or more and still accruing interest at December 31, 2005 consisted primarily of consumer loans.  Loans classified as past-due 90 days or more and still accruing interest at December 31, 2004 consisted of consumer loans totaling $104,000 and residential mortgage loans totaling $61,000.


The restructured loan at December 31, 2005 and 2004 consists of a commercial loan whose predecessor loans were classified as loans past due 90 days or more and still accruing at December 31, 2003, at which time they had a total balance of $2,030,000.  Principal payments of $100,000 were received in 2005.  Information received during the first quarter, 2004, raised uncertainties concerning the collectibility of certain collateral and management transferred the loans to the non-accrual classification, where they remained until they were re-written in October, 2004.  All related interest due on the predecessor loans was paid during October, 2004, and the loans were re-written at that time.  Such interest was recorded on a cash basis as received.  The restructured loan is secured by a combination of mortgages and other collateral.


The following is a summary of information pertaining to loans considered to be impaired in accordance with SFAS No. 114 at December 31 (000’s):


  

2005

 

2004

     

Impaired loans without a valuation allowance

$

4,026

 

71

Impaired loans with a valuation allowance

 

2,333

 

2,049

Total impaired loans

 

6,359

 

2,120

     

Valuation allowance related to impaired loans

$

746

 

540



- 17 -







NOTE 4 -

LOANS (Continued)


The increase in impaired loans without a valuation allowance is primarily due to four loans totaling $3,869,000.  Each loan is secured by real estate that has sufficient estimated fair value to pay the principal in full.  


The average balance of impaired loans during 2005 and 2004 was $6,601,000 and $2,629,000, respectively.  During 2005 LCNB recognized approximately $408,000 of interest on impaired loans, of which $15,000 was recognized on a cash basis.   LCNB continued to accrue interest on certain loans classified as impaired during 2005 because they were considered well secured and in the process of collection.  During 2004 LCNB received and recognized $164,000 of interest income on impaired loans.  


The Company is not committed to lend additional funds to debtors whose loans have been modified to provide a reduction or deferral of principal or interest because of deterioration in the financial position of the borrower.


Mortgage loans sold to and serviced for the Federal Home Loan Mortgage Corporation are not included in the accompanying balance sheets.  The unpaid principal balances of those loans at December 31, 2005, 2004 and 2003 were $46,244,000, $46,345,000, and $54,802,000 respectively.  


Approximately $66,000 and $25,000 in mortgage servicing rights were capitalized and $75,000 and $86,000 were amortized to loan servicing income during the years ended  December 31, 2005 and 2004, respectively.



NOTE 5 -

PREMISES AND EQUIPMENT


Premises and equipment at December 31 are summarized as follows (000's):


  

2005

 

2004

 
      

Land

$

2,335

 

2,244

 

Buildings

 

11,212

 

10,592

 

Equipment

 

9,238

 

8,888

 

Construction in progress

 

25

 

 81

 

     Total

 

22,810

 

21,805

 

Less – Accumulated depreciation

 

10,239

 

 9,572

 

     Premises and equipment – net

$

12,571

 

12,233

 


Depreciation charged to income was $1,113,000 in 2005, $1,080,000 in 2004 and $1,040,000 in 2003.




- 18 -








NOTE 5 -

PREMISES AND EQUIPMENT (Continued)


Some of the Bank's branches, telephone equipment, and other equipment are leased under agreements expiring at various dates through 2050.  These leases are accounted for as operating leases.  At December 31, 2005, required minimum annual rentals due in the future on non-cancelable leases having terms in excess of one year aggregated $2,239,000.  Minimum annual rentals for each of the years 2006 through 2010 are as follows (000's):


2006

$

320

2007

 

197

2008

 

66

2009

 

66

2010

 

61


Rental expense for all leased branches and equipment amounted to $349,000 in 2005, $321,000 in 2004, and $309,000 in 2003.



NOTE 6 -

CERTIFICATES OF DEPOSIT


Contractual maturities of time deposits at December 31, 2005 were as follows (000’s):


 

Certificates

All other

 
 

over $100,000

Certificates

Total

        

2006

$

25,666

  

62,653

 

88,319

2007

 

11,809

  

38,356

 

50,165

2008

 

744

  

8,865

 

9,609

2009

 

1,494

  

6,167

 

7,661

2010

 

7,567

  

7,527

 

15,094

Thereafter

 

14,172

  

16,841

 

31,013

 

$

61,452

  

140,409

 

201,861





- 19 -







NOTE 7 -

EMPLOYEE BENEFITS


The Company's noncontributory defined benefit retirement plan covers all regular full-time employees.  The benefits are based on years of service and the employee's highest average compensation during five consecutive years.  Pension costs are funded based on the Plan's actuarial cost method.  All plan assets were invested in time and other deposits with the Bank at December 31, 2005 and 2004.


The Company used a December 31 measurement date for its retirement plan starting in 2004 and a September 30 measurement date for previous years.


The components of net periodic pension cost are summarized as follows (000's):


  

2005

 

2004

 

2003

       

Service cost

$

  645

 

624 

 

624 

Interest cost

 

  331

 

296 

 

298 

Expected return on plan assets

 

(366)

 

(325)

 

(233)

Recognized net actuarial loss (gain)

 

     2

 

      2

 

   (46)

        Net periodic pension cost

$

  612

 

597 

 

643 


A summary of the Plan's prepaid benefit cost, included in other assets on the consolidated balance sheets, and the Plan's funded status at December 31 follows (000's):


  

2005

 

2004

 

Change in projected benefit obligations

     

Projected benefit obligation at beginning of year

$

 6,077

 

5,732 

 

Service cost

 

    645

 

624 

 

Interest cost

 

    331

 

296 

 

Actuarial (gain) or loss

 

     61

 

(181)

 

Benefits paid

 

(117)

 

(394)

 

Projected benefit obligation at end of year

 

 6,997

 

6,077 

 
      

Change in plan assets

     

Fair value of plan assets at beginning of year

 

 6,288

 

5,942 

 

Actual return on plan assets

 

   237

 

114 

 

Employer contribution

 

    832

 

626 

 

Benefits paid

 

(117)

 

(394)

 

Fair value of plan assets at end of year

 

 7,240

 

6,288 

 
      

Funded status

 

    243

 

   211

 

Unrecognized net actuarial loss

 

    843

 

654 

 

Prepaid benefit cost

$

 1,086

 

865 

 



- 20 -







NOTE 7 -

EMPLOYEE BENEFITS  (Continued)


Significant actuarial assumptions used for 2005 and 2004 included a discount rate of 5.50% for both years, an expected long-term rate of return on Plan assets of 5.50% for both years, and a future compensation rate increase of 4.00% for both years.  The expected long-term rate of return on Plan assets was estimated using historic returns on investments, adjusted for expected long-term interest rates.


The accumulated benefit obligation at December 31, 2005 and 2004 was $6,187,000 and $5,478,000, respectively.


The Company expects to contribute approximately $875,000 to its retirement plan in 2006.


The following estimated future benefit payments, which reflect expected future service, as appropriate, are expected to be paid (000's):


2006

$

-

2007

 

29

2008

 

67

2009

 

136

2010

 

169

2011 through 2015

 

2,170


The Bank has a benefit plan which permits eligible officers to defer a portion of their compensation.  The deferred compensation balance, which accrues interest at 8% annually, is distributable in cash after retirement or termination of employment.  The amount of such deferred compensation liability at December 31, 2005 and 2004 was $942,000 and $797,000, respectively.


The Bank also has a supplemental income plan which provides a covered employee an amount based on a percentage of average compensation, payable annually for ten years upon retirement. The projected benefit obligation included in other liabilities for this supplemental income plan at December 31, 2005 and 2004 is $227,000 and $192,000, respectively. The discount rate used to determine the present value of the obligation was 5.5% in 2005 and 2004. The service cost associated with this plan was $24,000 for 2005, $24,000 for 2004, and $16,000 for 2003.  Interest costs were approximately $11,000, $10,000, and $9,000 for 2005, 2004, and 2003, respectively.  Both of these plans are nonqualified and unfunded.  Participation in each plan is limited to a select group of management.






- 21 -









NOTE 8 -

STOCK OPTIONS AND AWARDS


The Company established an Ownership Incentive Plan (the "Plan") during 2002 that allows for stock-based awards to eligible employees, as determined by the Board of Directors.  The awards may be in the form of stock options, share awards, and/or appreciation rights.  The Plan provides for the issuance of up to 100,000 shares.  No awards were granted during 2005 or 2002.  Stock options for 4,054 and 5,528 shares with an exercise price of $35.32 and $26.19 per share were granted to key executive officers of the Company during the first quarter, 2004 and 2003, respectively.  Such options vest ratably over a five year period and expire in 2014 and 2013, respectively.  At December 31, 2005, 3,022 options were exercisable, but none had been exercised through that date.


The estimated weighted-average fair value of the options granted in 2004 and 2003 were $5.57 and $3.77 per option, respectively.  The fair value was estimated at the date of grant using the Black-Scholes option-pricing model and the following assumptions:


  

2004

2003

Risk-free interest rate

 

2.76%

2.72%

Average dividend yield

 

3.50%

4.65%

Volatility factor of the expected market

   

  price of the Company's common stock

 

24.54%

25.79%

Average life

 

4 years

4 years


Total expense related to options included in salaries and wages in the consolidated statements of income for the year ended December 31, 2005 was $9,000.  Total compensation cost related to option awards to be recognized ratably through the first quarter of 2009 is approximately $23,000.


Prior to January 1, 2005, LCNB accounted for stock options under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25), and related Interpretations.  Under APB No. 25, no stock-based employee compensation cost was reflected in net income, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant.  The following table illustrates the effect on net income and earnings per share for the years ended December 31, 2004 and 2003 if the Company had applied the fair value recognition provisions of SFAS No. 123 (revised) to stock-based employee compensation (000's):


  

2004

 

2003

Net income, as reported

$

6,596

 

6,737

Deduct total stock-based employee compensation

   expense estimated using Black-Scholes model,

   net of tax

 



6

 



3

Pro-forma net income

$

6,590

 

6,734


The pro-forma affect of the above adjustment on basic and diluted earnings per share was not material.



- 22 -









NOTE 9 -     LONG-TERM DEBT AND OTHER BORROWINGS


Long-term debt consists of the following at December 31 (000’s):


  

2005

 

2004

 
      

Federal  Home Loan Bank note

$

2,000

 

2,000

 

Note payable to former shareholder of Dakin

 

73

 

137

 

     Total

$

2,073

 

2,137

 


Maturities of long-term debt in the years ending December 31 are as follows (000's):


  2006

$

2,067

  2007

 

    6


At December 31, 2005 and 2004, the Federal Home Loan Bank borrowing consisted of a note with a  five-year maturity and an interest rate of 5.54%.  Interest on the note is fixed and payable monthly.  The note is secured by $2.5 million of 1-4 family residential mortgage loans.  Additionally, the Company is required to hold minimum levels of FHLB stock, based on the outstanding borrowings.  The Company’s remaining borrowing capacity at December 31, 2005 is approximately $86 million.


The note payable to a former shareholder of Dakin matures in 2007.  Payments are due monthly at a contractual interest rate of 6%.


At December 31, 2005 and 2004, accrued interest and other liabilities include U.S. Treasury demand note borrowings of approximately $1,031,000 and $1,269,000, respectively.  The interest rate on these borrowings is variable and was 4.00% and 1.87% at December 31, 2005 and 2004, respectively.



NOTE 10 -

INCOME TAXES


The provision for federal income taxes consists of (000's):


  

2005

 

2004

 

2003

       

Income taxes currently payable

$

2,315

 

2,464 

 

2,351 

Deferred income tax provision (benefit)

 

(75)

 

  (14)

 

   83

     Provision for income taxes

$

2,240

 

2,450 

 

2,434 




- 23 -







NOTE 10 -

INCOME TAXES (continued)


A reconciliation between the statutory income tax and the Company's effective tax rate follows:


  

2005

 

2004

 

2003

       

Statutory tax rate

 

34.0%

 

34.0%

 

34.0%

Increase (decrease) resulting from -

      

   Tax exempt interest

 

 (7.2)  

 

(6.9) 

 

(7.2) 

   Tax exempt income on bank owned

      life insurance

 


 (1.9)  

 


(0.1)

 


   -

   Other – net

 

  0.1

 

 0.1 

 

(0.2)

      Effective tax rate

 

25.0%

 

27.1%

 

26.6%


Deferred tax assets and liabilities at December 31 consist of the following (000's):


  

2005

 

2004

 

Deferred tax assets:

     

   Allowance for loan losses

$

   680

 

627 

 

   Amortization of intangibles

 

   400

 

340 

 

   Unrealized losses on securities available for sale

 

   361

 

       -

 

   Pension and deferred compensation

 

     34

 

     47

 
  

 1,475

 

1,014 

 
      

Deferred tax liabilities:

     

   Depreciation of premises and equipment

 

(582)

 

(590)

 

   Unrealized gains on securities available for sale

 

       -

 

(271)

 

   Deferred loan fees

 

(18)

 

(27)

 

   FHLB stock dividends

 

(195)

 

(153)

 
  

(795)

 

(1,041)

 

       Net deferred tax asset (liability)

$

   680

 

(27)

 



NOTE 11 -

COMMITMENTS AND CONTINGENT LIABILITIES


The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit.  They involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets.  The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contract amount of those instruments.




- 24 -









NOTE 11 -

COMMITMENTS AND CONTINGENT LIABILITIES (Continued)


The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.  Financial instruments whose contract amounts represent off-balance-sheet credit risk at December 31 were as follows (000's):


  

2005

 

2004

 
      

Commitments to extend credit

$

74,753

 

68,235

 

Standby letters of credit

 

5,946

 

6,186

 


Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses.  Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. At December 31, 2005 and 2004, outstanding guarantees of $1,892,000 and  $1,983,000, respectively, were issued to developers and contractors. These guarantees generally are fully secured and have varying maturities.  In addition, the Company has a participation in a letter of credit securing payment of principal and interest on a bond issue.  The participation amount at December 31, 2005 and 2004 was approximately $4.1 million and $4.2 million, respectively.  The letter of credit will expire on July 15, 2009.  It is secured by an assignment of rents and the underlying real property.


The Company evaluates each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Company, is based on management's credit evaluation of the borrower.  Collateral held varies, but may include deposit accounts, accounts receivable, inventory, property, plant and equipment, residential realty, and income-producing commercial properties.


At December 31, 2005, the Company is committed under various contracts to expend approximately $45,000 to complete certain building renovation projects and information technology system improvements.


The Company and its subsidiaries are parties to various claims and proceedings arising in the normal course of business.  Management, after consultation with legal counsel, believes that the liabilities, if any, arising from such proceedings and claims will not be material to the consolidated financial position or results of operations.




- 25 -







NOTE 12 -

RELATED PARTY TRANSACTIONS


The Company has entered into related party transactions with various directors and executive officers.  Management believes these transactions do not involve more than a normal risk of collectibility or present other unfavorable features.   At December 31, 2005 and 2004, executive officers, directors and related interests of such persons were indebted to the Bank directly or as guarantors in the aggregate amount of $2,822,000 and $2,792,000, respectively.  Loan activity for these officers and directors was as follows (000's):


  

2005

 

2004

 
      

Beginning balances

$

2,792

 

3,340

 

Additions

 

2,496

 

  812

 

Reductions

 

(2,466)

 

(1,360)

 

Ending Balance

$

2,822

 

2,792

 


Deposits from executive officers, directors and related interests of such persons held by the Company at December 31, 2005 and 2004 amounted to $6,603,000 and $7,023,000, respectively.



