FFKY First Financial Service Corp.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Basis of Presentation – The accompanying unaudited consolidated financial statements include the accounts of First Financial Service Corporation (the “Corporation”) and its wholly owned subsidiary, First Federal Savings Bank (the “Bank”). First Federal Savings Bank has three wholly owned subsidiaries, First Service Corporation of Elizabethtown, Heritage Properties, LLC and First Federal Office Park, LLC. Unless the text clearly suggests otherwise, references to "us," "we," or "our" include First Financial Service Corporation and its wholly owned subsidiary, collectively referred to as the “Company”. All significant intercompany transactions and balances have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six month periods ending June 30, 2013 are not necessarily indicative of the results that may occur for the year ending December 31, 2013. For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the period ended December 31, 2012.

Reclassifications – Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year operations or shareholder’s equity.

Adoption of New Accounting Standards – Effective February 2013, we adopted, ASU No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive (ASU 2013-02).  This guidance is the culmination of the FASB’s deliberation on reporting reclassification adjustments from accumulated other comprehensive income (AOCI). The amendments in ASU 2013-02 do not change the current requirements for reporting net income or other comprehensive income.  However, the amendments require disclosure of amounts reclassified out of AOCI in its entirety, by component, on the face of the statement of operations or in the notes thereto.  Amounts that are not required to be reclassified in their entirety to net income must be cross-referenced to other disclosures that provide additional detail.  This standard was effective for public entities for annual and interim reporting periods beginning after December 15, 2012. The adoption of this update did not have a material impact on the consolidated financial statements.

In July 2013, the Financial Accounting Standards Board issued Accounting Standards Update 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (ASU 2013-11). Current GAAP does not include explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The adoption of ASU 2013-11 will require an unrecognized tax benefit, or a portion of an unrecognized tax benefit to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, unless an exception applies. The amendments in this update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2013. We are currently evaluating the effect that the provisions of ASU 2013-11 will have on the consolidated financial statements.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

On January 27, 2011, the Bank entered into a Consent Order with the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”). The 2011 Consent Order required the Bank to achieve a total capital to risk-weighted assets ratio of 12% and a Tier 1 capital to average total assets ratio of 9% by June 30, 2011. The 2011 Consent Order also forbade the Bank from declaring dividends without the prior written approval of the FDIC and KDFI and required the Bank to develop and implement plans to reduce its level of non-performing assets and concentrations of credit in commercial real estate loans, maintain adequate reserves for loan and lease losses, implement procedures to ensure compliance with applicable laws, and take certain other actions. A copy of the Consent Order is included as an exhibit to our Form 8−K filed on January 27, 2011.

In April 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends and to take steps to ensure the Bank complies with the Consent Order. We also may not redeem shares or obtain additional borrowings without prior approval.

On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The 2012 Consent Order requires the Bank to achieve the minimum capital ratios in the 2011 Consent Order by June 30, 2012. The Bank also agreed that if it should be unable to reach the required capital levels by that date, and if directed in writing by the FDIC, then within 30 days the Bank would develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. To date, the Bank has not received such a written direction. The 2012 Consent Order includes the substantive provisions of the 2011 Consent Order and requires the Bank to continue to adhere to the plans implemented in response to the 2011 Consent Order. A copy of the March 9, 2012 Consent Order is included as Exhibit 10.8 to our 2011 Annual Report on Form 10-K filed March 30, 2012. At June 30, 2013, the Bank’s Tier 1 capital ratio was 7.27% and the total risk-based capital ratio was 12.36% as compared to the minimum capital ratios as required by the 2011 Consent Order of 9.00% and 12.00%, respectively.

We notified the bank regulatory agencies that we have achieved and maintained the total risk-based capital ratio, but we have yet to achieve the Tier 1 capital ratio. We are continuing to explore our strategic alternatives to achieve and maintain the Tier 1 capital ratio as well as all of the other consent order issues.

The Consent Orders also resulted in the Bank being designated as a "troubled institution," which status prohibits the Bank from accepting, renewing or rolling over brokered deposits, restricts the amount of interest the Bank may pay on deposits, and increases its deposit insurance assessment.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a regulatory order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any material failures to comply with our regulatory orders would likely result in more stringent enforcement actions by the bank regulatory agencies, which could damage our reputation and have a material adverse effect on our business.

The 2012 Consent Order and the formal agreement will remain in effect until modified or terminated by the FDIC, KDFI and Federal Reserve Bank of St. Louis.

In response to the 2011 Consent Order, we engaged an investment banking firm with expertise in the financial services sector to assist with a review of all of our strategic alternatives as we work to achieve the higher required capital ratios. One of these alternatives was to sell branches located outside of our core market. On July 6, 2012, we sold our four banking centers in Southern Indiana, receiving a 3.65% premium on the $102.3 million of consumer and commercial deposits at closing. The buyer assumed a total of approximately $115.4 million in non-brokered deposits, which included $13.1 million of government, corporate, other financial institution and municipal deposits for which we received no premium or discount. We also sold approximately $30.4 million in performing loans at a discount of 0.80%. Other assets sold included vault cash of $367,000 and fixed assets of $887,000. The Indiana branch sale resulted in a gain of $3.1 million.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

In addition to the sale of our Indiana branches, we also sold commercial real estate loans totaling $10.7 million at par during 2012.

Our plans for 2013 include the following even though there can be no assurances that our plans will be achieved:

The amortized cost and fair value of securities at June 30, 2013, by contractual maturity, are shown below. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

The following schedule shows the proceeds from sales of available-for-sale securities and the gross realized gains and losses on those sales:

Investment securities pledged to secure public deposits and Federal Home Loan Bank (FHLB) advances had an amortized cost of $145.0 million and fair value of $143.4 million at June 30, 2013 and a $130.4 million amortized cost and fair value of $132.3 million at December 31, 2012.

Securities with unrealized losses at June 30, 2013 and December 31, 2012 aggregated by major security type and length of time in a continuous unrealized loss position are as follows:

We evaluate investment securities with significant declines in fair value on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation, to determine whether they should be considered other-than-temporarily impaired under current accounting guidance, which generally provides that if a security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the securities must assess whether the impairment is other-than-temporary.

Consideration is given to 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, underlying credit quality of the issuer, and our intent and ability to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.  In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, the sector or industry trends and cycles affecting the issuer, and the results of reviews of the issuer’s financial condition.  

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Accounting guidance requires entities to split other than temporary impairment charges between credit losses (i.e., the loss based on the entity’s estimate of the decrease in cash flows, including those that result from expected voluntary prepayments), which are charged to earnings, and the remainder of the impairment charge (non-credit component) to accumulated other comprehensive income. This requirement pertains to both debt securities held to maturity and debt securities available for sale.

The unrealized losses on our investment securities were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we do not intend to sell and it is more likely than not that we will not be required to sell these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at June 30, 2013.

We recognized other-than-temporary impairment charges of $26,000 for the expected credit loss during the 2012 period. The 2012 impairment charge was related to Preferred Term Security VI which was called for early redemption in July 2012.

The table below presents a roll-forward of the credit losses recognized in earnings. During 2012, all of our trust preferred securities were either called or sold which represented the remaining balance in the OTTI roll-forward.

The following tables present the activity in the allowance for loan losses by portfolio segment for the quarter and six months ending June 30, 2013 and 2012: