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HILLS BANCORPORATION - Quarter Report: 2014 September (Form 10-Q)

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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, 2014

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
October 31, 2014
 
 
Common Stock, no par value
4,694,840
 
 
 
 


Index

HILLS BANCORPORATION
Index to Form 10-Q

Part I
FINANCIAL INFORMATION
 
 
 
Page
 
 
Number
 
 
 
Item 1.
Financial Statements
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
Part II
 
 
OTHER INFORMATION
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
Item 5.
 
 
 
Item 6.
 
 
 
 
 
 

Page 2

Index



HILLS BANCORPORATION CONSOLIDATED BALANCE SHEETS (Amounts In Thousands, Except Share Amounts) 
 
September 30, 2014
 
December 31, 2013
ASSETS
(Unaudited)
 
Cash and cash equivalents
$
68,864

 
$
43,702

Investment securities available for sale at fair value (amortized cost September 30, 2014 $241,159; December 31, 2013 $236,702)
243,818

 
238,510

Stock of Federal Home Loan Bank
7,651

 
7,579

Loans held for sale
2,484

 
4,927

Loans, net of allowance for loan losses (September 30, 2014 $24,500; December 31, 2013 $25,550)
1,914,139

 
1,801,247

Property and equipment, net
28,623

 
29,836

Tax credit real estate
17,498

 
18,180

Accrued interest receivable
8,980

 
7,676

Deferred income taxes, net
9,090

 
8,605

Other real estate
1,084

 
541

Goodwill
2,500

 
2,500

Other assets
3,550

 
4,492

Total Assets
$
2,308,281

 
$
2,167,795

 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

 
 
 
 
Liabilities
 

 
 

Noninterest-bearing deposits
$
270,139

 
$
256,788

Interest-bearing deposits
1,569,357

 
1,453,089

Total deposits
$
1,839,496

 
$
1,709,877

Short-term borrowings
36,033

 
42,016

Federal Home Loan Bank borrowings
125,000

 
125,000

Accrued interest payable
906

 
1,102

Other liabilities
20,877

 
16,437

Total Liabilities
$
2,022,312

 
$
1,894,432

 
 
 
 
Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)
$
32,500

 
$
29,574

 
 
 
 
STOCKHOLDERS' EQUITY
 

 
 

Common stock, no par value; authorized 10,000,000 shares; issued September 30, 2014 5,081,004 shares; December 31, 2013 5,074,894 shares
$

 
$

Paid in capital
42,660

 
42,194

Retained earnings
266,774

 
250,370

Accumulated other comprehensive income
748

 
1,591

Unearned ESOP shares
(1,008
)
 
(1,008
)
Treasury stock at cost (September 30, 2014 391,351 shares; December 31, 2013 347,269 shares)
(23,205
)
 
(19,784
)
Total Stockholders' Equity
$
285,969

 
$
273,363

Less maximum cash obligation related to ESOP shares
32,500

 
29,574

Total Stockholders' Equity Less Maximum Cash Obligations Related to ESOP Shares
$
253,469

 
$
243,789

Total Liabilities & Stockholders' Equity
$
2,308,281

 
$
2,167,795


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,
 
2014
 
2013
 
2014
 
2013
Interest income:
 
 
 
 
 
 
 
Loans, including fees
$
20,676

 
$
19,886

 
$
60,775

 
$
59,353

Investment securities:
 

 
 

 
 
 
 
Taxable
275

 
303

 
815

 
957

Nontaxable
840

 
823

 
2,513

 
2,497

Federal funds sold
3

 
11

 
29

 
57

Total interest income
$
21,794

 
$
21,023

 
$
64,132

 
$
62,864

Interest expense:
 

 
 

 
 
 
 
Deposits
$
2,245

 
$
2,684

 
$
7,036

 
$
8,488

Short-term borrowings
50

 
41

 
97

 
102

FHLB borrowings
1,409

 
1,409

 
4,181

 
4,181

Total interest expense
$
3,704

 
$
4,134

 
$
11,314

 
$
12,771

Net interest income
$
18,090

 
$
16,889

 
$
52,818

 
$
50,093

Provision for loan losses
(1,008
)
 
112

 
(1,209
)
 
(309
)
Net interest income after provision for loan losses
$
19,098

 
$
16,777

 
$
54,027

 
$
50,402

Noninterest income:
 

 
 

 
 
 
 
Net gain on sale of loans
$
338

 
$
531

 
$
638

 
$
1,793

Trust fees
1,595

 
1,185

 
4,494

 
3,740

Service charges and fees
2,152

 
2,240

 
6,001

 
6,616

Rental revenue on tax credit real estate
377

 
398

 
1,112

 
1,114

Net gain on sale of other real estate owned and other repossessed assets
186

 
18

 
426

 
168

Other noninterest income
599

 
591

 
1,944

 
1,939

 
$
5,247

 
$
4,963

 
$
14,615

 
$
15,370

 
 
 
 
 
 
 
 
Noninterest expenses:
 

 
 

 
 
 
 
Salaries and employee benefits
$
6,400

 
$
6,158

 
$
19,042

 
$
18,312

Occupancy
947

 
907

 
2,900

 
2,780

Furniture and equipment
1,212

 
1,183

 
3,685

 
3,650

Office supplies and postage
390

 
445

 
1,157

 
1,163

Advertising and business development
775

 
624

 
2,216

 
1,895

Outside services
1,773

 
1,819

 
4,981

 
5,437

Rental expenses on tax credit real estate
552

 
614

 
1,635

 
1,571

FDIC insurance assessment
282

 
229

 
823

 
760

Other noninterest expense
490

 
432

 
1,177

 
1,298

 
$
12,821

 
$
12,411

 
$
37,616

 
$
36,866

Income before income taxes
$
11,524

 
$
9,329

 
$
31,026

 
$
28,906

Income taxes
3,625

 
2,705

 
9,202

 
8,558

Net income
$
7,899

 
$
6,624

 
$
21,824

 
$
20,348

 
 
 
 
 
 
 
 
Earnings per share:
 

 
 

 
 
 
 
Basic
$
1.69

 
$
1.41

 
$
4.65

 
$
4.32

Diluted
$
1.68

 
$
1.40

 
$
4.64

 
$
4.31

 
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,
 
2014
 
2013
 
2014
 
2013
Net income
$
7,899

 
$
6,624

 
$
21,824

 
$
20,348

 
 
 
 
 
 
 
 
Other comprehensive loss
 

 
 

 
 
 
 
Securities:
 

 
 

 
 
 
 
Net change in unrealized gain (loss) on securities available for sale
$
26

 
$
(1,084
)
 
$
851

 
$
(4,236
)
Reclassification adjustment for net gains realized in net income

 

 

 
(17
)
Income taxes
(10
)
 
414

 
(325
)
 
1,627

Other comprehensive income (loss) on securities available for sale
$
16

 
$
(670
)
 
$
526

 
$
(2,626
)
Derivatives used in cash flow hedging relationships:
 

 
 

 
 
 
 
Unrealized loss on derivatives
$
(37
)
 
$

 
$
(2,216
)
 
$

Income taxes
14

 

 
847

 

Other comprehensive loss on cash flow hedges
$
(23
)
 
$

 
$
(1,369
)
 
$

 
 
 
 
 
 
 
 
Other comprehensive loss, net of tax
$
(7
)
 
$
(670
)
 
$
(843
)
 
$
(2,626
)
 
 
 
 
 
 
 
 
Comprehensive income
$
7,892

 
$
5,954

 
$
20,981

 
$
17,722

 
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, 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

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2013
$
42,194

 
$
250,370

 
$
1,591

 
$
(1,008
)
 
$
(19,784
)
 
$
(29,574
)
 
$
243,789

Issuance of 5,064 shares of common stock
266

 

 

 

 

 

 
266

Issuance of 1,617 shares of common stock under the employee stock purchase plan
121

 

 

 

 

 

 
121

Unearned restricted stock compensation
48

 

 

 

 

 

 
48

Forfeiture of 571 shares of common stock
(40
)
 

 

 

 

 

 
(40
)
Share-based compensation
21

 

 

 

 

 

 
21

Income tax benefit related to share-based compensation
50

 

 

 

 

 

 
50

Change related to ESOP shares

 

 

 

 

 
(2,926
)
 
(2,926
)
Net income

 
21,824

 

 

 

 

 
21,824

Cash dividends ($1.15 per share)

 
(5,420
)
 

 

 

 

 
(5,420
)
Purchase of 44,082 shares of common stock

 

 

 

 
(3,421
)
 

 
(3,421
)
Other comprehensive loss

 

 
(843
)
 

 

 

 
(843
)
Balance, September 30, 2014
$
42,660

 
$
266,774

 
$
748

 
$
(1,008
)
 
$
(23,205
)
 
$
(32,500
)
 
$
253,469

 
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,
 
2014
 
2013
Cash Flows from Operating Activities
 
 
 
Net income
$
21,824

 
$
20,348

Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
 

 
 

Depreciation
1,916

 
2,176

Provision for loan losses
(1,209
)
 
(309
)
Net gain on sale of investment securities

 
(17
)
Share-based compensation
21

 
21

Forfeiture of common stock
(40
)
 
(25
)
Compensation expensed through issuance of common stock
286

 
176

Excess tax benefits from share-based compensation
(50
)
 
(85
)
Provision for deferred income taxes
37

 
(103
)
Net gain on sale of other real estate owned and other repossessed assets
(426
)
 
(168
)
Increase in accrued interest receivable
(1,304
)
 
(609
)
Amortization of discount on investment securities, net
654

 
834

Decrease in prepaid FDIC insurance

 
2,957

Decrease in other assets
222

 
3,175

Increase in accrued interest payable and other liabilities
2,845

 
1,287

Loans originated for sale
(80,798
)
 
(178,872
)
Proceeds on sales of loans
83,879

 
206,110

Net gain on sales of loans
(638
)
 
(1,793
)
Net cash and cash equivalents provided by operating activities
$
27,219

 
$
55,103

 
 
 
 
Cash Flows from Investing Activities
 

 
 

Proceeds from maturities of investment securities available for sale
$
46,252

 
$
21,070

Proceeds from sales of investment securities available for sale

 
566

Purchases of investment securities available for sale
(51,434
)
 
(27,721
)
Loans made to customers, net of collections
(113,409
)
 
(71,241
)
Proceeds on sale of other real estate owned and other repossessed assets
1,609

 
1,275

Purchases of property and equipment
(703
)
 
(1,428
)
Income from tax credit real estate, net
682

 
478

Net cash and cash equivalents used in investing activities
$
(117,003
)
 
$
(77,001
)
 
 
 
 
Cash Flows from Financing Activities
 

 
 

Net increase in deposits
$
129,619

 
$
30,761

Net decrease in short-term borrowings
(5,983
)
 
(9,620
)
Stock options exercised
101

 
175

Excess tax benefits related to share-based compensation
50

 
85

Purchase of treasury stock
(3,421
)
 
(976
)
Dividends paid
(5,420
)
 
(5,186
)
Net cash and cash equivalents provided by financing activities
$
114,946

 
$
15,239

 
(Continued)


Page 7

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)
 
Nine Months Ended 
 September 30,
 
2014
 
2013
Increase (decrease) in cash and cash equivalents
$
25,162

 
$
(6,659
)
Cash and cash equivalents:
 

 
 

Beginning of year
43,702

 
63,582

End of period
$
68,864

 
$
56,923

 
 
 
 
Supplemental Disclosures
 

 
 

Cash payments for:
 

 
 

Interest paid to depositors
$
7,232

 
$
8,757

Interest paid on other obligations
4,278

 
4,283

Income taxes paid
8,072

 
6,800

 
 
 
 
Noncash activities:
 

 
 

Increase (decrease) in maximum cash obligation related to ESOP shares
$
2,926

 
$
(2,575
)
Transfers to other real estate owned
1,726

 
949

 
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 have been reclassified to conform to the current year presentation.  The Company considers that it operates as one business segment, a commercial bank.

Operating results for the nine month period ended September 30, 2014 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2014.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Form 10-K Annual Report of Hills Bancorporation and subsidiary (the “Company”) for the year ended December 31, 2013 filed with the Securities Exchange Commission on March 11, 2014.  The consolidated balance sheet as of December 31, 2013, has been derived from the audited consolidated financial statements for that period.

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

Effect of New Financial Accounting Standards:

In January 2014, the FASB issued ASU No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects", to amend FASB ASC Topic 323, Investments – Equity Method and Joint Ventures.  The objective of this standard is to provide guidance on accounting for investments by a reporting entity in flow-through limited liability entities that manage or invest in affordable housing projects that qualify for the low-income housing tax credit.  The amendments in the standard permit, but do not require, reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met.  Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit).  The standard will be effective for the Company beginning January 1, 2015; however, early adoption is permitted.  The Company does have significant investments in such qualified affordable housing projects and is currently reviewing the provisions of this standard to determine what, if any, impacts it may have on the Company’s financial position or results of operations.

In January 2014, the FASB issued ASU No. 2014-04, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure.  ASU 2014-4 clarifies that an in substance foreclosure repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either the creditor obtaining legal title to the residential real estate property upon foreclosure or the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement.  Additional disclosures are required.  ASU 2014-4 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2014.  The adoption of ASU 2014-4 by the Company is not expected to have a material impact.

In May 2014, The FASB and International Accounting Standards Board (IASB) issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). The core principle of ASU 2014-09 is that a company should recognize revenue to depict the transfer of promised good or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. For financial institutions, significant changes are not expected given that most financial instruments are not in the scope of the accounting standard update. ASU 2014-09 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2016. Early adoption is not permitted. The Company is currently reviewing the provisions of this standard to determine the application to financial institutions. The adoption of ASU 2014-09 by the Company is not expected to have a material impact.

Page 9

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(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,
 
2014
 
2013
 
2014
 
2013
Common shares outstanding at the beginning of the period
4,696,591

 
4,708,910

 
4,711,995

 
4,712,328

Weighted average number of net shares redeemed
(10,673
)
 
(720
)
 
(12,490
)
 
(364
)
Weighted average shares outstanding (basic)
4,685,918

 
4,708,190

 
4,699,505

 
4,711,964

Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method
2,139

 
3,220

 
2,365

 
3,755

Weighted average number of shares (diluted)
4,688,057

 
4,711,410

 
4,701,870

 
4,715,719

Net income (In thousands)
$
7,899

 
$
6,624

 
$
21,824

 
$
20,348

Earnings per share:
 

 
 

 
 

 
 

Basic
$
1.69

 
$
1.41

 
$
4.65

 
$
4.32

Diluted
$
1.68

 
$
1.40

 
$
4.64

 
$
4.31



Page 10

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 3.
Other Comprehensive Income

The following table summarizes the balances of each component of accumulated other comprehensive income (AOCI), included in stockholders’ equity, at September 30, 2014 and December 31, 2013:

 
September 30, 2014

December 31, 2013
 
(amounts in thousands)
Net unrealized gain on available-for-sale securities
$
2,659

 
$
1,808

Net unrealized (loss) gain on derivatives used for cash flow hedges
(1,447
)
 
769

Tax effect
(464
)
 
(986
)
Net-of-tax amount
$
748

 
$
1,591

 
Amounts reclassified from AOCI and the affected line items in the statement of income during the three and nine months ended September 30, 2014 and 2013, were as follows:

 
Amounts reclassifed from AOCI
 
 
 
Three Months Ended September 30,
 
 
 
2014
 
2013
 
Affected Line Item in the Statements of Income
 
(amounts in thousands)
 
 
Unrealized gains on available-for-sale securities
$

 
$

 
Other noninterest income
Tax effect

 

 
Tax (expense) benefit
Total reclassification out of AOCI
$

 
$

 
 
 
 
 
 
 
 
 
Nine Months Ended 
 September 30,
 
 
 
2014
 
2013
 
Affected Line Item in the Statements of Income
 
(amounts in thousands)
 
 
Unrealized gains on available-for-sale securities
$

 
$
17

 
Other noninterest income
Tax effect

 
(7
)
 
Tax (expense) benefit
Total reclassification out of AOCI
$

 
$
10

 
 



Page 11

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 4.
Securities

The carrying values of investment securities at September 30, 2014 and December 31, 2013 are summarized in the following table (dollars in thousands):

 
September 30, 2014
 
December 31, 2013
 
Amount
 
Percent
 
Amount
 
Percent
Securities available for sale
 
 
 
 
 
 
 
U.S. Treasury
$
19,794

 
8.12
%
 
$

 
%
State and political subdivisions
154,198

 
63.24

 
151,366

 
63.46

Other securities (FHLB, FHLMC and FNMA)
69,826

 
28.64

 
87,144

 
36.54

Total securities available for sale
$
243,818

 
100.00
%
 
$
238,510

 
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, 2014 or December 31, 2013. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of September 30, 2014 and December 31, 2013 (in thousands):

 
Amortized Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
(Losses)
 
Estimated Fair
Value
September 30, 2014:
 
 
 
 
 
 
 
U.S. Treasury
$
19,828

 
$
6

 
$
(40
)
 
$
19,794

State and political subdivisions
151,632

 
2,969

 
(403
)
 
154,198

Other securities (FHLB, FHLMC and FNMA)
69,699

 
191

 
(64
)
 
69,826

Total
$
241,159

 
$
3,166

 
$
(507
)
 
$
243,818

December 31, 2013:
 

 
 

 
 

 
 

U.S. Treasury
$

 
$

 
$

 
$

State and political subdivisions
149,704

 
3,182

 
(1,520
)
 
151,366

Other securities (FHLB, FHLMC and FNMA)
86,998

 
316

 
(170
)
 
87,144

Total
$
236,702

 
$
3,498

 
$
(1,690
)
 
$
238,510


The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at September 30, 2014, were as follows (in thousands):
 
 
Amortized
Cost
 
Fair Value
Due in one year or less
$
35,464

 
$
35,621

Due after one year through five years
136,084

 
138,213

Due after five years through ten years
69,611

 
69,984

Due over ten years

 

Total
$
241,159

 
$
243,818


As of September 30, 2014 investment securities with a carrying value of $36.03 million were pledged to collateralize short-term borrowings.


Page 12

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

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, 2014 and December 31, 2013 (in thousands):

 
Less than 12 months
 
12 months or more
 
Total
September 30, 2014
Description of Securities
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
U.S. Treasury
4

 
$
9,876

 
$
(40
)
 
0.41
%
 

 
$

 
$

 
%
 
4

 
$
9,876

 
$
(40
)
 
0.41
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and political subdivisions
57

 
14,490

 
(76
)
 
0.52
%
 
95

 
19,873

 
(327
)
 
1.65
%
 
152

 
34,363

 
(403
)
 
1.17
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other securities (FHLB, FHLMC and FNMA)
5

 
10,505

 
(46
)
 
0.44
%
 
2

 
4,359

 
(18
)
 
0.41
%
 
7

 
14,864

 
(64
)
 
0.43
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total temporarily impaired securities
66

 
$
34,871

 
$
(162
)
 
0.46
%
 
97

 
$
24,232

 
$
(345
)
 
1.42
%
 
163

 
$
59,103

 
$
(507
)
 
0.86
%

 
Less than 12 months
 
12 months or more
 
Total
December 31, 2013
Description of Securities
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
U.S. Treasury

 
$

 
$

 
%
 

 
$

 
$

 
%
 

 
$

 
$

 
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and political subdivisions
164

 
36,212

 
(1,259
)
 
3.48
%
 
25

 
5,565

 
(261
)
 
4.69
%
 
189

 
41,777

 
(1,520
)
 
3.64
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other securities (FHLB, FHLMC and FNMA)
10

 
21,810

 
(149
)
 
0.68
%
 
1

 
2,557

 
(21
)
 
0.82
%
 
11

 
24,367

 
(170
)
 
0.70
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total temporarily impaired securities
174

 
$
58,022

 
$
(1,408
)
 
2.43
%
 
26

 
$
8,122

 
$
(282
)
 
3.47
%
 
200

 
$
66,144

 
$
(1,690
)
 
2.56
%

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.  None of the unrealized losses in the above table was 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,
2014
 
December 31,
2013
 
(Amounts In Thousands)
Agricultural
$
86,243

 
$
82,138

Commercial and financial
179,872

 
166,102

Real estate:
 
 
 
Construction, 1 to 4 family residential
39,551

 
30,309

Construction, land development and commercial
80,273

 
69,182

Mortgage, farmland
145,070

 
142,685

Mortgage, 1 to 4 family first liens
658,766

 
605,687

Mortgage, 1 to 4 family junior liens
107,443

 
105,785

Mortgage, multi-family
241,768

 
244,090

Mortgage, commercial
322,714

 
315,187

Loans to individuals
20,324

 
19,824

Obligations of state and political subdivisions
55,940

 
45,167

 
$
1,937,964

 
$
1,826,156

Net unamortized fees and costs
675

 
641

 
$
1,938,639

 
$
1,826,797

Less allowance for loan losses
24,500

 
25,550

 
$
1,914,139

 
$
1,801,247



Page 14

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

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, 2014 were as follows:

 
Three Months Ended September 30, 2014
 
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
$
3,036

 
$
4,832

 
$
3,431

 
$
2,749

 
$
6,831

 
$
3,739

 
$
732

 
$
25,350

Charge-offs

 
(60
)
 

 

 
(471
)
 

 
(50
)
 
(581
)
Recoveries
60

 
258

 
37

 

 
244

 
99

 
41

 
739

Provision
(402
)
 
(328
)
 
(483
)
 
(173
)
 
497

 
(98
)
 
(21
)
 
(1,008
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
2,694

 
$
4,702

 
$
2,985

 
$
2,576

 
$
7,101

 
$
3,740

 
$
702

 
$
24,500



Nine Months Ended September 30, 2014
 
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
$
2,852

 
$
4,733

 
$
2,918

 
$
2,557

 
$
7,064

 
$
4,787

 
$
639

 
$
25,550

Charge-offs
(125
)
 
(515
)
 
(247
)
 

 
(963
)
 
(48
)
 
(255
)
 
(2,153
)
Recoveries
65

 
867

 
311

 

 
696

 
259

 
114

 
2,312

Provision
(98
)
 
(383
)
 
3

 
19

 
304

 
(1,258
)
 
204

 
(1,209
)
 


 


 


 


 


 


 


 


Ending balance
$
2,694

 
$
4,702

 
$
2,985

 
$
2,576

 
$
7,101

 
$
3,740

 
$
702

 
$
24,500

 


 


 


 


 


 


 


 


Ending balance, individually evaluated for impairment
$
2

 
$
10

 
$
28

 
$
21

 
$
73

 
$
11

 
$

 
$
145

 


 


 


 


 


 


 


 


Ending balance, collectively evaluated for impairment
$
2,692

 
$
4,692

 
$
2,957

 
$
2,555

 
$
7,028

 
$
3,729

 
$
702

 
$
24,355

 


 


 


 


 


 


 


 


Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
86,243

 
$
179,872

 
$
119,824

 
$
145,070

 
$
766,209

 
$
564,482

 
$
76,264

 
$
1,937,964

 


 


 


 


 


 


 


 


Ending balance, individually evaluated for impairment
$
1,772

 
$
2,737

 
$
475

 
$
2,267

 
$
5,117

 
$
17,847

 
$

 
$
30,215

 


 


 


 


 


 


 


 


Ending balance, collectively evaluated for impairment
$
84,471

 
$
177,135

 
$
119,349

 
$
142,803

 
$
761,092

 
$
546,635

 
$
76,264

 
$
1,907,749


Page 15

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Changes in the allowance for loan losses 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)

The following table presents the credit quality indicators by type of loans in each category as of September 30, 2014 and December 31, 2013, 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, 2014
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Pass
$
62,482

 
$
141,198

 
$
32,670

 
$
66,560

Monitor
14,386

 
18,511

 
3,881

 
4,289

Special Mention
6,159

 
13,010

 
2,625

 
8,983

Substandard
3,216

 
7,153

 
375

 
441

Total
$
86,243

 
$
179,872

 
$
39,551

 
$
80,273


 
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, 2014
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Pass
$
124,813

 
$
580,005

 
$
100,191

 
$
187,591

Monitor
12,834

 
41,707

 
2,783

 
36,089

Special Mention
2,115

 
17,718

 
2,404

 
17,715

Substandard
5,308

 
19,336

 
2,065

 
373

Total
$
145,070

 
$
658,766

 
$
107,443

 
$
241,768


 
Real Estate:
Mortgage,
commercial
 
Loans to
individuals
 
Obligations of state and
political subdivisions
 
Total
September 30, 2014
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Pass
$
274,011

 
$
19,682

 
$
54,913

 
$
1,644,116

Monitor
33,471

 
210

 
1,027

 
169,188

Special Mention
8,835

 
324

 

 
79,888

Substandard
6,397

 
108

 

 
44,772

Total
$
322,714

 
$
20,324

 
$
55,940

 
$
1,937,964

 

Page 17

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

 
Agricultural
 
Commercial and
Financial
 
Real Estate:
Construction, 1 to 4
family residential
 
Real Estate:
Construction, land
development and
commercial
December 31, 2013
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Pass
$
71,370

 
$
134,605

 
$
26,519

 
$
56,555

Monitor
3,579

 
12,469

 
758

 
3,963

Special Mention
1,076

 
12,971

 
2,242

 
6,854

Substandard
6,113

 
6,057

 
790

 
1,810

Total
$
82,138

 
$
166,102

 
$
30,309

 
$
69,182


 
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, 2013
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Pass
$
132,988

 
$
532,921

 
$
98,142

 
$
196,616

Monitor
5,413

 
30,454

 
2,273

 
28,438

Special Mention
1,795

 
22,097

 
3,187

 
18,161

Substandard
2,489

 
20,215

 
2,183

 
875

Total
$
142,685

 
$
605,687

 
$
105,785

 
$
244,090


 
Real Estate:
Mortgage,
commercial
 
Loans to
individuals
 
Obligations of state and
political subdivisions
 
Total
December 31, 2013
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Pass
$
262,252

 
$
19,263

 
$
43,047

 
$
1,574,278

Monitor
30,140

 
117

 
1,061

 
118,665

Special Mention
14,749

 
316

 
1,059

 
84,507

Substandard
8,046

 
128

 

 
48,706

Total
$
315,187

 
$
19,824

 
$
45,167

 
$
1,826,156



Page 18

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

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.

Monitor – Monitor 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 monitor indicator assists the Company in identifying and monitoring loans for which credit quality could deteriorate.  This grade was labeled potential watch in previous reports; the Company changed the label only and has not changed the overall description of the credit quality indicator.

Special Mention – Special mention 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 special mention credit would typically have a weakness in one of the general categories (cash flow, collateral position or payment history) but not in all categories.  This grade was labeled watch in previous reports; the Company changed the label only and has not changed the overall description of the credit quality indicator

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.

Page 19

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Past due loans as of September 30, 2014 and December 31, 2013 were as follows:

 
30 - 59 Days
Past Due
 
60 - 89 Days
Past Due
 
90 Days
or More
Past Due
 
Total Past
Due
 
Current
 
Total
Loans
Receivable
 
Accruing Loans
Past Due 90
Days or More
 
(Amounts In Thousands)
September 30, 2014
 
 
 
 
 
 
 
 
 
 
 
 
 
Agricultural
$

 
$
43

 
$

 
$
43

 
$
86,200

 
$
86,243

 
$

Commercial and financial
988

 
98

 
951

 
2,037

 
177,835

 
179,872

 

Real estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential

 

 

 

 
39,551

 
39,551

 

Construction, land development and commercial
265

 

 
132

 
397

 
79,876

 
80,273

 

Mortgage, farmland
289

 

 

 
289

 
144,781

 
145,070

 

Mortgage, 1 to 4 family first liens
347

 
1,437

 
1,947

 
3,731

 
655,035

 
658,766

 
996

Mortgage, 1 to 4 family junior liens
247

 
82

 
492

 
821

 
106,622

 
107,443

 
103

Mortgage, multi-family
23

 

 

 
23

 
241,745

 
241,768

 

Mortgage, commercial
1,020

 
622

 
197

 
1,839

 
320,875

 
322,714

 

Loans to individuals
8

 
1

 

 
9

 
20,315

 
20,324

 

Obligations of state and political subdivisions

 

 

 

 
55,940

 
55,940

 

 
$
3,187

 
$
2,283

 
$
3,719

 
$
9,189

 
$
1,928,775

 
$
1,937,964

 
$
1,099

 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2013:
 

 
 

 
 

 
 

 
 

 
 

 
 

Agricultural
$
8

 
$
10

 
$

 
$
18

 
$
82,120

 
$
82,138

 
$

Commercial and financial
526

 
177

 
951

 
1,654

 
164,448

 
166,102

 

Real estate:
 

 
 

 
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential

 

 

 

 
30,309

 
30,309

 

Construction, land development and commercial
276

 
144

 
731

 
1,151

 
68,031

 
69,182

 

Mortgage, farmland
108

 

 

 
108

 
142,577

 
142,685

 

Mortgage, 1 to 4 family first liens
4,418

 
1,649

 
2,223

 
8,290

 
597,397

 
605,687

 
959

Mortgage, 1 to 4 family junior liens
835

 
43

 
29

 
907

 
104,878

 
105,785

 

Mortgage, multi-family

 
150

 

 
150

 
243,940

 
244,090

 

Mortgage, commercial
1,350

 

 
493

 
1,843

 
313,344

 
315,187

 

Loans to individuals
7

 
4

 

 
11

 
19,813

 
19,824

 

Obligations of state and political subdivisions
14

 

 

 
14

 
45,153

 
45,167

 

 
$
7,542

 
$
2,177

 
$
4,427

 
$
14,146

 
$
1,812,010

 
$
1,826,156

 
$
959

 

Page 20

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

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.

Certain impaired loan information by loan type at September 30, 2014 and December 31, 2013, was as follows:

 
September 30, 2014
 
December 31, 2013
 
Non-accrual
loans (1)
 
Accruing loans
past due 90 days
or more (2)
 
TDR loans
 
Non-
accrual
loans (1)
 
Accruing loans
past due 90 days
or more (2)
 
TDR loans
 
(Amounts In Thousands)
 
(Amounts In Thousands)
Agricultural
$

 
$

 
$
1,772

 
$

 
$

 
$
120

Commercial and financial
1,170

 

 
1,567

 
1,462

 

 
945

Real estate:
 

 
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential

 

 
170

 

 

 

Construction, land development and commercial
132

 

 
173

 
1,319

 

 

Mortgage, farmland

 

 
2,267

 

 

 
284

Mortgage, 1 to 4 family first liens
2,025

 
996

 
1,604

 
2,209

 
959

 
1,272

Mortgage, 1 to 4 family junior liens
389

 
103

 

 
178

 

 

Mortgage, multi-family
58

 

 
5,932

 
456

 

 
5,608

Mortgage, commercial
1,884

 

 
9,973

 
1,568

 

 
10,146

Loans to individuals

 

 

 

 

 

 
$
5,658

 
$
1,099

 
$
23,458

 
$
7,192

 
$
959

 
$
18,375


(1)
There were $2.03 million and $2.72 million of TDR loans included within nonaccrual loans as of September 30, 2014 and December 31, 2013, respectively.
(2)
There were no TDR loans within accruing loans past due 90 days or more as of September 30, 2014 and December 31, 2013, respectively.

Loans 90 days or more past due that are still accruing interest increased $0.14 million from December 31, 2013 to September 30, 2014 due to an increase in the number of loans past due greater than 90 days. The average accruing loans past due 90 days or more balance was $0.08 million as of September 30, 2014 and $0.08 million as of December 31, 2013.  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.

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.


Page 21

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Below is a summary of information for TDR loans as of September 30, 2014 and December 31, 2013:

 
September 30, 2014
 
December 31, 2013
 
Number
of
contracts
 
Recorded
investment
 
Commitments
outstanding
 
Number
of
contracts
 
Recorded
investment
 
Commitments
outstanding
 
 
 
(Amounts In Thousands)
 
 
 
(Amounts In Thousands)
Agricultural
9

 
$
1,772

 
$
13

 
1

 
$
120

 
$
4

Commercial and financial
15

 
2,408

 
157

 
12

 
2,214

 
101

Real estate:
 

 
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
1

 
170

 

 

 

 

Construction, land development and commercial
1

 
173

 

 
1

 
13

 

Mortgage, farmland
4

 
2,267

 

 
1

 
284

 

Mortgage, 1 to 4 family first liens
15

 
1,881

 

 
12

 
1,697

 

Mortgage, 1 to 4 family junior liens
1

 
225

 
45

 

 

 
177

Mortgage, multi-family
4

 
5,932

 

 
3

 
6,000

 

Mortgage, commercial
10

 
10,659

 

 
9

 
10,766

 
10

Loans to individuals

 

 

 

 

 

 
60

 
$
25,487

 
$
215

 
39

 
$
21,094

 
$
292


The following is a summary of TDR loans that were modified during the three and nine months ended September 30, 2014:

 
Three Months Ended September 30, 2014
 
Nine Months Ended September 30, 2014
 
Number
of
contracts
 
Pre-modification
recorded
investment
 
Post-modification
recorded
investment
 
Number
of
contracts
 
Pre-modification
recorded
investment
 
Post-modification
recorded
investment
 
 
 
(Amounts In Thousands)
 
 
 
 
 
 
Agricultural
6

 
$
1,874

 
$
1,874

 
9

 
$
2,033

 
$
2,033

Commercial and financial
1

 
85

 
85

 
8

 
882

 
882

Real estate:
 

 
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential

 

 

 
1

 
170

 
170

Construction, land development and commercial

 

 

 
1

 
184

 
173

Mortgage, farmland
3


2,007


2,007


3


2,007


2,007

Mortgage, 1 to 4 family first lien
2

 
333

 
333

 
5

 
514

 
514

Mortgage, 1 to 4 family junior liens

 

 

 
1

 
225

 
225

Mortgage, multi-family

 

 

 
1

 
89

 
89

Mortgage, commercial

 

 

 
2

 
269

 
269

 
12

 
$
4,299

 
$
4,299

 
31

 
$
6,373

 
$
6,362



Page 22

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

The Company had commitments to lend $0.22 million in additional borrowings to restructured loan customers as of September 30, 2014.  The Company had commitments to lend $0.29 million in additional borrowings to restructured loan customers as of December 31, 2013.  These commitments were in the normal course of business.  The additional borrowings were not used to facilitate payments on these loans.

There were $1.23 million and $0.00 million of TDR loans that were in payment default (defined as past due 90 days or more) as of September 30, 2014 and December 31, 2013, respectively.  As of September 30, 2014, TDR loans in payment default consisted of a $0.09 million 1 to 4 family first lien mortgage loan, a $0.22 million 1 to 4 family junior lien loan, a $0.16 million commercial mortgage loan and a commercial and financial loan totaling $0.76 million.


Page 23

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Information regarding impaired loans as of and for the three and nine months ended September 30, 2014 is as follows:
 
September 30, 2014
 
Three Months Ended September 30, 2014
 
Nine Months Ended 
 September 30, 2014
 
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
$
1,659

 
$
1,756

 
$

 
$
1,812

 
$
22

 
$
1,674

 
$
60

Commercial and financial
2,068

 
3,655

 

 
1,839

 
9

 
1,832

 
25

Real estate:
 

 
 

 
 

 
 

 
 
 
 
 
 
Construction, 1 to 4 family residential

 

 

 

 

 

 

Construction, land development and commercial
132

 
222

 

 
138

 

 
144

 

Mortgage, farmland
977

 
977

 

 
977

 
12

 
1,047

 
37

Mortgage, 1 to 4 family first liens
3,470

 
4,672

 

 
3,450

 
16

 
3,515

 
47

Mortgage, 1 to 4 family junior liens
389

 
682

 

 
392

 

 
396

 

Mortgage, multi-family
5,990

 
6,643

 

 
6,020

 
66

 
6,071

 
201

Mortgage, commercial
10,996

 
13,745

 

 
11,069

 
103

 
11,245

 
311

Loans to individuals

 
20

 

 

 

 

 

 
$
25,681

 
$
32,372

 
$

 
$
25,697

 
$
228

 
$
25,924

 
$
681

 
 
 
 
 
 
 
 
 
 
 
 
 
 
With an allowance recorded:
 

 
 

 
 

 
 

 
 

 
 
 
 
Agricultural
$
113

 
$
113

 
$
2

 
$
114

 
$
1

 
$
117

 
$
4

Commercial and financial
669

 
669

 
10

 
683

 
9

 
712

 
28

Real estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential
170

 
170

 
20

 
170

 
2

 
170

 
6

Construction, land development and commercial
173

 
184

 
8

 
173

 
2

 
178

 
7

Mortgage, farmland
1,290

 
1,290

 
21

 
1,271

 
15

 
994

 
36

Mortgage, 1 to 4 family first liens
1,155

 
1,347

 
69

 
1,195

 
13

 
1,216

 
38

Mortgage, 1 to 4 family junior liens
103

 
158

 
4

 
105

 
1

 
105

 
3

Mortgage, multi-family

 