NOTE 13 -

FAIR VALUE OF FINANCIAL INSTRUMENTS


Carrying amounts and estimated fair values of financial instruments as of December 31, were as follows (000’s):


  

2005

  

2004

 

Carrying

Fair

Carrying

 

Fair

  

Amount

  

Value

 

Amount

 

Value

            

FINANCIAL ASSETS:

           

  Cash and cash equivalents

$

15,324

  

15,324

  

43,115

  

43,115

  Securities available for sale

 

133,505

  

133,505

  

113,437

  

113,437

  Federal Reserve Bank and

    Federal Home Loan Bank

    Stock

 



3,181

  



3,181

  



3,058

  



3,058

  Loans, net

 

357,651

  

360,141

  

334,440

  

334,761

            

FINANCIAL LIABILITIES:

           

  Deposits

 

481,475

  

480,489

  

463,900

  

463,831

  Short-term borrowings

 

1,031

  

1,031

  

1,269

  

1,269

  Long-term debt

 

2,073

  

2,100

  

2,137

  

2,189






-. 26 -







NOTE 13 -

FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)


The fair value of off-balance-sheet financial instruments at December 31, 2005 and 2004 was not material.


Fair values of financial instruments are based on various assumptions, including the discount rate and estimates of future cash flows.  Therefore, the fair values presented may not represent amounts that could be realized in actual transactions.  In addition, because the required disclosures exclude certain financial instruments and all nonfinancial instruments, any aggregation of the fair value amounts presented would not represent the underlying value of the Company.  The following methods and assumptions were used to estimate the fair value of certain financial instruments:


Cash and cash equivalents

The carrying amounts presented are deemed to approximate fair value.


Investment Securities

Fair values are based on quoted market prices, if available.  If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.


Loans

Fair value is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.


Deposits

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date.  The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.


Borrowings

The carrying amounts of federal funds purchased and U.S. Treasury notes are deemed to approximate fair value of short-term borrowings.  For long-term debt, fair values are estimated based on the discounted value of expected net cash flows using current interest rates.





- 27 -







NOTE 14 -

REGULATORY MATTERS


The Federal Reserve Act requires depository institutions to maintain cash reserves with the Federal Reserve Bank.  In 2005 and 2004, the Bank was required to maintain average reserve balances of $2,772,000 and $1,924,000, respectively.  The required reserve balances at December 31, 2005 and 2004 were $2,106,000 and $2,030,000, respectively.


The Company (consolidated) and the Bank must meet certain minimum capital requirements set by 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 material effect on the Company's and Bank's financial statements.  The minimum regulatory capital ratios are 8% for total risk-based, 4% for Tier 1 risk-based, and 4% for leverage.  The Company’s and Bank’s capital amounts and classification are also subject to qualitative judgments by regulators about components, risk weightings, and other factors.


For various regulatory purposes, institutions are classified into categories based upon capital adequacy.  The highest "well-capitalized" category requires capital ratios of at least 10% for total risk-based, 6% for Tier 1 risk-based, and 5% for leverage.  As of the most recent notification from their regulators, the Company and Bank were categorized as "well-capitalized" under the regulatory framework for prompt corrective action.  Management believes that no conditions or events have occurred since the last notification that would change the Bank's category.  A summary of the regulatory capital of the Consolidated Company and Bank at December 31 follows ($000's):


  

2005

  

2004

 

Consolidated

 

Consolidated

  
 

Company

 

Bank

 

Company

 

Bank

            

Regulatory Capital:

           

  Shareholders' equity

$

 52,022

  

 46,940

  

52,296 

  

46,511 

  Intangible assets

 

(1,348)

  

(1,314)

  

(1,939)

  

(1,888)

  Net unrealized securities

    losses (gains)

 


      701

  


     672

  


(526)

  


(526)

       Tier 1 risk-based capital

 

 51,375

  

 46,298

  

49,831 

  

44,097 

Eligible allowance for loan

  losses

 


