HILLS BANCORPORATION - Quarter Report: 2013 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013

Commission file number: 0-12668

Hills Bancorporation

Incorporated in Iowa	I.R.S. Employer Identification
	No. 42-1208067

131 MAIN STREET, HILLS, IOWA 52235

Telephone number: (319) 679-2291

Indicate by checkmark 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.

þ Yes o No

Indicate by checkmark whether the Registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§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).

þ Yes o No

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o	Accelerated Filer þ
Non-accelerated filer o	Small Reporting Company o

Indicate by checkmark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o Yes þ No

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date.

	SHARES OUTSTANDING
CLASS	At October 31, 2013

Common Stock, no par value	4,726,245

Index

HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION

		Page
		Number

Item 1.	Financial Statements

	Consolidated balance sheets, September 30, 2013 (unaudited) and December 31, 2012	3
	Consolidated statements of income (unaudited) for three and nine months ended September 30, 2013 and 2012	4
	Consolidated statements of comprehensive income (unaudited) for three and nine months ended September 30, 2013 and 2012	5
	Consolidated statements of stockholders' equity (unaudited) for nine months ended September 30, 2013 and 2012	6
	Consolidated statements of cash flows (unaudited) for nine months ended September 30, 2013 and 2012	7
	Notes to consolidated financial statements	9

Item 2.	Management Discussion and Analysis of Financial Condition and Results of Operations	36

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	53

Item 4.	Controls and Procedures	53

	Part II
	OTHER INFORMATION

Item 1.	Legal proceedings	54

Item 1A.	Risk factors	54

Item 2.	Unregistered sales of equity securities and use of proceeds	54

Item 3.	Defaults upon senior securities	54

Item 4.	Mine safety disclosures	54

Item 5.	Other information	54

Item 6.	Exhibits	55

Signatures		56

Exhibits Index		57

Page 2

Index

HILLS BANCORPORATION CONSOLIDATED BALANCE SHEETS (Amounts In Thousands, Except Share Amounts)

ASSETS	September 30, 2013 (Unaudited)			December 31, 2012

Cash and cash equivalents	$	56,923		$	63,582
Investment securities available for sale at fair value (amortized cost September 30, 2013 $225,527; December 31, 2012 $219,777)		227,679			226,182
Stock of Federal Home Loan Bank		7,580			8,062
Loans held for sale		2,811			28,256
Loans, net of allowance for loan losses (September 30, 2013 $24,750; December 31, 2012 $25,160)		1,767,603			1,697,002
Property and equipment, net		29,876			30,624
Tax credit real estate		18,267			18,745
Accrued interest receivable		8,460			7,851
Deferred income taxes, net		8,874			7,144
Other real estate		588			746
Goodwill		2,500			2,500
Prepaid FDIC insurance		-			2,957
Other assets		2,979			6,069
Total Assets	$	2,134,140		$	2,099,720

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities
Noninterest-bearing deposits	$	250,226		$	273,973
Interest-bearing deposits		1,443,079			1,388,571
Total deposits	$	1,693,305		$	1,662,544
Short-term borrowings		29,163			38,783
Federal Home Loan Bank borrowings		125,000			125,000
Accrued interest payable		1,092			1,361
Other liabilities		18,337			16,121
Total Liabilities	$	1,866,897		$	1,843,809

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	28,140		$	30,715

STOCKHOLDERS' EQUITY
Common stock, no par value; authorized 10,000,000 shares; issued September 30, 2013 - 5,071,780 shares; December 31, 2012 - 5,064,383 shares	$	-		$	-
Paid in capital		42,013			42,241
Retained earnings		244,787			229,625
Accumulated other comprehensive income		1,329			3,955
Unearned ESOP shares		(1,513	)		(1,513	)
Treasury stock at cost (September 30, 2013 - 341,666 shares; December 31, 2012 - 328,065 shares)		(19,373	)		(18,397	)
Total Stockholders' Equity	$	267,243		$	255,911
Less maximum cash obligation related to ESOP shares		28,140			30,715
Total Stockholders' Equity Less Maximum Cash Obligations Related to ESOP Shares	$	239,103		$	225,196
Total Liabilities & Stockholders' Equity	$	2,134,140		$	2,099,720

See Notes to Consolidated Financial Statements.

Page 3

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (Amounts In Thousands, Except Per Share Amounts)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2013		2012			2013			2012
Interest income:
Loans, including fees	$	20,104	$	20,907		$	60,000		$	63,291
Investment securities:
Taxable		303		460			957			1,535
Nontaxable		823		857			2,497			2,544
Federal funds sold		11		32			57			90
Total interest income	$	21,241	$	22,256		$	63,511		$	67,460
Interest expense:
Deposits	$	2,684	$	3,396		$	8,488		$	10,493
Short-term borrowings		41		61			102			156
FHLB borrowings		1,409		1,983			4,181			5,963
Total interest expense	$	4,134	$	5,440		$	12,771		$	16,612
Net interest income	$	17,107	$	16,816		$	50,740		$	50,848
Provision for loan losses		112		(608	)		(309	)		(2,900	)
Net interest income after provision for loan losses	$	16,995	$	17,424		$	51,049		$	53,748
Noninterest income:
Net gain on sale of loans	$	531	$	1,023		$	1,793		$	2,589
Trust fees		1,185		1,160			3,740			3,450
Service charges and fees		2,022		1,970			5,969			5,802
Rental revenue on tax credit real estate		398		397			1,114			1,189
Net gain on sale of other real estate owned and other repossessed assets		18		163			168			604
Other noninterest income		591		608			1,939			1,880
	$	4,745	$	5,321		$	14,723		$	15,514
Noninterest expenses:
Salaries and employee benefits	$	6,158	$	5,782		$	18,312		$	17,725
Occupancy		907		773			2,780			2,469
Furniture and equipment		1,183		1,183			3,650			3,477
Office supplies and postage		445		427			1,222			1,145
Advertising and business development		624		608			1,895			1,705
Outside services		1,819		1,689			5,378			5,026
Rental expenses on tax credit real estate		614		560			1,571			1,774
FDIC insurance assessment		229		259			760			784
Loss on extinguishment of debt - Federal Home Loan Bank borrowings		-		3,544			-			3,544
Other noninterest expense		432		447			1,298			1,382
	$	12,411	$	15,272		$	36,866		$	39,031
Income before income taxes	$	9,329	$	7,473		$	28,906		$	30,231
Income taxes		2,705		1,971			8,558			8,759
Net income	$	6,624	$	5,502		$	20,348		$	21,472

Earnings per share:
Basic	$	1.41	$	1.16		$	4.32		$	4.52
Diluted	$	1.40	$	1.16		$	4.31		$	4.51

See Notes to Consolidated Financial Statements.

Page 4

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (Amounts In Thousands)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012

Net income	$	6,624		$	5,502		$	20,348		$	21,472

Other comprehensive (loss) income before tax:
Unrealized holding (losses) gains arising during the period		(1,084	)		152			(4,236	)		(876	)
Less: reclassification adjustments for gains included in net income		-			-			(17	)		(6	)

Other comprehensive (loss) income, before tax:	$	(1,084	)	$	152		$	(4,253	)	$	(882	)

Tax benefit (expense) related to other comprehensive loss		414			(58	)		1,627			337

Other comprehensive (loss) income, net of tax	$	(670	)	$	94		$	(2,626	)	$	(545	)

Comprehensive income	$	5,954		$	5,596		$	17,722		$	20,927

See Notes to Consolidated Financial Statements.

Page 5

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited) (Amounts In Thousands, Except Share Amounts)

	Paid In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Unearned ESOP Shares			Treasury Stock			Maximum Cash Obligation Related To ESOP Shares			Total

Balance, December 31, 2011	$	41,467		$	207,790		$	4,974		$	(2,017	)	$	(15,959	)	$	(27,826	)	$	208,429

Issuance of 8,797 shares of common stock		488			-			-			-			-			-			488
Forfeiture of 718 shares of common stock		(41	)		-			-			-			-			-			(41	)
Share-based compensation		13			-			-			-			-			-			13
Income tax benefit related to share-based compensation		38			-			-			-			-			-			38
Change related to ESOP shares		-			-			-			-			-			(1,772	)		(1,772	)
Net income		-			21,472			-			-			-			-			21,472
Cash dividends ($1.05 per share)		-			(4,998	)		-			-			-			-			(4,998	)
Purchase of 25,990 shares of common stock		-			-			-			-			(1,739	)		-			(1,739	)
Other comprehensive loss		-			-			(545	)		-			-			-			(545	)
Balance, September 30, 2012	$	41,965		$	224,264		$	4,429		$	(2,017	)	$	(17,698	)	$	(29,598	)	$	221,345


Balance, December 31, 2012	$	42,241		$	229,625		$	3,955		$	(1,513	)	$	(18,397	)	$	(30,715	)	$	225,196

Issuance of 6,180 shares of common stock		240			-			-			-			-			-			240
Issuance of 1,592 shares of common stock under the employee stock purchase plan		111			-			-			-			-			-			111
Unearned restricted stock compensation		(660	)		-			-			-			-			-			(660	)
Forfeiture of 375 shares of common stock		(25	)		-			-			-			-			-			(25	)
Share-based compensation		21			-			-			-			-			-			21
Income tax benefit related to share-based compensation		85			-			-			-			-			-			85
Change related to ESOP shares		-			-			-			-			-			2,575			2,575
Net income		-			20,348			-			-			-			-			20,348
Cash dividends ($1.10 per share)		-			(5,186	)		-			-			-			-			(5,186	)
Purchase of 13,601 shares of common stock		-			-			-			-			(976	)		-			(976	)
Other comprehensive loss		-			-			(2,626	)		-			-			-			(2,626	)
Balance, September 30, 2013	$	42,013		$	244,787		$	1,329		$	(1,513	)	$	(19,373	)	$	(28,140	)	$	239,103

See Notes to Consolidated Financial Statements.

Page 6

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Amounts In Thousands)

	Nine Months Ended September 30,
	2013			2012
Cash Flows from Operating Activities
Net income	$	20,348		$	21,472
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation		2,176			2,149
Provision for loan losses		(309	)		(2,900	)
Net gain on sale of investment securities		(17	)		(6	)
Share-based compensation		21			13
Forfeiture of common stock		(25	)		(41	)
Compensation expensed through issuance of common stock		176			400
Excess tax benefits from share-based compensation		(85	)		(38	)
Provision for deferred income taxes		(103	)		1,529
Net gain on sale of other real estate owned and other repossessed assets		(168	)		(604	)
Increase in accrued interest receivable		(609	)		(425	)
Amortization of discount on investment securities, net		834			747
Decrease in prepaid FDIC insurance		2,957			694
Decrease (increase) in other assets		3,175			(827	)
Increase in accrued interest payable and other liabilities		1,287			81
Loans originated for sale		(178,872	)		(235,155	)
Proceeds on sales of loans		206,110			246,356
Net gain on sales of loans		(1,793	)		(2,589	)
Net cash and cash equivalents provided by operating activities	$	55,103		$	30,856

Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	21,070		$	43,126
Proceeds from sales of investment securities available for sale		566			246
Purchases of investment securities available for sale		(27,721	)		(51,634	)
Loans made to customers, net of collections		(71,241	)		(45	)
Proceeds on sale of other real estate owned and other repossessed assets		1,275			2,476
Purchases of property and equipment		(1,428	)		(2,756	)
Income from tax credit real estate, net		478			937
Net cash and cash equivalents used in investing activities	$	(77,001	)	$	(7,650	)

Cash Flows from Financing Activities
Net increase in deposits	$	30,761		$	81,674
Net decrease in short-term borrowings		(9,620	)		(7,709	)
Stock options exercised		175			88
Excess tax benefits related to share-based compensation		85			38
Payments on FHLB borrowings		-			(40,000	)
Purchase of treasury stock		(976	)		(1,739	)
Dividends paid		(5,186	)		(4,998	)
Net cash and cash equivalents provided by financing activities	$	15,239		$	27,354

(Continued)

Page 7

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)

	Nine Months Ended September 30,
	2013			2012

(Decrease) increase in cash and cash equivalents	$	(6,659	)	$	50,560

Cash and cash equivalents:
Beginning of year		63,582			29,291
End of period	$	56,923		$	79,851

Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	8,757		$	10,681
Interest paid on other obligations		4,283			6,119
Income taxes paid		6,800			8,208

Noncash activities:

(Decrease) increase in maximum cash obligation related to ESOP shares	$	(2,575	)	$	1,772
Transfers to other real estate owned		949			1,666

See Notes to Consolidated Financial Statements.

Page 8

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1.

Summary of Significant Accounting Policies

Basis of Presentation:

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with instructions for Form 10-Q and Regulation S-X. These financial statements include all adjustments (consisting of normal recurring accruals) which in the opinion of management are considered necessary for the fair presentation of the financial position and results of operations for the periods shown. Certain prior year amounts may be reclassified to conform to the current year presentation. The Company considers that it operates as one business segment, a commercial bank.

The consolidated balance sheet of the Company as of December 31, 2012, has been derived from the audited consolidated balance sheet of the Company as of that date. Operating results for the nine month period ended September 30, 2013 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2013.

Certain information and note disclosures normally included in the Company's annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012 filed with the Securities and Exchange Commission on March 13, 2013.

The Company evaluated subsequent events through the filing date of its quarterly report on Form 10-Q with the SEC.

Recently Adopted Accounting Standards:

In July 2012, the FASB issued ASU 2012-02, Intangibles – Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment, which permits an entity to make a qualitative assessment to determine whether it is more likely than not that an indefinite-lived intangible asset, other than goodwill, is impaired. Under the new standard, if an entity concludes, based on an evaluation of all relevant qualitative factors, that it is not more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount, it will not be required to perform the quantitative impairment test for that asset. The standard is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. The adoption of this standard did not have a material impact on the consolidated financial statements.

In February 2013, the FASB issued ASU 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified out of Accumulated Other Comprehensive Income, to improve the transparency of reporting reclassification out of accumulated other comprehensive income. The new standard is effective for reporting periods beginning after December 15, 2012, and the amendments should be prospectively applied. The amendments do not change the current requirement for reporting net income or other comprehensive income. The amendments require an organization to present on the face of the financial statements or in the footnotes the effects on the line items of net income of significant amounts reclassified out of accumulated other comprehensive income if the item reclassified is required to be reclassified to net income in its entirety in the same reporting period. Additionally, for other amounts that are not required to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required to provide additional detail about those amounts. The adoption of this standard did not have a material impact on the consolidated financial statements.

Page 9

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 2.

Earnings Per Share

Basic earnings per share is computed using the weighted average number of actual common shares outstanding during the period. Diluted earnings per share reflects the potential dilution that would occur from the exercise of common stock options outstanding. ESOP shares are considered outstanding for this calculation unless unearned.

The computation of basic and diluted earnings per share for the periods presented is as follows:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2013			2012			2013			2012

Common shares outstanding at the beginning of the period		4,708,910			4,746,393			4,712,328			4,759,818
Weighted average number of net shares redeemed		(720	)		(4,818	)		(364	)		(9,203	)
Weighted average shares outstanding (basic)		4,708,190			4,741,575			4,711,964			4,750,615
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method		3,220			6,777			3,755			6,954
Weighted average number of shares (diluted)		4,711,410			4,748,352			4,715,719			4,757,569

Net income (In thousands)	$	6,624		$	5,502		$	20,348		$	21,472

Earnings per share:
Basic	$	1.41		$	1.16		$	4.32		$	4.52
Diluted	$	1.40		$	1.16		$	4.31		$	4.51

Page 10

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 3.

Other Comprehensive Income

The following table summarizes the changes in the balances of each component of accumulated other comprehensive income for the three and nine months ended September 30, 2013 and 2012 (in thousands):

	Three Months Ended September 30, 2013						Nine Months Ended September 30, 2013

	Unrealized Gains on Securities			Accumulated Other Comprehensive Income			Unrealized Gains on Securities				Accumulated Other Comprehensive Income
Balance at the beginning of the period		$	659		$	659		$	3,955			$	3,955
Current period, other comprehensive income (loss)			670			670			(2,626	)			(2,626	)
Balance September 30, 2013		$	1,329		$	1,329		$	1,329			$	1,329

	Three Months Ended September 30, 2012						Nine Months Ended September 30, 2012

	Unrealized Gains on Securities			Accumulated Other Comprehensive Income			Unrealized Gains on Securities				Accumulated Other Comprehensive Income
Balance at the beginning of the period		$	4,335		$	4,335		$	4,974			$	4,974
Current period, other comprehensive income (loss)			94			94			(545	)			(545	)
Balance September 30, 2012		$	4,429		$	4,429		$	4,429			$	4,429

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4.

Securities

The carrying values of investment securities at September 30, 2013 and December 31, 2012 are summarized in the following table (dollars in thousands):

	September 30, 2013					December 31, 2012
	Amount		Percent			Amount		Percent
Securities available for sale
State and political subdivisions	$	135,056		59.32	%	$	134,332		59.39	%
Other securities (FHLB, FHLMC and FNMA)		92,623		40.68			91,850		40.61

Total securities available for sale	$	227,679		100.00	%	$	226,182		100.00	%

Investment securities have been classified in the consolidated balance sheets according to management’s intent. Available-for-sale securities consist of debt securities not classified as trading or held to maturity. Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity. There were no trading or held to maturity securities as of September 30, 2013 or December 31, 2012. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of September 30, 2013 and December 31, 2012 (in thousands):

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Estimated Fair Value
September 30, 2013:
State and political subdivisions	$	133,288	$	3,182	$	(1,414	)	$	135,056
Other securities (FHLB, FHLMC and FNMA)		92,239		477		(93	)		92,623
Total	$	225,527	$	3,659	$	(1,507	)	$	227,679

December 31, 2012:
State and political subdivisions	$	128,848	$	5,593	$	(109	)	$	134,332
Other securities (FHLB, FHLMC and FNMA)		90,929		946		(25	)		91,850
Total	$	219,777	$	6,539	$	(134	)	$	226,182

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at September 30, 2013, were as follows (in thousands):

	Amortized Cost		Fair Value
Due in one year or less	$	45,053	$	45,344
Due after one year through five years		108,733		111,048
Due after five years through ten years		71,641		71,190
Due over ten years		100		97
Total	$	225,527	$	227,679

As of September 30, 2013 investment securities with a carrying value of $29.16 million were pledged to collateralize short-term borrowings.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4.

Securities (continued)

The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2013 and December 31, 2012 (in thousands):

	Less than 12 months										12 months or more										Total
September 30, 2013					Unrealized										Unrealized										Unrealized
Description of Securities		#	Fair Value		Loss			%				#	Fair Value		Loss			%				#	Fair Value		Loss			%

State and political subdivisions		163	$	37,949	$	(1,381	)		3.64	%		10	$	2,080	$	(33	)		1.59	%		173	$	40,029	$	(1,414	)		3.53	%

Other securities (FHLB, FHLMC and FNMA)		6		16,647		(93	)		0.56	%		-		-		-			-			6		16,647		(93	)		0.56	%

Total temporarily impaired securities		169	$	54,596	$	(1,474	)		2.70	%		10	$	2,080	$	(33	)		1.59	%		179	$	56,676	$	(1,507	)		2.66	%

	Less than 12 months										12 months or more										Total
December 31, 2012					Unrealized										Unrealized										Unrealized
Description of Securities		#	Fair Value		Loss			%				#	Fair Value		Loss			%				#	Fair Value		Loss			%

State and political subdivisions		37	$	7,854	$	(92	)		1.17	%		2	$	483	$	(17	)		3.52	%		39	$	8,337	$	(109	)		1.31	%

Other securities (FHLB, FHLMC and FNMA)		5		12,865		(25	)		0.19	%		-		-		-			-			5		12,865		(25	)		0.19	%

Total temporarily impaired securities		42	$	20,719	$	(117	)		0.56	%		2	$	483	$	(17	)		3.52	%		44	$	21,202	$	(134	)		0.63	%

The Company considered the following information in reaching the conclusion that the impairments disclosed in the table above are temporary and not other-than-temporary impairments. Two of the ten state and political subdivision securities with gross unrealized losses greater than twelve months as of September 30, 2013 are municipal bonds which are rated Ba2. Bonds with a Ba2 rating are less than investment grade. The aggregate fair value of these Ba2 rated bonds is $0.49 million while their amortized cost is $0.50 million, representing an unrealized loss of $0.01 million. None of the unrealized losses in the above table were due to the deterioration in the credit quality of any of the issues that might result in the non-collection of contractual principal and interest. The unrealized losses are due to changes in interest rates. The Company has not recognized any unrealized loss in income because management does not have the intent to sell the securities included in the previous table. Management has concluded that it is more likely than not that the Company will not be required to sell these securities prior to recovery of the amortized cost basis.

Page 13

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans

Classes of loans are as follows:

	September 30, 2013		December 31, 2012
	(Amounts In Thousands)
Agricultural	$	82,740	$	76,190
Commercial and financial		166,175		148,034
Real estate:
Construction, 1 to 4 family residential		31,852		25,788
Construction, land development and commercial		67,302		79,097
Mortgage, farmland		131,105		113,841
Mortgage, 1 to 4 family first liens		596,838		583,567
Mortgage, 1 to 4 family junior liens		103,278		104,278
Mortgage, multi-family		239,795		214,812
Mortgage, commercial		310,847		312,506
Loans to individuals		19,034		20,350
Obligations of state and political subdivisions		42,761		43,102
	$	1,791,727	$	1,721,565
Net unamortized fees and costs		626		597
	$	1,792,353	$	1,722,162
Less allowance for loan losses		24,750		25,160
	$	1,767,603	$	1,697,002

The Bank primarily makes loans in the Bank’s market area. The Bank’s market area includes the counties of Johnson, Linn and Washington as well as the contiguous counties of Benton, Buchanan, Cedar, Delaware, Henry, Iowa, Jefferson, Jones, Keokuk, Louisa, and Muscatine. Out of market area financing is limited and according to the Bank’s loan policy is subject to additional preapproval requirements.

Agricultural loans include loans made to finance agricultural production and other loans to farmers and farming operations. Agricultural loans, most of which are secured by crops and machinery, are provided to finance capital improvement and farm operations as well as acquisitions of livestock and machinery. The ability of the borrower to repay may be affected by many factors outside of the borrower’s control including adverse weather conditions, loss of livestock due to disease or other factors, declines in market prices for agricultural products and the impact of government regulations. The ultimate repayment of agricultural loans is dependent upon the profitable operation or management of the agricultural entity. Agricultural loans generally have a term of one year and may have a fixed or variable rate.

Page 14

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans (continued)

The Bank’s commercial and financial loans include loans to contractors, retailers and other businesses. The Bank provides a wide range of business loans, including lines of credit for working capital and operational purposes and term loans for the acquisition of equipment. Although most loans are made on a secured basis, loans may be made on an unsecured basis where warranted by the overall financial condition of the borrower. Terms of commercial and financial loans generally range from one to five years. Interest rates for commercial loans can be fixed or variable. The Bank’s commercial and financial loans are primarily made based on the reported cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The collateral support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of personal guarantees, if applicable. The primary repayment risks of commercial loans are that the cash flows of the borrower may be unpredictable, and the collateral securing these loans may fluctuate in value.

The Bank offers loans both to individuals that are constructing personal residences and to real estate developers and building contractors for the acquisition of land for development and the construction of homes and commercial properties. Construction loans generally have a term of one year or less, with interest payable at maturity. Interest rate arrangements are variable for construction projects. Generally, collateral for construction loans is the underlying construction project.

Loans for farmland are made to individuals and businesses. The primary source of repayment is the cash flow generated by the collateral underlying the loan. The secondary repayment source would be the liquidation of the collateral. Terms for real estate loans secured by farmland range from one to five years with an amortization period of 25 years or less. Generally, interest rates are fixed for mortgage loans secured by farmland.

Residential real estate loans include first and junior liens on 1 to 4 family residences. The Bank sells certain mortgage loans to third parties on the secondary market. For the loans sold on the secondary market the Bank does not retain any percentage of ownership or servicing rights. Interest rates for residential real estate mortgages are determined by competitive pricing factors on the secondary market and within the Bank’s market area. Collateral for residential real estate mortgages is generally the underlying property. Generally, repayment of these loans is from monthly principal and interest payments from the borrower’s personal cash flows and liquidity, and collateral values are a function of residential real estate values in the markets that the Bank serves.

Multi-family real estate loans are primarily secured by properties such as apartment complexes. The primary source of repayment is the cash flow generated by the collateral underlying the loan. The secondary repayment source would be the liquidation of the collateral. Terms for commercial real estate loans range from one to five years with an amortization period of 25 years or less. Generally, interest rates for multi-family loans are fixed for the loan term.

The Bank originates loans for commercial properties to individuals and businesses. The primary source of repayment is the cash flow generated by the collateral underlying the loan. The secondary repayment source would be the liquidation of the collateral. Terms for commercial real estate loans range from one to five years with an amortization period of 25 years or less. The Bank offers both fixed and variable rate loans for commercial real estate.

The Bank offers loans to individuals including personal loans and automobile loans. These consumer loans typically have shorter terms and lower balances.

Obligations to State and Political Subdivisions include only tax-exempt loans.

Page 15

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans (continued)

Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the three and nine months ended September 30, 2013 were as follows:

	Three Months Ended September 30, 2013
	Agricultural			Commercial and Financial				Real Estate: Construction and land development				Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family				Real Estate: Mortgage, multi- family and commercial				Other				Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance		$	2,379		$	4,878			$	2,988			$	2,150		$	6,984			$	4,370			$	651			$	24,400
Charge-offs			-			(283	)			-				-			(103	)			(44	)			(19	)			(449	)
Recoveries			12			220				76				-			85				258				36				687
Provision			150			58				(258	)			139			105				(12	)			(70	)			112

Ending balance		$	2,541		$	4,873			$	2,806			$	2,289		$	7,071			$	4,572			$	598			$	24,750

	Nine Months Ended September 30, 2013
	Agricultural		Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi-family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	1,653	$	4,573		$	3,175		$	1,746	$	8,088		$	5,104		$	821		$	25,160
Charge-offs		-		(778	)		(220	)		-		(651	)		(327	)		(143	)		(2,119	)
Recoveries		30		772			242			-		434			414			126			2,018
Provision		858		306			(391	)		543		(800	)		(619	)		(206	)		(309	)

Ending balance	$	2,541	$	4,873		$	2,806		$	2,289	$	7,071		$	4,572		$	598		$	24,750

Ending balance, individually evaluated for impairment	$	3	$	13		$	-		$	4	$	69		$	218		$	1		$	308

Ending balance, collectively evaluated for impairment	$	2,538	$	4,860		$	2,806		$	2,285	$	7,002		$	4,354		$	597		$	24,442

Loans:

Ending balance	$	82,740	$	166,175		$	99,154		$	131,105	$	700,116		$	550,642		$	61,795		$	1,791,727

Ending balance, individually evaluated for impairment		123		1,868			1,722			459		4,519			17,912			12			26,615

Ending balance, collectively evaluated for impairment	$	82,617	$	164,307		$	97,432		$	130,646	$	695,597		$	532,730		$	61,783		$	1,765,112

Page 16

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans (continued)

Changes in the allowance for loan losses for the three and nine months ended September 30, 2012 were as follows:

	Three Months Ended September 30, 2012
	Agricultural			Commercial and Financial				Real Estate: Construction and land development				Real Estate: Mortgage, farmland				Real Estate: Mortgage, 1 to 4 family				Real Estate: Mortgage, multi- family and commercial				Other				Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance		$	1,607		$	5,203			$	4,104			$	1,687			$	8,271			$	5,171			$	627			$	26,670
Charge-offs			-			(162	)			(88	)			-				(378	)			(3	)			(46	)			(677	)
Recoveries			10			461				8				-				155				99				52				785
Provision			287			(818	)			8				(36	)			89				(186	)			48				(608	)

Ending balance		$	1,904		$	4,684			$	4,032			$	1,651			$	8,137			$	5,081			$	681			$	26,170

	Nine Months Ended September 30, 2012
	Agricultural		Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi-family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	1,354	$	6,429		$	4,994		$	1,411	$	9,051		$	6,150		$	761		$	30,150
Charge-offs		-		(991	)		(689	)		-		(1,113	)		(214	)		(136	)		(3,143	)
Recoveries		43		1,156			15			-		409			225			215			2,063
Provision		507		(1,910	)		(288	)		240		(210	)		(1,080	)		(159	)		(2,900	)

Ending balance	$	1,904	$	4,684		$	4,032		$	1,651	$	8,137		$	5,081		$	681		$	26,170

Ending balance, individually evaluated for impairment	$	3	$	24		$	41		$	-	$	66		$	82		$	-		$	216

Ending balance, collectively evaluated for impairment	$	1,901	$	4,660		$	3,991		$	1,651	$	8,071		$	4,999		$	681		$	25,954

Loans:

Ending balance	$	68,769	$	142,888		$	106,738		$	102,457	$	689,835		$	526,427		$	52,251		$	1,689,365

Ending balance, individually evaluated for impairment	$	14	$	3,012		$	2,136		$	810	$	3,122		$	19,921		$	-		$	29,015

Ending balance, collectively evaluated for impairment	$	68,755	$	139,876		$	104,602		$	101,647	$	686,713		$	506,506		$	52,251		$	1,660,350

Page 17

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans (continued)

The following table presents the credit quality indicators by type of loans in each category as of September 30, 2013 and December 31, 2012, respectively (amounts in thousands):

	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
September 30, 2013
Grade:
Pass	$	71,917	$	134,059	$	27,396	$	56,994
Potential Watch		3,438		11,036		1,384		4,774
Watch		1,550		15,383		2,760		3,858
Substandard		5,835		5,697		312		1,676
Total	$	82,740	$	166,175	$	31,852	$	67,302

	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family
September 30, 2013
Grade:
Pass	$	122,593	$	524,283	$	95,965	$	197,317
Potential Watch		4,553		27,236		1,639		17,376
Watch		1,570		25,295		3,719		24,281
Substandard		2,389		20,024		1,955		821
Total	$	131,105	$	596,838	$	103,278	$	239,795

	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
September 30, 2013
Grade:
Pass	$	264,347	$	18,500	$	40,630	$	1,554,001
Potential Watch		22,432		112		1,072		95,052
Watch		14,810		292		1,059		94,577
Substandard		9,258		130		-		48,097
Total	$	310,847	$	19,034	$	42,761	$	1,791,727

Page 18

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans (continued)

	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial

December 31, 2012
Grade:
Pass	$	70,821	$	123,005	$	20,698	$	67,011
Potential Watch		1,169		7,996		2,232		4,636
Watch		1,376		10,927		1,826		3,855
Substandard		2,824		6,106		1,032		3,595
Total	$	76,190	$	148,034	$	25,788	$	79,097

	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family

December 31, 2012
Grade:
Pass	$	106,041	$	517,684	$	94,219	$	173,348
Potential Watch		2,434		24,240		3,839		11,098
Watch		1,863		21,266		3,584		27,936
Substandard		3,503		20,377		2,636		2,430
Total	$	113,841	$	583,567	$	104,278	$	214,812

	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total

December 31, 2012
Grade:
Pass	$	267,883	$	19,763	$	42,022	$	1,502,495
Potential Watch		11,687		118		-		69,449
Watch		24,890		318		1,080		98,921
Substandard		8,046		151		-		50,700
Total	$	312,506	$	20,350	$	43,102	$	1,721,565

The below are descriptions of the credit quality indicators:

Pass – Pass rated loans are supported by sound payment capacity, are adequately collateralized and have no apparent weaknesses that would affect the full repayment of the loan under the established terms and conditions.

Potential Watch – Potential watch rated loans are supported by adequate payment capacity, are adequately collateralized and are performing according to the established terms and conditions. However, the loan requires more than average monitoring due to a potential weakness. The potential watch indicator assists the Company in identifying and monitoring loans for which credit quality could deteriorate.

Page 19

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans (continued)

Watch – Watch rated loans are supported by a marginal payment capacity and may be marginally collateralized. There are identified weaknesses that if not monitored and corrected may adversely affect the Company’s credit position. A watch credit would typically have a weakness in one of the general categories (cash flow, collateral position or payment history) but not in all categories.

Substandard – Substandard loans are not adequately supported by the paying capacity of the borrower and may be inadequately collateralized. These loans have a well-defined weakness or weaknesses. For these loans, it is more probable than not that the Company could sustain some loss if the deficiency(ies) is not corrected.

Past due loans as of September 30, 2013 and December 31, 2012 were as follows:

					90 Days						Total		Accruing Loans
	30 - 59 Days		60 - 89 Days		or More		Total Past				Loans		Past Due 90
	Past Due		Past Due		Past Due		Due		Current		Receivable		Days or More
	(Amounts In Thousands)

September 30, 2013
Agricultural	$	492	$	-	$	-	$	492	$	82,248	$	82,740	$	-
Commercial and financial		871		492		13		1,376		164,799		166,175		13
Real estate:
Construction, 1 to 4 family residential		-		859		-		859		30,993		31,852		-
Construction, land development and commercial		144		385		823		1,352		65,950		67,302		91
Mortgage, farmland		-		60		171		231		130,874		131,105		171
Mortgage, 1 to 4 family first liens		596		1,399		2,144		4,139		592,699		596,838		1,127
Mortgage, 1 to 4 family junior liens		355		264		95		714		102,564		103,278		66
Mortgage, multi-family		846		-		68		914		238,881		239,795		-
Mortgage, commercial		2,817		302		509		3,628		307,219		310,847		14
Loans to individuals		27		13		12		52		18,982		19,034		12
Obligations of state and political subdivisions		-		-		-		-		42,761		42,761		-
	$	6,148	$	3,774	$	3,835	$	13,757	$	1,777,970	$	1,791,727	$	1,494

December 31, 2012:
Agricultural	$	374	$	-	$	-	$	374	$	75,816	$	76,190	$	-
Commercial and financial		712		100		100		912		147,122		148,034		10
Real estate:
Construction, 1 to 4 family residential		-		-		-		-		25,788		25,788		-
Construction, land development and commercial		909		15		-		924		78,173		79,097		-
Mortgage, farmland		-		-		512		512		113,329		113,841		-
Mortgage, 1 to 4 family first liens		5,433		1,579		2,033		9,045		574,522		583,567		1,592
Mortgage, 1 to 4 family junior liens		640		43		221		904		103,374		104,278		221
Mortgage, multi-family		840		-		845		1,685		213,127		214,812		592
Mortgage, commercial		2,060		-		1,415		3,475		309,031		312,506		228
Loans to individuals		22		-		-		22		20,328		20,350		-
Obligations of state and political subdivisions		-		-		-		-		43,102		43,102		-
	$	10,990	$	1,737	$	5,126	$	17,853	$	1,703,712	$	1,721,565	$	2,643

The Company does not have a significant amount of loans that are past due less than 90 days where there are serious doubts as to the ability of the borrowers to comply with the loan repayment terms.

Page 20

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans (continued)

Certain impaired loan information by loan type at September 30, 2013 and December 31, 2012, was as follows:

	September 30, 2013						December 31, 2012
	Non-accrual loans		Accruing loans past due 90 days or more (1)		TDR loans (2)		Non- accrual loans		Accruing loans past due 90 days or more (1)		TDR loans (2)
	(Amounts In Thousands)						(Amounts In Thousands)

Agricultural	$	-	$	-	$	122	$	-	$	-	$	-
Commercial and financial		108		13		1,748		265		10		1,824
Real estate:
Construction, 1 to 4 family residential		-		-		-		714		-		-
Construction, land development and commercial		1,572		91		58		2,169		-		95
Mortgage, farmland		-		171		288		512		-		294
Mortgage, 1 to 4 family first liens		1,909		1,127		1,295		580		1,592		1,065
Mortgage, 1 to 4 family junior liens		199		66		-		17		221		90
Mortgage, multi-family		476		-		5,643		2,027		592		5,739
Mortgage, commercial		1,804		14		9,899		1,401		228		10,323
Loans to individuals		-		12		-		-		-		-
	$	6,068	$	1,494	$	19,053	$	7,685	$	2,643	$	19,430

(1)	There were $0.09 million TDR loans included within accruing loans past due 90 days or more as of September 30, 2013. There were no TDR loans included within accruing loans past due 90 days or more as of December 31, 2012.

(2)	Total TDR loans were $20.68 million and $22.13 million as of September 30, 2013 and December 31, 2012, respectively. Included in the total nonaccrual loans were $1.54 million and $2.69 million of TDR loans as of September 30, 2013 and December 31, 2012.

Loans 90 days or more past due that are still accruing interest decreased $1.15 million from December 31, 2012 to September 30, 2013. The average accruing loans past due 90 days or more balance was $62,000 as of September 30, 2013 and $110,000 as of December 31, 2012. The accruing loans past due 90 days or more balances are believed to be adequately collateralized and the Company expects to collect all principal and interest as contractually due under these loans.

Page 21

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans (continued)

The Company may modify the terms of a loan to maximize the collection of amounts due. Such a modification is considered a troubled debt restructuring (“TDR”). In most cases, the modification is either a reduction in interest rate, conversion to interest only payments or an extension of the maturity date. The borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term, so a concessionary modification is granted to the borrower that would otherwise not be considered. TDR loans accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance at a level commensurate with the modified terms over several payment cycles.

Below is a summary of information for TDR loans as of September 30, 2013 and December 31, 2012:

	September 30, 2013						December 31, 2012
	Number						Number
	of		Recorded		Commitments		of		Recorded		Commitments
	contracts		investment		outstanding		contracts		investment		outstanding
			(Amounts In Thousands)						(Amounts In Thousands)

Agriculture		1	$	122	$	-		-	$	-	$	-
Commercial and financial		12		1,856		54		11		1,927		15
Real estate:
Construction, 1 to 4 family residential		-		-		-		-		-		-
Construction, land development and commercial		3		190		-		3		401		-
Mortgage, farmland		1		288		-		1		295		-
Mortgage, 1 to 4 family first liens		11		1,701		-		8		1,277		-
Mortgage, 1 to 4 family junior liens		-		-		-		2		90		8
Mortgage, multi-family		3		6,051		-		5		7,364		-
Mortgage, commercial		7		10,475		-		8		10,771		-
Loans to individuals		-		-		-		-		-		-
		38	$	20,683	$	54		38	$	22,125	$	23

The Company had no loan modifications considered TDR loans during the three months ended September 30, 2013. The following is a summary of TDR loans that were modified during the nine months ended September 30, 2013:

	Nine Months Ended September 30, 2013
	Number		Pre-modification		Post-modification
	of		recorded		recorded
	contracts		investment		investment
			(Amounts In Thousands)

Agriculture		1	$	125	$	125
Commercial and financial		2		66		66
Real estate:
Mortgage, 1 to 4 family first lien		3		483		448
		6	$	674	$	639

The Company had commitments to lend $0.05 million in additional borrowings to restructured loan customers as of September 30, 2013. The Company had commitments to lend $0.02 million in additional borrowings to restructured loan customers as of December 31, 2012. These commitments were in the normal course of business and allowed the borrowers to build pre-sold homes and commercial property, which was expected to increase their overall cash flow. The additional borrowings were not used to facilitate payments on these loans.

Page 22

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans (continued)

There were $0.09 million and $0.0 million of TDR loans that were in payment default (defined as past due 90 days or more) as of September 30, 2013 and December 31, 2012, respectively. As of September 30, 2013, TDR loans in payment default consisted of a $0.09 million land development construction loan.

Information regarding impaired loans as of and for the three and nine months ended September 30, 2013 is as follows:

	September 30, 2013						Three Months Ended September 30, 2013				Nine Months Ended September 30, 2013
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	-	$	-	$	-	$	-	$	-	$	-	$	-
Commercial and financial		990		2,442		-		998		11		1,053		33
Real estate:
Construction, 1 to 4 family residential		140		140		-		229		-		229		-
Construction, land development and commercial		1,582		3,237		-		1,751		2		1,883		4
Mortgage, farmland		288		288		-		288		4		291		14
Mortgage, 1 to 4 family first liens		2,447		3,353		-		2,466		7		2,436		21
Mortgage, 1 to 4 family junior liens		199		471		-		199		-		218		-
Mortgage, multi-family		476		1,077		-		484		-		676		-
Mortgage, commercial		2,745		5,555		-		2,919		12		3,026		35
Loans to individuals		-		20		-		-		-		-		-
	$	8,867	$	16,583	$	-	$	9,334	$	36	$	9,812	$	107
With an allowance recorded:
Agricultural	$	123	$	123	$	3	$	124	$	1	$	124	$	4
Commercial and financial		878		878		13		895		12		925		37
Real estate:
Construction, 1 to 4 family residential		-		-		-		-		-		-		-
Construction, land development and commercial		-		-		-		-		-		-		-
Mortgage, farmland		171		171		4		171		3		171		8
Mortgage, 1 to 4 family first liens		1,807		2,080		68		1,819		22		1,859		66
Mortgage, 1 to 4 family junior liens		66		66		1		66		1		67		3
Mortgage, multi-family		5,643		5,643		200		5,660		64		5,691		192
Mortgage, commercial		9,048		9,048		18		9,072		135		9,124		402
Loans to individuals		12		12		1		12		1		13		1
	$	17,748	$	18,021	$	308	$	17,819	$	239	$	17,974	$	713
Total:
Agricultural	$	123	$	123	$	3	$	124	$	1	$	124	$	4
Commercial and financial		1,868		3,320		13		1,893		23		1,978		70
Real estate:
Construction, 1 to 4 family residential		140		140		-		229		-		229		-
Construction, land development and commercial		1,582		3,237		-		1,751		2		1,883		4
Mortgage, farmland		459		459		4		459		7		462		22
Mortgage, 1 to 4 family first liens		4,254		5,433		68		4,285		29		4,295		87
Mortgage, 1 to 4 family junior liens		265		537		1		265		1		285		3
Mortgage, multi-family		6,119		6,720		200		6,144		64		6,367		192
Mortgage, commercial		11,793		14,603		18		11,991		147		12,150		437
Loans to individuals		12		32		1		12		1		13		1
	$	26,615	$	34,604	$	308	$	27,153	$	275	$	27,786	$	820

Page 23

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans (continued)

Information regarding impaired loans as of December 31, 2012 is as follows:

	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	-	$	-	$	-
Commercial and financial		364		1,911		-
Real estate:
Construction, 1 to 4 family residential		714		946		-
Construction, land development and commercial		2,264		3,520		-
Mortgage, farmland		806		808		-
Mortgage, 1 to 4 family first liens		952		1,332		-
Mortgage, 1 to 4 family junior liens		68		361		-
Mortgage, multi-family		2,027		2,766		-
Mortgage, commercial		2,369		5,046		-
Loans to individuals		-		20		-
	$	9,564	$	16,710	$	-
With an allowance recorded:
Agricultural	$	-	$	-	$	-
Commercial and financial		1,788		1,788		22
Real estate:
Construction, 1 to 4 family residential		-		-		-
Construction, land development and commercial		-		-		-
Mortgage, farmland		-		-		-
Mortgage, 1 to 4 family first liens		2,286		2,487		83
Mortgage, 1 to 4 family junior liens		259		259		7
Mortgage, multi-family		6,331		6,331		241
Mortgage, commercial		9,530		9,530		20
Loans to individuals		-		-		-
	$	20,194	$	20,395	$	373
Total:
Agricultural	$	-	$	-	$	-
Commercial and financial		2,152		3,699		22
Real estate:
Construction, 1 to 4 family residential		714		946		-
Construction, land development and commercial		2,264		3,520		-
Mortgage, farmland		806		808		-
Mortgage, 1 to 4 family first liens		3,238		3,819		83
Mortgage, 1 to 4 family junior liens		327		620		7
Mortgage, multi-family		8,358		9,097		241
Mortgage, commercial		11,899		14,576		20
Loans to individuals		-		20		-
	$	29,758	$	37,105	$	373

Page 24

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5.

Loans (continued)

Impaired loans decreased $3.14 million from December 31, 2012 to September 30, 2013. Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans. Impaired loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement. Impaired loans were 1.49% of loans held for investment as of September 30, 2013 and 1.73% as of December 31, 2012. The decrease in impaired loans is due mainly to a decrease in nonaccrual loans of $1.62 million from December 31, 2012 to September 30, 2013 primarily resulting from the payoff of $1.24 million in multi-family real estate loans and a decrease in accruing loans past due 90 days or more of $1.15 million.

The Company regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans are impaired in accordance with ASC 310. If the loans are impaired, the Company determines if a specific allowance is appropriate. In addition, the Company's management also reviews and, where determined necessary, provides allowances for particular loans based upon (1) reviews of specific borrowers and (2) management’s assessment of areas that management considers are of higher credit risk, including loans that have been restructured. Loans that are determined not to be impaired and for which there are no specific allowances are classified into one or more risk categories. Based upon the risk category assigned, the Company allocates a percentage, as determined by management, for a required allowance needed. The determination of the appropriate percentage begins with historical loss experience factors, which are then adjusted for levels and trends in past due loans, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in restructured loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.

Specific allowances for losses on impaired loans are established if the loan balances exceed the net present value of the relevant future cash flows or the fair value of the relevant collateral based on updated appraisals and/or updated collateral analysis for the properties if the loan is collateral dependent. The Company recognizes a charge off related to an impaired loan if there is a collateral shortfall or it is unlikely the borrower can make all principal and interest payments as contractually due.

For loans that are collateral dependent, losses are evaluated based on the portion of a loan that exceeds the fair market value of the collateral. In general, this is the amount that the carrying value of the loan exceeds the related appraised value less estimated costs to sell the collateral. Generally, it is the Company’s policy not to rely on appraisals that are older than one year prior to the date the impairment is being measured. The most recent appraisal values may be adjusted if, in the Company’s judgment, experience and other market data indicate that the property’s value, use, condition, exit market or other variable affecting its value may have changed since the appraisal was performed, consistent with the December 2006 joint interagency guidance on the allowance for loan losses. The charge off or loss adjustment supported by an appraisal is considered the minimum charge off. Any adjustments made to the appraised value are to provide an additional charge off or specific reserve based on the applicable facts and circumstances. In instances where there is an estimated decline in value, a specific reserve may be provided or a charge off taken pending confirmation of the amount of the loss from an updated appraisal. Upon receipt of the new appraisals, an additional specific reserve may be provided or charge off taken based on the appraised value of the collateral. On average, appraisals are obtained within one month of order.

Page 25

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6.

Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments as of September 30, 2013 are as follows:

	September 30, 2013
	Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)
	(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents	$	56,923	$	56,923	$	56,923	$	-	$	-
Investment securities		235,259		235,259		-		235,259		-
Loans held for sale		2,811		2,811				2,811
Loans
Agricultural		80,199		82,894		-		-		82,894
Commercial and financial		161,302		166,959		-		-		166,959
Real estate:
Construction, 1 to 4 family residential		30,895		30,371		-		-		30,371
Construction, land development and commercial		65,453		64,522		-		-		64,522
Mortgage, farmland		128,816		128,334		-		-		128,334
Mortgage, 1 to 4 family first liens		590,719		592,889		-		-		592,889
Mortgage, 1 to 4 family junior liens		102,326		102,810		-		-		102,810
Mortgage, multi-family		237,866		239,274		-		-		239,274
Mortgage, commercial		308,204		309,885		-		-		309,885
Loans to individuals		18,781		18,963		-		-		18,963
Obligations of state and political subdivisions		42,416		42,371		-		-		42,371
Accrued interest receivable		8,460		8,460		-		8,460		-
Total financial instrument assets	$	2,070,430	$	2,082,727	$	56,923	$	246,530	$	1,779,274
Financial instrument liabilities:
Deposits
Noninterest-bearing deposits	$	250,226	$	250,226	$	-	$	250,226	$	-
Interest-bearing deposits		1,443,079		1,448,957		-		1,448,957		-
Short-term borrowings		29,163		29,163		-		29,163		-
Federal Home Loan Bank borrowings		125,000		133,029		-		133,029		-
Accrued interest payable		1,092		1,092		-		1,092		-
Total financial instrument liabilities	$	1,848,560	$	1,862,467	$	-	$	1,862,467	$	-

	Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	362,985	$	-	$	-	$	-	$	-
Letters of credit		11,229		-		-		-		-
Total financial instrument liabilities with off-balance-sheet risk	$	374,214	$	-	$	-	$	-	$	-

See Notes to Consolidated Financial Statements.

(1)

Considered Level 1 under Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”).

(2)

Considered Level 2 under ASC 820.

(3)

Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

Page 26

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6.

Fair Value Measurements (continued)

The carrying value and estimated fair values of the Company's financial instruments as of December 31, 2012 are as follows:

	December 31, 2012
	Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)
	(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents	$	63,582	$	63,582	$	63,582	$	-	$	-
Investment securities		234,244		234,244		-		234,244		-
Loans held for sale		28,256		28,256		-		28,256		-
Loans
Agricultural		74,537		72,605		-		-		72,605
Commercial and financial		143,461		138,350		-		-		138,350
Real estate:
Construction, 1 to 4 family residential		24,940		25,516		-		-		25,516
Construction, land development and commercial		76,770		78,827		-		-		78,827
Mortgage, farmland		112,095		116,751		-		-		116,751
Mortgage, 1 to 4 family first liens		577,027		603,442		-		-		603,442
Mortgage, 1 to 4 family junior liens		102,730		107,049		-		-		107,049
Mortgage, multi-family		212,972		223,295		-		-		223,295
Mortgage, commercial		309,242		323,639		-		-		323,639
Loans to individuals		19,968		20,148		-		-		20,148
Obligations of state and political subdivisions		42,663		42,487		-		-		42,487
Accrued interest receivable		7,851		7,851		-		7,851		-
Total financial instrument assets	$	2,030,338	$	2,086,042	$	63,582	$	270,351	$	1,752,109
Financial instrument liabilities:
Deposits
Noninterest-bearing deposits	$	273,973	$	273,973	$	-	$	273,973	$	-
Interest-bearing deposits		1,388,571		1,400,509		-		1,400,509		-
Short-term borrowings		38,783		38,783		-		38,783		-
Federal Home Loan Bank borrowings		125,000		136,842		-		136,842		-
Accrued interest payable		1,361		1,361		-		1,361		-
Total financial instrument liabilities	$	1,827,688	$	1,851,468	$	-	$	1,851,468	$	-

	Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	344,120	$	-	$	-	$	-	$	-
Letters of credit		10,778		-		-		-		-
Total financial instrument liabilities with off-balance-sheet risk	$	354,898	$	-	$	-	$	-	$	-

(1)

Considered Level 1 under ASC 820.

(2)

Considered Level 2 under ASC 820.

(3)

Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

Page 27

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6.

Fair Value Measurements (continued)

Fair value of financial instruments: FASB ASC 820, Fair Value Measurements and Disclosures (“ASC 820”) provides a single definition for fair value, a framework for measuring fair value and expanded disclosures concerning fair value. Fair value is defined under ASC 820 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

The Company determines the fair market value of its financial instruments based on the fair value hierarchy established in ASC 820. There are three levels of inputs that may be used to measure fair value as follows:

Level 1

Quoted prices in active markets for identical assets or liabilities.

Level 2

Observable inputs other than quoted prices included within Level 1. Observable inputs include the quoted prices for similar assets or liabilities in markets that are not active and inputs other than quoted prices that are observable for the asset or liability.

Level 3

Unobservable inputs supported by little or no market activity for financial instruments. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. Recent market conditions have led to diminished, and in some cases, non-existent trading in certain of the financial asset classes. The Company is required to use observable inputs, to the extent available, in the fair value estimation process unless that data results from forced liquidations or distressed sales. Despite the Company’s best efforts to maximize the use of relevant observable inputs, the current market environment has diminished the observability of trades and assumptions that have historically been available.

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value and for estimating fair value for assets or liabilities not recorded at fair value.

ASSETS

Cash and cash equivalents: The carrying amounts reported in the consolidated balance sheets for cash and short-term instruments approximate their fair values (Level 1).

Investment securities available for sale: Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If a quoted price is not available, the fair value is obtained from benchmarking the security against similar securities. All of the Company’s securities are considered Level 2.

The pricing for investment securities is obtained from an independent source. There are no level 1 or level 3 investment securities owned by the Company. The Company obtains an understanding of the independent source’s valuation methodologies used to determine fair value by level of security. The Company validates assigned fair values on a sample basis using an additional third-party provider pricing service to determine if the fair value measurement is reasonable. Due to the nature of our investment portfolio, we do not expect significant and unusual fluctuations as fair value changes primarily relate to interest rate changes. No unusual fluctuations were identified during the nine months ended September 30, 2013. If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.

Page 28

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6.

Fair Value Measurements (continued)

ASSETS (continued)

Loans held for sale: Loans held for sale are carried at historical cost. The carrying amount is a reasonable estimate of fair value because of the short time between origination of the loan and its sale on the secondary market (Level 2). The market is active for these loans and as a result prices for similar assets are available.

Loans: The Company does not record loans at fair value on a recurring basis. For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values (Level 3). The fair values for other loans are determined using estimated future cash flows, discounted at the interest rates currently being offered for loans with similar terms to borrowers with similar credit quality utilizing an entrance price concept (Level 3). The Company does record nonrecurring fair value adjustments to loans to reflect (1) partial write-downs that are based on the observable market price or appraised value of the collateral or (2) the full charge-off of the loan carrying value (Level 3). These loans are considered Level 3 as the instruments used to determine fair market value require significant management judgment and estimation.

Foreclosed assets: The Company does not record foreclosed assets at fair value on a recurring basis. Foreclosed assets consist mainly of other real estate owned but may include other types of assets repossessed by the Company. Foreclosed assets are adjusted to the lower of carrying value or fair value less the cost of disposal. Fair value is generally based upon independent market prices or appraised values of the collateral, and may include a marketability discount as deemed necessary by management based on its experience with similar types of real estate. The value of foreclosed assets is evaluated periodically as a nonrecurring fair value adjustment. Foreclosed assets are classified as Level 3.

Off-balance sheet instruments: Fair values for outstanding letters of credit 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 the outstanding letters of credit is not significant. Unfunded loan commitments are not valued since the loans are generally priced at market at the time of funding (Level 2).

Accrued interest receivable: The fair value of accrued interest receivable equals the amount receivable due to the current nature of the amounts receivable (Level 2).

Non-marketable equity investments: Non-marketable equity investments are recorded under the cost or equity method of accounting. There are generally restrictions on the sale and/or liquidation of these investments, including stock of the Federal Home Loan Bank. The carrying value of stock of the Federal Home Loan Bank approximates fair value (Level 2).

Page 29

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6.

Fair Value Measurements (continued)

LIABILITIES

Deposit liabilities: Deposit liabilities are carried at historical cost. The fair value of demand deposits, savings accounts and certain money market account 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. If the fair value of the fixed maturity certificates of deposit is calculated at less than the carrying amount, the carrying value of these deposits is reported as the fair value (Level 2). Deposit liabilities are classified as Level 2 due to available prices for similar liabilities in the market.

Short-term borrowings: Short-term borrowings are carried at historical cost and include federal funds purchased and securities sold under agreements to repurchase. The carrying amount is a reasonable estimate of fair value because of the relatively short time between the origination of the liability and its expected realization (Level 2). Short-term borrowings are classified as Level 2 due to available prices for similar liabilities in the market.

Federal Home Loan Bank borrowings: Federal Home Loan Bank borrowings are recorded at historical cost. The fair values of the Company’s Federal Home Loan Bank borrowings are estimated using discounted cash flow analyses, based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements (Level 2). Federal Home Loan Bank borrowings are classified as Level 2 due to available prices for similar liabilities in the market.

Accrued interest payable: The fair value of accrued interest payable equals the amount payable due to the current nature of the amounts payable (Level 2).

Page 30

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6.

Fair Value Measurements (continued)

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below represents the balances of assets and liabilities measured at fair value on a recurring basis at September 30, 2013 and December 31, 2012:

	September 30, 2013
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value
	(Amounts In Thousands)

State and political subdivisions	$	-	$	135,056	$	-	$	135,056
Other securities (FHLB, FHLMC and FNMA)		-		92,623		-		92,623
Total	$	-	$	227,679	$	-	$	227,679

	December 31, 2012
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value
	(Amounts In Thousands)

State and political subdivisions	$	-	$	134,332	$	-	$	134,332
Other securities (FHLB, FHLMC and FNMA)		-		91,850		-		91,850
Total	$	-	$	226,182	$	-	$	226,182

(1)

Considered Level 1 under ASC 820.

(2)

Considered Level 2 under ASC 820.

(3)

Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

There were no transfers between Levels 1, 2 or 3 during the nine months ended September 30, 2013.

Page 31

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6.

Fair Value Measurements (continued)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The Company is required to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. The following tables present the Company’s assets that are measured at fair value on a nonrecurring basis.

									Three Months Ended		Nine Months Ended
	September 30, 2013								September 30, 2013		September 30, 2013
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses		Total Losses
	(Amounts in Thousands)

Impaired Loans
Agricultural	$	-	$	-	$	120	$	120	$	-	$	-
Commercial and financial		-		-		1,855		1,855		-		5
Real Estate:
Construction, 1 to 4 family residential		-		-		140		140		-		-
Construction, land development and commercial		-		-		1,582		1,582		-		-
Mortgage, farmland		-		-		455		455		-		-
Mortgage, 1 to 4 family first liens		-		-		4,186		4,186		72		317
Mortgage, 1 to 4 family junior liens		-		-		264		264		-		59
Mortgage, multi-family		-		-		5,919		5,919		41		41
Mortgage, commercial		-		-		11,775		11,775		-		229
Loans to individuals		-		-		11		11		-		-
Foreclosed assets		-		-		250		250		23		23
Total	$	-	$	-	$	26,557	$	26,557	$	136	$	674

(1)

Considered Level 1 under ASC 820.

(2)

Considered Level 2 under ASC 820.

(3)

Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6.

Fair Value Measurements (continued)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis (continued)

									Year Ended
	December 31, 2012								December 31, 2012
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses
	(Amounts in Thousands)

Impaired Loans
Agricultural	$	-	$	-	$	-	$	-	$	-
Commercial and financial		-		-		2,130		2,130		302
Real Estate:
Construction, 1 to 4 family residential		-		-		714		714		-
Construction, land development and commercial		-		-		2,264		2,264		1,176
Mortgage, farmland		-		-		806		806		-
Mortgage, 1 to 4 family first liens		-		-		3,155		3,155		665
Mortgage, 1 to 4 family junior liens		-		-		320		320		82
Mortgage, multi-family		-		-		8,117		8,117		-
Mortgage, commercial		-		-		11,879		11,879		210
Loans to individuals		-		-		-		-		12
Foreclosed assets		-		-		234		234		164
Total	$	-	$	-	$	29,619	$	29,619	$	2,611

(1)

Considered Level 1 under ASC 820.

(2)

Considered Level 2 under ASC 820.

(3)

Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

Collateral-dependent impaired loans are evaluated and valued at the time the loan is identified as impaired, at the lower of cost or fair value and are classified as Level 3 in the fair value hierarchy. Fair value is measured based on the value of the collateral securing the loans. Collateral may be real estate and/or business assets and is determined based on appraisals by qualified licensed appraisers hired by the Company. Appraised and reported values may be discounted based on management’s historical knowledge, change in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s business.

Foreclosed assets in the table above consist of property acquired through foreclosures and settlements of loans. Property acquired is carried at the estimated fair value of the property, less disposal costs, and is classified as a Level 3 in the fair value hierarchy. The estimated fair value of the property is determined based on appraisals by licensed appraisers hired by the Company. Appraised and reported values are discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and /or management’s expertise and knowledge of the property.

During the year ended December 31, 2012 the Company revised the classification of impaired loans and foreclosed assets from previous filings. In previous filings, the Company classified impaired loans and foreclosed assets as Level 2 under ASC 820. The Company revised the classification to Level 3 as the determination of fair value requires significant management judgment or estimation due to the inherent subjectivity of the inputs used to determine value. The resulting change in presentation does not have a material impact on the Company’s financial position.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 7.

Stock Repurchase Program

On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). The authorization was previously set to expire on December 31, 2013. In September 2012 the Company’s Board of Directors extended the expiration date of the 2005 Stock Repurchase Program to December 31, 2014. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors. The Company has purchased 341,666 shares of its common stock in privately negotiated transactions from August 1, 2005 through September 30, 2013. Of these 341,666 shares, 4,208 shares were purchased during the quarter ended September 30, 2013, at an average price per share of $72.68.

Note 8.

Commitments and Contingencies

Concentrations of credit risk: The Bank’s loans, commitments to extend credit, unused lines of credit and outstanding letters of credit have been granted to customers primarily within the Bank's market area. Investments in securities issued by state and political subdivisions within the state of Iowa totaled approximately $61.82 million. The concentrations of credit by type of loan are set forth in Note 5 to the Consolidated Financial Statements. Outstanding letters of credit were granted primarily to commercial borrowers. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the economic conditions in Johnson, Linn and Washington Counties, Iowa.

Contingencies: In the normal course of business, the Company and Bank are involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the accompanying consolidated financial statements.

Financial instruments with off-balance sheet risk: The Bank 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, credit card participations and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments at September 30, 2013 and December 31, 2012 is as follows:

	September 30, 2013		December 31, 2012
	(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	37,858	$	36,030
Credit cards		42,440		44,554
Commercial, real estate and home construction		111,696		96,326
Commercial lines and real estate purchase loans		170,991		167,210
Outstanding letters of credit		11,229		10,778

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 9.

Income Taxes

Federal income tax expense for the nine months ended September 30, 2013 and 2012 was computed using the consolidated effective federal tax rate. The Company also recognized income tax expense pertaining to state franchise taxes payable individually by the subsidiary bank. The Company files a consolidated tax return for federal purposes and separate tax returns for State of Iowa purposes. The tax years ended December 31, 2012, 2011, and 2010 remain subject to examination by the Internal Revenue Service. For state tax purposes, the tax years ended December 31, 2012, 2011, and 2010 remain open for examination. There were no material unrecognized tax benefits at September 30, 2013 and December 31, 2012 and therefore no interest or penalties on unrecognized tax benefits has been recorded. As of September 30, 2013, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending September 30, 2014.

Income taxes as a percentage of income before taxes were 29.61% for the nine months ended September 30, 2013 and 28.97% for the same period in 2012. The increase in the effective tax rate is due to tax-exempt interest income and income tax credits and the relationship to total income before income taxes.

Note 10.

Subsequent Event

The Company intends to enter into two interest rate swaps prior to year ending December 31, 2013. Each interest rate swap will be in a notional amount of $25.00 million. The intent of the interest rate swaps is to fix the interest rates on the Company’s future cash flows attributable to interest payments on $50.00 million of variable rate debt.

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is management’s discussion and analysis of the financial condition of Hills Bancorporation (“Hills Bancorporation” or “the Company”) and its banking subsidiary Hills Bank and Trust Company (“the Bank”) for the dates and periods indicated. The discussion and analysis should be read in conjunction with the consolidated financial statements and the accompanying footnotes.

Special Note Regarding Forward Looking Statements

This report contains, and future oral and written statements of the Company and its management may contain, forward-looking statements within the meaning of such term in the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Actual results may differ materially from those included in the forward-looking statements. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company’s management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.

The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, the following:

The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company’s assets.

The effects of financial market disruptions, and monetary and other governmental actions designed to address such disruptions.

The financial strength of the counterparties with which the Company or the Company’s customers do business and as to which the Company has investment or financial exposure.

The credit quality and credit agency ratings of the securities in the Company’s investment securities portfolio, a deterioration or downgrade of which could lead to other-than-temporary impairment of the affected securities and the recognition of an impairment loss.

The effects of, and changes in, laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters as well as any laws otherwise affecting the Company.

The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.

The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.

The ability of the Company to obtain new customers and to retain existing customers.

The timely development and acceptance of products and services, including products and services offered through alternative electronic delivery channels.

Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers.

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

The ability of the Company to develop and maintain secure and reliable electronic systems.

The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.

Consumer spending and saving habits which may change in a manner that affects the Company’s business adversely.

The economic impact of natural disasters, terrorist attacks and military actions.

Business combinations and the integration of acquired businesses and assets which may be more difficult or expensive than expected.

The costs, effects and outcomes of existing or future litigation.

Changes in accounting policies and practices that may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board.

The ability of the Company to manage the risks associated with the foregoing as well as anticipated.

These risks and uncertainties should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company’s financial results, is included in the Company’s filings with the Securities and Exchange Commission.

Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these financial statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses. The Company's allowance for loan losses methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company's markets, including economic conditions throughout the Midwest and the state of certain industries. Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. The future impact of the global recession has introduced additional uncertainty into such determinations. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position. Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations. Although management believes the levels of the allowance as of September 30, 2013 and December 31, 2012 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Overview

This overview highlights selected information and may not contain all of the information that is important to you in understanding our performance during the period. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources, and critical accounting estimates, you should carefully read this entire report.

The Company is a holding company engaged in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa. At September 30, 2013, the Bank has seventeen full-service locations.

Net income for the nine month period ended September 30, 2013 was $20.35 million compared to $21.47 million for the same nine months of 2012, a decrease of 5.22%. The $1.12 million decrease in net income was caused by a number of factors. The principal factors in the decrease in net income for the first nine months of 2013 are an increase in the provision for loan losses of $2.59 million, a decrease in other income of $0.79 million and a decrease in other expenses of $2.17 million.

The Company achieved a return on average assets of 1.23% and a return on average equity of 11.36% for the twelve months ended September 30, 2013, compared to the twelve months ended September 30, 2012, which were 1.34% and 12.77%, respectively. Dividends of $1.10 per share were paid in January 2013 to 2,199 shareholders. The 2012 dividend was $1.05 per share.

The Bank’s net interest income is the largest component of revenue and it is primarily a function of the average earning assets and the net interest margin percentage. The Bank achieved a net interest margin on a tax-equivalent basis of 3.55% for the nine months ended September 30, 2013 compared to 3.63% for the same nine months of 2012. Average earning assets were $1.985 billion in 2013 and $1.937 billion in 2012.

Highlights noted on the balance sheet as of September 30, 2013 for the Company included the following:

Ÿ	Total assets were $2.134 billion, an increase of $34.42 million since December 31, 2012.

Ÿ	Cash and cash equivalents were $56.92 million, a decrease of $6.66 million since December 31, 2012.

Ÿ	Net loans were $1.770 billion, an increase of $45.16 million since December 31, 2012.

Ÿ	Total deposits were $1.693 billion, an increase of $30.76 million since December 31, 2012.

Reference is made to Note 6 for a discussion of fair value measurements which relate to methods used by the Company in recording assets and liabilities on its financial statements.

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Financial Condition

The following table sets forth the composition of the loan portfolio as of September 30, 2013 and December 31, 2012:

	September 30, 2013					December 31, 2012
	Amount		Percent			Amount		Percent
	(Amounts In Thousands)					(Amounts In Thousands)

Agricultural	$	82,740		4.62	%	$	76,190		4.43	%
Commercial and financial		166,175		9.27			148,034		8.60
Real estate:
Construction, 1 to 4 family residential		31,852		1.78			25,788		1.50
Construction, land development and commercial		67,302		3.76			79,097		4.59
Mortgage, farmland		131,105		7.32			113,841		6.61
Mortgage, 1 to 4 family first liens		596,838		33.31			583,567		33.90
Mortgage, 1 to 4 family junior liens		103,278		5.76			104,278		6.06
Mortgage, multi-family		239,795		13.38			214,812		12.48
Mortgage, commercial		310,847		17.35			312,506		18.15
Loans to individuals		19,034		1.06			20,350		1.18
Obligations of state and political subdivisions		42,761		2.39			43,102		2.50
	$	1,791,727		100.00	%	$	1,721,565		100.00	%
Net unamortized fees and costs		626					597
	$	1,792,353				$	1,722,162
Less allowance for loan losses		24,750					25,160
	$	1,767,603				$	1,697,002

Loan demand has been steady and is expected to remain steady throughout the year ending December 31, 2013. As indicated above, growth in the commercial loan portfolio and real estate loans secured by farmland have been primarily responsible for the increase in total loans as a result of general improvement in market conditions. Management expects the commercial loan growth to remain steady or increase due to seasonality and fluctuations in commercial loan demand. Real estate loans secured by farmland are expected to increase based on increasing agricultural land prices along with growth in the Bank’s agricultural customer base.

The Bank has an established formal loan origination policy. In general, the loan origination policy attempts to reduce the risk of credit loss to the Bank by requiring, among other things, maintenance of minimum loan to value ratios, evidence of appropriate levels of insurance carried by borrowers and documentation of appropriate types and amounts of collateral and sources of expected payment. The collateral relied upon in the loan origination policy is generally the property being financed by the Bank. The source of expected payment is generally the income produced from the property being financed. Personal guarantees are required of individuals owning or controlling at least 20% of the ownership of an entity. Limited or proportional guarantees may be accepted in circumstances if approved by the Company’s Board of Directors. Financial information provided by the borrower is verified as considered necessary by reference to tax returns, or audited, reviewed or compiled financial statements. The Bank does not originate subprime loans. In order to modify, restructure or otherwise change the terms of a loan, the Bank’s policy is to evaluate each borrower situation individually. Modifications, restructures, extensions and other changes are done to improve the Bank’s position and to protect the Bank’s capital. If a borrower is not current with its payments, any additional loans to such borrowers are evaluated on an individual borrower basis.

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

The Company has not experienced any significant time lapses in recognizing the required provisions for collateral dependent loans, nor has the Company delayed appropriate charge offs. When an updated appraisal value has been obtained, the Company has used the appraisal amount in determining the appropriate charge off or required reserve. The Company also evaluates any changes in the financial condition of the borrower and guarantors (if applicable), economic conditions, and the Company’s loss experience with the type of property in question. Any information utilized in addition to the appraisal is intended to identify additional charge offs or provisions, not to override the appraised value.

In accordance with Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues, the Company determines and assigns ratings to loans using factors that include the following: an assessment of the financial condition of the borrower; a realistic determination of the value and adequacy of underlying collateral; the condition of the local economy and the condition of the specific industry of the borrower; an analysis of the levels and trends of loan categories; and a review of delinquent and classified loans.

Through the credit risk rating process, loans are reviewed to determine if they are performing in accordance with the original contractual terms. If the borrower has failed to comply with the original contractual terms, further action may be required by the Company, including a downgrade in the credit risk rating, movement to non-accrual status, a charge-off or the establishment of a specific impairment reserve. In the event a collateral shortfall is identified during the credit review process, the Company will work with the borrower for a principal reduction and/or a pledge of additional collateral and/or additional guarantees. In the event that these options are not available, the loan may be subject to a downgrade of the credit risk rating. If the Company determines a loan amount or portion thereof is uncollectible, the loan’s credit risk rating is immediately downgraded and the uncollectible amount is charged-off. The Bank’s credit and legal departments undertake a thorough and ongoing analysis to determine if additional impairment and/or charge-offs are appropriate and to begin a workout plan for the loan to minimize actual losses.

The following table presents the allowance for loan losses on loans by type of loans and the percentage in each category to total loans as of September 30, 2013 and December 31, 2012:

	September 30, 2013								December 31, 2012
	Amount		% of Total Allowance			% of Loans to Total Loans			Amount		% of Total Allowance			% of Loans to Total Loans
	(In Thousands)								(In Thousands)
Agricultural	$	2,541		10.27	%		4.62	%	$	1,653		6.57	%		4.43	%
Commercial and financial		4,873		19.69			9.27			4,573		18.18			8.60
Real estate:
Construction, 1 to 4 family residential		957		3.87			1.78			848		3.37			1.50
Construction, land development and commercial		1,849		7.47			3.76			2,327		9.25			4.59
Mortgage, farmland		2,289		9.25			7.32			1,746		6.94			6.61
Mortgage, 1 to 4 family first liens		6,119		24.72			33.31			6,540		25.99			33.90
Mortgage, 1 to 4 family junior liens		952		3.85			5.76			1,548		6.15			6.06
Mortgage, multi-family		1,929		7.79			13.38			1,840		7.31			12.48
Mortgage, commercial		2,643		10.68			17.35			3,264		12.97			18.15
Loans to individuals		253		1.02			1.06			382		1.52			1.18
Obligations of state and political subdivisions		345		1.39			2.39			439		1.75			2.50
	$	24,750		100.00	%		100.00	%	$	25,160		100.00	%		100.00	%

Page 40

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

The allowance for loan losses totaled $24.75 million at September 30, 2013 compared to $25.16 million at December 31, 2012. The percentage of the allowance to outstanding loans was 1.38% and 1.46% at September 30, 2013 and December 31, 2012, respectively. The allowance was based on management’s consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks and the overall amount of loans outstanding. The reduction in the allowance in 2013 is the result of a decrease in the historical loss rates used in the allowance for loan losses calculation as well as improvements in asset quality. Credit quality has improved to levels experienced prior to the recession. Improvement of credit quality has been trending throughout the Bank’s market.

The adequacy of the allowance is reviewed quarterly and adjusted as appropriate after consideration has been given to the impact of economic conditions on the borrowers’ ability to repay, loan collateral values, past collection experience, the risk characteristics of the loan portfolio and such other factors that deserve current recognition. The growth of the loan portfolio and the trends in problem and watch loans are significant elements in the determination of the provision for loan losses. Quantitative factors include the Company’s historical loss experience, which is then adjusted for levels and trends in past due, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in restructured loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.

Management has determined that the allowance for loan losses was appropriate at September 30, 2013, and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for loan losses is based on a comprehensive, well documented, and consistently applied analysis of the Company’s loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for loan losses is reviewed and compared to industry data. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.

Residential real estate loan products that include features such as loan-to-values in excess of 100% or interest only payments, which expose a borrower to payment increases in excess of changes in the market interest rate, increase the credit risk of a loan. The Bank has not offered and does not intend to offer this type of loan product.

Investment securities available for sale held by the Company increased by $1.50 million from December 31, 2012 to September 30, 2013. The fair value of securities available for sale was $2.15 million more than the amortized cost of such securities as of September 30, 2013. At December 31, 2012, the fair value of the securities available for sale was $6.41 million more than the amortized cost of such securities.

Deposits increased by $30.76 million in the first nine months of 2013. Repurchase agreements decreased $9.62 million in the same period. In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Brokered deposits are included in total deposits and totaled $38.98 million as of September 30, 2013 with an average rate of 0.57%. Brokered deposits were $41.54 million as of December 31, 2012 with an average rate of 0.70%. As of September 30, 2013 and December 31, 2012, brokered deposits were 2.30% and 2.50% of total deposits, respectively.

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Dividends and Equity

In January 2013, Hills Bancorporation paid a dividend of $5.19 million or $1.10 per share. The dividend was $1.05 per share in January 2012. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of September 30, 2013 totaled $239.10 million. Under risk-based capital rules, the total amount of Tier 1 risk-based capital was 15.99% and 15.33% as of September 30, 2013 and December 31, 2012, respectively. The Tier 1 risk-based capital was in excess of the required minimum of 8.00%. Risk-based capital was 17.24% and 16.59% as of September 30, 2013 and December 31, 2012, respectively. As of September 30, 2013, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.

In July 2013, the Officer of the Comptroller of the Currency and Board of Governors of the Federal Reserve System adopted a final rule implementing agreements reached by the Basel Committee on Banking Supervision in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems”(BASEL III). The final rule also adopts changes to the agencies’ regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The rule implements a revised definition of regulatory capital, a new 4.50% common equity tier 1 minimum capital requirement, a 6.00% tier 1 capital requirement, and a tier 1 risk-based capital ratio of 8.00%. The Bank expects to remain categorized as well capitalized under the final rule when it becomes effective on January 1, 2015.

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Discussion of operations for the nine months ended September 30, 2013 and 2012

Net Income Overview

Net income decreased $1.12 million for the nine months ended September 30, 2013 compared to the first nine months of 2012. Total net income was $20.35 million in 2013 and $21.47 million in the comparable period in 2012, a decrease of 5.22%. The changes in net income in 2013 from the first nine months of 2012 were primarily the result of the following:

Ÿ	Net interest income decreased by $0.11 million.

Ÿ	The provision for loan losses increased by $2.59 million.

Ÿ	Other income decreased by $0.79 million.

Ÿ	Other expenses decreased by $2.17 million.

For the nine-month periods ended September 30, 2013 and 2012, basic earnings per share were $4.32 and $4.52, respectively. Diluted earnings per share were $4.31 for the nine months ended September 30, 2013 compared to $4.51 for the same period in 2012. The Company’s net income continues to be driven primarily by four primary factors. The first important factor is the interaction between changes in net interest margin and changes in average earning assets, and the impact of those changes on net interest income. The second significant factor affecting the Company’s net income is the provision for loan losses. The third factor is the amount of loans originated for sale into the secondary market, and the fourth factor affecting net income is income tax expense.

Net Interest Income

Net interest income is the excess of the interest and fees earned on interest bearing assets over the interest expense of the interest bearing liabilities. The factors that have the greatest impact on net interest income are the respective volumes of average interest earning assets and interest bearing liabilities and the net interest margin, which represents the average of the yield earned on interest earning assets over the rate paid on interest bearing liabilities. Net interest income of $50.74 million for the first nine months of 2013 was derived from the Company’s $1.985 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.55%. Average earning assets in the nine months ended September 30, 2012 were $1.937 billion and the tax-equivalent net interest margin was 3.63%. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of 10 basis points to 3.45% would have resulted approximately in a $1.49 million decrease in income before income taxes in the nine month period ended September 30, 2013. Similarly, an increase in the net interest margin of 10 basis points to 3.65% would have resulted in approximately a $1.49 million increase in net interest income before taxes. The decrease in net interest income for the nine month period was due to the decrease in interest rates on average earning assets, which have continued to trend downward. The decrease in interest rates on average earnings assets result from the assets repricing from pre-recession rates and locking in for an average of 5 years at the current historically low interest rates available. The Company has been able to lower the average cost of funding to the current level over the past 5 years. While lower interest rates have allowed the Company to also reduce its interest expense, this reduction has not kept pace with the reduction in yield on the asset side, which is commonly referred to as “net interest compression.” Based on our current rate environment there is diminished opportunity to continue to lower funding costs. As a result, the Company expects continued net interest compression to impact earnings for the foreseeable future. The Company believes net interest margin in dollars will be contingent on the growth of the Company’s earning assets.

Page 43

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Discussion of operations for the nine months ended September 30, 2013 and 2012

Net Interest Income (continued)

The net interest margin for the first nine months of 2013 was 3.55% compared to 3.63% in 2012 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the nine months ended in 2013 compared to the comparable period in 2012 are shown in the following table:

							Increase (Decrease) in Net Interest Income
	Change in Average Balance			Change in Average Rate			Volume Changes			Rate Changes			Net Change

	(Amounts in Thousands)

Interest income:
Loans, net	$	52,153			(0.38	)%	$	1,673		$	(4,849	)	$	(3,176	)
Taxable securities		(1,837	)		(0.74	)		(55	)		(523	)		(578	)
Nontaxable securities		14,212			(0.56	)		480			(553	)		(73	)
Federal funds sold		(17,049	)		-			(33	)		-			(33	)
	$	47,479					$	2,065		$	(5,925	)	$	(3,860	)

Interest expense:
Interest-bearing demand deposits	$	61,840			-	%	$	(97	)	$	9		$	(88	)
Savings deposits		56,196			(0.01	)		(81	)		18			(63	)
Time deposits		(47,927	)		(0.33	)		753			1,403			2,156
Short-term borrowings		(8,686	)		(0.08	)		25			23			48
FHLB borrowings		(58,963	)		0.15			1,926			(144	)		1,782
Interest-bearing other liabilities		(66	)		(0.26	)		1			5			6
	$	2,394					$	2,527		$	1,314		$	3,841
Change in net interest income							$	4,592		$	(4,611	)	$	(19	)

Rate/volume variances are allocated on a consistent basis using the absolute values of changes in volume compared to the absolute values of the changes in rates. Loan fees included in interest income are not material. Interest on nontaxable securities and loans is shown on a tax-equivalent basis.

A summary of the net interest spread and margin is as follows:

(Tax Equivalent Basis)	2013			2012

Yield on average interest-earning assets		4.41	%		4.77	%
Rate on average interest-bearing liabilities		1.08			1.40
Net interest spread		3.33	%		3.37	%
Effect of noninterest-bearing funds		0.22			0.26
Net interest margin (tax equivalent interest income divided by average interest-earning assets)		3.55	%		3.63	%

Page 44

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Discussion of operations for the nine months ended September 30, 2013 and 2012

Net Interest Income (continued)

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. The Federal Open Market Committee met six times during the first nine months of 2013. The target rate remains unchanged since December 31, 2008 at 0.25%. Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate. As of September 30, 2013, the rate indexes for the one, three and five year indexes were 0.11%, 0.73% and 1.54%, respectively. The one year index decreased 38.89% from 0.18% at September 30, 2012, the three year index increased 102.78% and the five year index increased 120.00%. The three year index was 0.36% and the five year index was 0.70% at September 30, 2012. The targeted federal funds rate was 0.25% at September 30, 2013 and 2012. The Company anticipates no significant changes in the indexes for 2013. U.S. Treasury indexes are expected to remain low into 2015.

Provision for Loan Losses

The majority of the Company’s interest-earning assets are in net loans outstanding, which amounted to approximately $1.770 billion at September 30, 2013. The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historically higher credit risk. The provision for loan losses was a reduction in expense of $0.31 million in 2013 compared to a reduction of expense of $2.90 million in 2012. The reduction in expense in 2012 and 2013 was the result of a decrease in the historical loss rates used in the allowance for loan losses calculation as well as improvements in credit quality. The Company believes that the provision for loan losses will increase for the foreseeable future resulting from projected increases in the size of the Company’s loan portfolio as well as stabilization of credit quality.

The allowance for loan losses decreased $0.41 million during the first nine months of 2013. In the first nine months of 2013, there was a decrease of $0.55 million due to the volume and composition of loans outstanding and a $0.14 million increase in the amount allocated to the allowance due to a combination of deterioration in credit quality and charge-offs. The Company believes the period of deteriorating credit quality is stabilizing.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the nine months ended September 30, 2013 and 2012, recoveries were $2.02 million and $2.06 million, respectively; and charge-offs were $2.12 million in 2013 and $3.14 million in 2012. The allowance for loan losses totaled $24.75 million at September 30, 2013 compared to $25.16 million at December 31, 2012. The allowance represented 1.38% and 1.46% of loans held for investment at September 30, 2013 and December 31, 2012, respectively.

The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks. Management expects credit quality to remain steady through the end of 2013. Provision expense is expected to be dependent on the Company’s loan growth through the end of 2013.

Page 45

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Discussion of operations for the nine months ended September 30, 2013 and 2012

Noninterest Income

The following table sets forth the various categories of noninterest income for the nine months ended September 30, 2013 and 2012.

	Nine Months Ended September 30,
	2013		2012		$ Change			% Change
	(Amounts in thousands)

Net gain on sale of loans	$	1,793	$	2,589	$	(796	)		(30.75	)%
Trust fees		3,740		3,450		290			8.41
Service charges and fees		5,969		5,802		167			2.88
Rental revenue on tax credit real estate		1,114		1,189		(75	)		(6.31	)
Net gain on sale of other real estate owned and other reposessed assets		168		604		(436	)		(72.19	)
Other noninterest income		1,939		1,880		59			3.14
	$	14,723	$	15,514	$	(791	)		(5.10	)%

Loans originated for sale in the first nine months of 2013 totaled $178.87 million compared to $235.16 million in the same period in 2012, a decrease of 23.94%. In the nine months ended September 30, 2013 and 2012, the net gain on sale of loans was $1.79 million and $2.59 million, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. A substantial portion of the decreased net gain on sale of loans resulted from a residential mortgage loan market where interest rates began to increase, resulting in a decline in the origination of loans generated for sale into the secondary market. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income. The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

Trust fees increased $0.29 million in the first nine months of 2013 as a result of assets under management increasing from $1.078 billion as of September 30, 2012 to $1.126 billion as of September 30, 2013 due to market conditions and new trust relationships.

The net gain on sale of other real estate owned and other repossessed assets decreased $0.44 million to a net gain of $0.17 million for the nine months ended September 30, 2013. The total net gain on sale of other real estate owned for the nine months ended September 30, 2013 consisted of a $0.19 million net gain on sale of 11 properties offset by a $0.02 million fair market value adjustment on 1 property. During the same period in 2012, the gain consisted of a $0.14 million fair market value adjustment on 6 properties within other real estate owned, offset by a $0.74 million net gain on sale of 19 properties.

Page 46

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Discussion of operations for the nine months ended September 30, 2013 and 2012

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the nine months ended September 30, 2013 and 2012.

	Nine Months Ended September 30,
	2013		2012		$ Change			% Change
	(Amounts in thousands)

Salaries and employee benefits	$	18,312	$	17,725	$	587			3.31	%
Occupancy		2,780		2,469		311			12.60
Furniture and equipment		3,650		3,477		173			4.98
Office supplies and postage		1,222		1,145		77			6.72
Advertising and business development		1,895		1,705		190			11.14
Outside services		5,378		5,026		352			7.00
Rental expenses on tax credit real estate		1,571		1,774		(203	)		(11.44	)
FDIC insurance assessment		760		784		(24	)		(3.06	)
Loss on extinguishment of debt - Federal Home Loan Bank borrowings		-		3,544		(3,544	)		(100.00	)
Other noninterest expense		1,298		1,382		(84	)		(6.08	)
	$	36,866	$	39,031	$	(2,165	)		(5.55	)%

Noninterest expenses of $36.87 million decreased $2.17 million for the nine months ended September 30, 2013 from the same period in 2012, a decrease of 5.55%. The decrease in noninterest expenses is primarily attributed to a $3.54 million prepayment penalty paid during the nine months ended September 30, 2012 on the Bank’s prepayment of $40.00 million of Federal Home Loan Bank borrowings. Most other noninterest expense categories experienced marginal period-to-period increases for the nine months ended September 30, 2013.

Occupancy expense was $2.78 million for the nine months ended September 30, 2013 an increase of $0.31 million from the same period in 2012. The negative variance is due to an increase of $0.07 million of janitorial expense resulting from an increase in offices using an outside service as well as a $0.11 million increase in building repairs and maintenance due to expenses associated with building upkeep.

Advertising and business development expense was $1.90 million for the nine months ended September 30, 2013 which was a $0.19 million increase from the same period in 2012. The increase is primarily due to an increase in expense related to debit card reward point program started in late 2012.

Income Taxes

Federal and state income tax expenses were $8.56 million and $8.76 million for the nine months ended September 30, 2013 and 2012, respectively. Income taxes as a percentage of income before taxes were 29.61% in 2013 and 28.97% in 2012.

Page 47

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Discussion of operations for the three months ended September 30, 2013 and 2012

Net Income Overview

Net income increased to $6.62 million for the three months ended September 30, 2013 from $5.50 million for the same period in 2012, an increase of 20.36%. Earnings per share, both basic and diluted, increased for the three months ended September 30, 2013 compared to the same period in 2012 as a result of the increase in net income. For the three month period ended September 30, 2013, basic earnings per share was $1.41 and diluted earnings per share was $1.40. For the three months ended September 30, 2012, basic and diluted earnings per share was $1.16.

Net Interest Income

Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin. The decrease in net interest income for the three month period was due to the decrease in the interest rates on average earning assets, which have continued to trend downward. While lower interest rates have allowed the Company to also reduce its interest expense, this reduction has not kept pace with the reductions in yield on the asset side, which is commonly referred to as “net interest compression.” Based on our current rate environment there is diminished opportunity to continue to lower funding costs. As a result, the Company expects continued net interest compression to impact earnings for the foreseeable future. The Company believes net interest margin in dollars will be contingent on the growth of the Company’s earning assets.

The net interest margin for the three months ended September 30, 2013 was 3.54% compared to 3.55% in 2012 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2013 compared to the comparable period in 2012 are shown in the following table:

							Increase (Decrease) in Net Interest Income
	Change in Average Balance			Change in Average Rate			Volume Changes			Rate Changes			Net Change

	(Amounts in Thousands)

Interest income:
Loans, net	$	63,385			(0.35	)%	$	793		$	(1,559	)	$	(766	)
Taxable securities		(1,477	)		(0.60	)		(23	)		(134	)		(157	)
Nontaxable securities		11,470			(0.54	)		127			(179	)		(52	)
Federal funds sold		(31,594	)		-			(21	)		-			(21	)
	$	41,784					$	876		$	(1,872	)	$	(996	)

Interest expense:
Interest-bearing demand deposits	$	67,154			(0.01	)%	$	(36	)	$	9		$	(27	)
Savings deposits		56,487			(0.01	)		(27	)		8			(20	)
Time deposits		(58,071	)		(0.34	)		285			474			759
Short-term borrowings		(13,643	)		(0.09	)		13			7			20
FHLB borrowings		(56,889	)		0.14			620			(47	)		574
Interest-bearing other liabilities		(70	)		0.01			-			-			-
	$	(5,032	)				$	855		$	451		$	1,306
Change in net interest income							$	1,731		$	(1,421	)	$	310

Page 48

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Discussion of operations for the three months ended September 30, 2013 and 2012

Net Interest Income (continued)

A summary of the net interest spread and margin is as follows:

(Tax Equivalent Basis)	2013			2012

Yield on average interest-earning assets		4.36	%		4.65	%
Rate on average interest-bearing liabilities		1.04			1.37
Net interest spread		3.32	%		3.28	%
Effect of noninterest-bearing funds		0.22			0.27
Net interest margin (tax equivalent interest income divided by average interest-earning assets)		3.54	%		3.55	%

Provision for Loan Losses

The provision for loan losses was an expense of $0.11 million in 2013 compared to a reduction of expense of $0.61 million in 2012, an increase of $0.72 million. The reduction in expense in 2012 was greater than 2013 as the result of decreases in historical loss rates used in the allowance for loan losses calculation as well as improvements in asset quality. The Company believes that the provision for loan losses will increase for the foreseeable future resulting from projected increases in the size of the Company’s loan portfolio as well as stabilization of credit quality.

The allowance for loan losses increased $0.35 million during the three months ended September 30, 2013. In the three months ended September 30, 2013, there was an increase of $0.64 million due to the volume and composition of loans outstanding and a $0.29 million decrease in the amount allocated to the allowance due to a combination of an improvement in credit quality and charge-offs. The Company believes the period of deteriorating credit quality is stabilizing.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the three months ended September 30, 2013 and 2012, recoveries were $0.69 million and $0.79 million, respectively; and charge-offs were $0.45 million in 2013 and $0.68 million in 2012. The allowance for loan losses totaled $24.75 million at September 30, 2013 compared to $26.17 million at September 30, 2012. The allowance represented 1.38% and 1.55% of loans held for investment at September 30, 2013 and September 30, 2012, respectively.

Page 49

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Discussion of operations for the three months ended September 30, 2013 and 2012

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended September 30, 2013 and 2012.

	Three Months Ended September 30,
	2013		2012		$ Change			% Change
	(Amounts in thousands)

Net gain on sale of loans	$	531	$	1,023	$	(492	)		(48.09	)%
Trust fees		1,185		1,160		25			2.16
Service charges and fees		2,022		1,970		52			2.64
Rental revenue on tax credit real estate		398		397		1			0.25
Net gain on sale of other real estate owned and other reposessed assets		18		163		(145	)		(88.96	)
Other noninterest income		591		608		(17	)		(2.80	)
	$	4,745	$	5,321	$	(576	)		(10.83	)%

In the three months ended September 30, 2013 and 2012, the net gain on sale of loans was $0.53 million and $1.02 million, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. A substantial portion of the decreased net gain on sale of loans resulted from a residential mortgage loan market where interest rates began to increase, resulting in a decline in the value of loans generated for sale into the secondary market. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income. The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

Trust fees increased $0.03 million for the three months ended September 30, 2013 compared to the same period in 2012 as a result of assets under management increasing from $1.078 billion as of September 30, 2012 to $1.126 billion as of September 30, 2013 due to market conditions and new trust relationships.

The net gain on sale of other real estate owned and other repossessed assets decreased $0.15 million to a net gain of $0.02 million for the three months ended September 30, 2013. The total net gain on sale of other real estate owned for the three months ended September 30, 2013 consisted of a $0.04 million net gain on sale of 3 properties and a $0.02 million fair market value adjustment on 1 property. During the same period in 2012, the gain consisted of a $0.02 million fair market value adjustment on 1 property within other real estate owned and a $0.18 million net gain on sale of 5 properties.

Page 50

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Discussion of operations for the three months ended September 30, 2013 and 2012

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended September 30, 2013 and 2012.

	Three Months Ended September 30,
	2013		2012		$ Change			% Change
	(Amounts in thousands)

Salaries and employee benefits	$	6,158	$	5,782	$	376			6.50	%
Occupancy		907		773		134			17.34
Furniture and equipment		1,183		1,183		-			-
Office supplies and postage		445		427		18			4.22
Advertising and business development		624		608		16			2.63
Outside services		1,819		1,689		130			7.70
Rental expenses on tax credit real estate		614		560		54			9.64
FDIC insurance assessment		229		259		(30	)		(11.58	)
Loss on extinguishment of debt - Federal Home Loan Bank borrowings		-		3,544		(3,544	)		(100.00	)
Other noninterest expense		432		447		(15	)		(3.36	)
	$	12,411	$	15,272	$	(2,861	)		(18.73	)%

Other expenses of $12.41 million decreased $2.86 million for the three months ended September 30, 2013 from the same period in 2012, a decrease of 18.73%. The decrease in noninterest expenses is primarily attributed to a $3.54 million prepayment penalty paid during the three months ended September 30, 2012 on the Bank’s prepayment of $40.00 million of Federal Home Loan Bank borrowings. Most other noninterest expense categories experienced marginal period-to-period increases for the three months ended September 30, 2013.

Occupancy expense increased by $0.13 million for the three months ended September 30, 2013 from the same period in 2012. The increase is due to a $0.11 million increase in building repairs and maintenance due to expenses associated with building upkeep.

During the three months ended September 30, 2013 the Bank has not incurred any loss on extinguishment of debt relating to prepayment of Federal Home Loan Bank borrowings. As of September 30, 2012 the Bank incurred a prepayment penalty of $3.54 million resulting from the Bank prepayment of $40.00 million of Federal Home Loan Bank borrowings.

Income Taxes

Federal and state income tax expenses were $2.71 million and $1.97 million for the three months ended September 30, 2013 and 2012, respectively. Income taxes as a percentage of income before taxes were 29.00% in 2013 and 26.37% in 2012.

Page 51

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HILLS BANCORPORATION

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs. Federal funds sold and investment securities available for sale are readily marketable assets. Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position. Investment securities available for sale comprised 10.67% of the Company’s total assets at September 30, 2013, compared to 10.77% at December 31, 2012.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position. As of September 30, 2013, the Company had borrowed $125.00 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. Advances are used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk. The Company had additional borrowing capacity available from the FHLB of approximately $406.02 million at September 30, 2013.

As additional sources of liquidity, the Company has the ability to borrow up to $10.00 million from the Federal Reserve Bank of Chicago, and has lines of credit with three banks totaling $209.17 million. The borrowings under these credit lines would be secured by the Bank’s investment securities. The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at September 30, 2013.

As of September 30, 2013, investment securities with a carrying value of $29.16 million were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as permitted by law. As of December 31, 2012, investment securities with a carrying value of $38.78 million were pledged.

Contractual Obligations

There have been no material changes with regard to contractual obligations disclosed in the Company’s Form 10-K for the year ended December 31, 2012.

Page 52

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HILLS BANCORPORATION

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

The Company's primary market risk exposure is to changes in interest rates. Interest rate risk is the risk to current or anticipated earnings or capital arising from movements in interest rates. Interest rate risk arises from repricing risk, basis risk, yield curve risk and options risk. Repricing risk is the difference between the timing of rate changes and the timing of cash flows. Basis risk is the difference from changing rate relationships among different yield curve affecting Bank activities. Yield curve risk is the difference from changing rate relationships across the spectrum of maturities. Option risk is the difference resulting from interest-related options imbedded in Bank products. The Bank’s primary source of interest rate risk exposure arises from repricing risk. To measure this risk the Bank uses a static gap measurement system that identifies the repricing gaps across the full maturity spectrum of the Bank’s assets and liabilities and an earnings simulation approach. The gap schedule is known as the interest rate sensitivity report. The report reflects the repricing characteristics of the Bank’s assets and liabilities. The report details the calculation of the gap ratio. This ratio indicated the amount if interest-earning assets repricing within a given period in comparison to the amount of interest-bearing liabilities repricing within the same period of time. A gap ratio of 1.0 indicates a matched position, in which case the effect on net interest income due to interest rate movements will be minimal. A gap ratio of less than 1.0 indicates that more liabilities than assets reprice within the time period, and a ratio greater than 1.0 indicates that more assets reprice than liabilities.

The Company's asset/liability management, or its management of interest rate risk, is focused primarily on evaluating and managing net interest income given various risk criteria. Factors beyond the Company's control, such as market interest rates and competition, may also have an impact on the Company's interest income and interest expense. In the absence of other factors, the Company's overall yield on interest-earning assets will increase as will its cost of funds on its interest-bearing liabilities when market interest rates increase over an extended period of time. Inversely, the Company's yields and cost of funds will decrease when market rates decline. The Company is able to manage these swings to some extent by attempting to control the maturity or rate adjustments of its interest-earning assets and interest-bearing liabilities over given periods of time.

The Bank maintains an Asset/Liability Committee, which meets at least quarterly to review the interest rate sensitivity position and to review and develop various strategies for managing interest rate risk within the context of the following factors: 1) capital adequacy, 2) asset/liability mix, 3) economic outlook, 4) market characteristics and 5) the interest rate forecast. In addition, the Bank uses a simulation model to review various assumptions relating to interest rate movement. The model attempts to limit rate risk even if it appears the Bank’s asset and liability maturities are perfectly matched and a favorable interest margin is present. The Bank’s policy is to generally maintain a balance between profitability and interest rate risk.

In order to minimize the potential effects of adverse material and prolonged increases or decreases in market interest rates on the Company's operations, management has implemented an asset/liability program designed to mitigate the Company's interest rate sensitivity. The program emphasizes the origination of adjustable rate loans, which are held in the portfolio, the investment of excess cash in short or intermediate term interest-earning assets, and the solicitation of transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.

Item 4.

Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission. There have been no changes in the Company’s internal controls over financial reporting during the nine months ended September 30, 2013 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

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HILLS BANCORPORATION

PART II - OTHER INFORMATION

Item 1.

Legal Proceedings

No material legal proceedings are pending.

Item 1A.

Risk Factors

There have been no material changes from the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2012.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended September 30, 2013:

Period	Total number of shares purchased		Average price paid per share		Total number of shares purchased as part of publicly announced plans or programs		Maximum number of shares that may yet be purchased under the plans or programs (1)
July 1 to July 31		1,328	$	72.00		338,786		411,214
August 1 to August 31		806		73.00		339,592		410,408
September 1 to September 30		2,074		73.00		341,666		408,334
Total		4,208	$	72.68		341,666		408,334

(1) On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). The Company’s Board of Directors authorized the 2005 Stock Repurchase Program to December 31, 2014. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.

During the first nine months of 2013, the Company issued 800 shares of restricted stock under the 2010 Stock Option and Incentive Plan. The restricted shares were issued to officers of the Company for no cash consideration and will vest over a five-year period from the date of grant. The issuance of these shares was exempt from the registration requirements of the SEC pursuant to Section 4(2) of the Securities Act of 1933.

Item 3.

Defaults upon Senior Securities

Hills Bancorporation has no senior securities.

Item 4.

Mine Safety Disclosure

Not applicable.

Item 5.

Other Information

None

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Index

HILLS BANCORPORATION

PART II - OTHER INFORMATION (Continued)

Item 6.

Exhibits

3.1	Articles of Incorporation of Hills Bancorporation, incorporated by reference to Exhibit 3.1 to the Company’s Form S-3 filed with the Commission on May 12, 2011.

3.2	By-laws of Hills Bancorporation, incorporated by reference to Exhibit 3.2 to the Company’s Form S-3 filed with the Commission on May 12, 2011.

31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002

101.INS

XBRL Instance Document (1)

101.SCH

XBRL Taxonomy Extension Schema Document (1)

101.CAL

XBRL Taxonomy Extension Calculation Linkbase Document (1)

101.DEF

XBRL Taxonomy Extension Definition Linkbase Document (1)

101.LAB

XBRL Taxonomy Extension Label Linkbase Document (1)

101.PRE

XBRL Taxonomy Extension Presentation Linkbase Document (1)

(1)

Users of this data are advised that, pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934, and are otherwise not subject to liability under these sections.

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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.

		HILLS BANCORPORATION

Date: November 7, 2013		By: /s/ Dwight O. Seegmiller
		Dwight O. Seegmiller, Director, President and Chief Executive Officer

Date: November 7, 2013		By: /s/ Shari DeMaris
		Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer

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HILLS BANCORPORATION

QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED SEPTEMBER 30, 2013

Exhibit Number	Description	Page Number In The Sequential Numbering System September 30, 2013 Form 10-Q

31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	58-59

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	60

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