   2,150

  


   2,150

  


2,150 

  


2,150 

       Total risk-based capital

$

 53,525

  

 48,448

  

51,981 

  

46,247 

            

Capital Ratios:

           

  Total risk-based

 

14.94%

  

13.57%

  

15.49%

  

13.85%

  Tier 1 risk-based

 

14.34%

  

12.96%

  

14.85%

  

13.20%

  Leverage

 

9.55%

  

8.67%

  

9.58%

  

8.57%



- 28 -







NOTE 14 -

REGULATORY MATTERS (continued)


The principal source of income and funds for LCNB Corp. is dividends paid by the Bank.  The payment of dividends is subject to restriction by regulatory authorities.  For 2006, the restrictions generally limit dividends to the aggregate of net income for the year 2006 plus the net earnings retained for 2005 and 2004.  In addition, dividend payments may not reduce capital levels below minimum regulatory guidelines. Accordingly, future dividends may require the prior approval of the Comptroller of the Currency.



NOTE 15 -

PARENT COMPANY FINANCIAL INFORMATION


Condensed financial information for the LCNB Corp., parent company only, follows (000’s):


Condensed Balance Sheets:

     

December 31,

     
  

2005

 

2004

 

Assets:

     

  Cash on deposit with subsidiary

$

971

 

   139

 

  Corporate and municipal debt securities

 

3,409

 

5,159

 

  Investment in subsidiaries

 

47,591

 

46,955

 

  Other assets

 

51

 

43

 

Total assets

$

52,022

 

52,296

 
      

Liabilities

$

-

 

 -

 
      

Shareholders' equity

 

52,022

 

52,296

 

Total liabilities and shareholders' equity

$

52,022

 

52,296

 


Condensed Statements of Income

      

Year ended December 31,

 

2005

 

2004

 

2003

       

Income:

      

  Dividends from subsidiary

$

4,800

 

4,895 

 

3,746 

  Interest

 

106

 

168 

 

216 

  Gain on sale of investment securities

 

-

 

- 

 

3 

Total income

 

4,906

 

5,063 

 

3,965 

       

Total expenses

 

38

 

31 

 

40 

       

Income before income tax benefit and

  equity in undistributed income of

  subsidiaries

 



4,868

 



5,032 

 



3,925 

Income tax (expense) benefit

 

13

 

     10

 

(17)

Equity in undistributed income of

  subsidiaries

 


1,824

 


1,554

 


2,829 

Net income

$

6,705

 

6,596 

 

6,737 


- 29 -







NOTE 15 -

PARENT COMPANY FINANCIAL INFORMATION (Continued)


Condensed Statements of Cash Flows

      

Year ended December 31,

 

2005

 

2004

 

2003

       

Cash flows from operating activities:

      

  Net income

$

6,705

 

6,596 

 

6,737 

  Adjustments for non-cash items -

      

    Increase in undistributed income

      

       of subsidiaries

 

(1,824)

 

(1,554)

 

(2,829)

    Other, net

 

    57

 

 57 

 

     114

Net cash flows from operating activities

 

4,938

 

5,099 

 

4,022 

       

Cash flows from investing activities:

      

  Purchases of securities available for sale

 

      -

 

(879)

 

(2,985)

  Proceeds from sales of securities

      

    available for sale

 

      -

 

     -

 

  1,775

  Proceeds from maturities of securities

      

    available for sale

 

1,655

 

1,300

 

  1,565

Net cash flows from investing activities

 

1,655

 

   421

 

     355 

       

Cash flows from financing activities:

      

  Treasury shares purchased

 

(1,933)

 

(1,722)

 

(2,163)

  Cash dividends paid

 

(3,828)

 

(3,733)

 

 (3,633)

Net cash flows from financing activities

 

(5,761)

 

(5,455)

 

(5,796)

Net change in cash

 

   832

 

    65

 

 (1,419)

Cash at beginning of year

 

   139

 

    74

 

  1,493

Cash at end of year

$

   971   

 

  139

 

      74 





- 30 -