 

 

 

 

 

Mortgage, commercial
861

 
875

 
11

 
864

 
9

 
873

 
28

Loans to individuals

 

 

 

 

 

 

 
$
4,534

 
$
4,806

 
$
145

 
$
4,575

 
$
52

 
$
4,365

 
$
150

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total:
 

 
 

 
 

 
 

 
 

 
 
 
 
Agricultural
$
1,772

 
$
1,869

 
$
2

 
$
1,926

 
$
23

 
$
1,791

 
$
64

Commercial and financial
2,737

 
4,324

 
10

 
2,522

 
18

 
2,544

 
53

Real estate:
 

 
 

 
 

 
 

 
 

 
 
 
 
Construction, 1 to 4 family residential
170

 
170

 
20

 
170

 
2

 
170

 
6

Construction, land development and commercial
305

 
406

 
8

 
311

 
2

 
322

 
7

Mortgage, farmland
2,267

 
2,267

 
21

 
2,248

 
27

 
2,041

 
73

Mortgage, 1 to 4 family first liens
4,625

 
6,019

 
69

 
4,645

 
29

 
4,731

 
85

Mortgage, 1 to 4 family junior liens
492

 
840

 
4

 
497

 
1

 
501

 
3

Mortgage, multi-family
5,990

 
6,643

 

 
6,020

 
66

 
6,071

 
201

Mortgage, commercial
11,857

 
14,620

 
11

 
11,933

 
112

 
12,118

 
339

Loans to individuals

 
20

 

 

 

 

 

 
$
30,215

 
$
37,178

 
$
145

 
$
30,272

 
$
280

 
$
30,289

 
$
831


Page 24

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Information regarding impaired loans as of December 31, 2013 is as follows:

 
Recorded
Investment
 
Unpaid Principal
Balance
 
Related
Allowance
With no related allowance recorded:
(Amounts In Thousands)
Agricultural
$

 
$

 
$

Commercial and financial
1,602

 
3,140

 

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
1,270

 
2,974

 

Construction, land development and commercial
140

 
140

 

Mortgage, farmland

 

 

Mortgage, 1 to 4 family first liens
2,597

 
3,542

 

Mortgage, 1 to 4 family junior liens
177

 
451

 

Mortgage, multi-family
456

 
1,068

 

Mortgage, commercial
2,494

 
5,303

 

Loans to individuals

 
20

 

 
$
8,736

 
$
16,638

 
$

 
 
 
 
 
 
With an allowance recorded:
 

 
 

 
 

Agricultural
$
120

 
$
120

 
$
3

Commercial and financial
805

 
838

 
16

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential

 

 

Construction, land development and commercial

 

 

Mortgage, farmland
284

 
284

 
14

Mortgage, 1 to 4 family first liens
1,768

 
1,897

 
66

Mortgage, 1 to 4 family junior liens

 

 

Mortgage, multi-family
5,608

 
5,608

 
188

Mortgage, commercial
9,205

 
9,205

 
17

Loans to individuals

 

 

 
$
17,790

 
$
17,952

 
$
304

 
 
 
 
 
 
Total:
 

 
 

 
 

Agricultural
$
120

 
$
120

 
$
3

Commercial and financial
2,407

 
3,978

 
16

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
1,270

 
2,974

 

Construction, land development and commercial
140

 
140

 

Mortgage, farmland
284

 
284

 
14

Mortgage, 1 to 4 family first liens
4,365

 
5,439

 
66

Mortgage, 1 to 4 family junior liens
177

 
451

 

Mortgage, multi-family
6,064

 
6,676

 
188

Mortgage, commercial
11,699

 
14,508

 
17

Loans to individuals

 
20

 

 
$
26,526

 
$
34,590

 
$
304



Page 25

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Impaired loans increased $3.52 million from December 31, 2013 to September 30, 2014.  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 1.56% of loans held for investment as of September 30, 2014 and 1.45% as of December 31, 2013.  The increase in impaired loans is due mainly to an increase in TDR loans of $5.08 million from December 31, 2013 to September 30, 2014.

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 26

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, 2014 are as follows:
 
September 30, 2014
 
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
$
68,864


$
68,864


$
68,864


$


$

Investment securities
251,469


251,469




251,469



Loans held for sale
2,484


2,484


 


2,484


 

Loans
 


 


 


 


 

Agricultural
83,549


83,530






83,530

Commercial and financial
175,170


176,122






176,122

Real estate:
 


 


 


 


 

Construction, 1 to 4 family residential
38,471


38,311






38,311

Construction, land development and commercial
78,368


78,338






78,338

Mortgage, farmland
142,494


142,785






142,785

Mortgage, 1 to 4 family first liens
652,582


655,991






655,991

Mortgage, 1 to 4 family junior liens
106,526


110,723






110,723

Mortgage, multi-family
240,235


243,133






243,133

Mortgage, commercial
320,507


319,958






319,958

Loans to individuals
19,974


19,922






19,922

Obligations of state and political subdivisions
55,588


54,717






54,717

Accrued interest receivable
8,980


8,980




8,980



Total financial instrument assets
$
2,245,261

 
$
2,255,327

 
$
68,864

 
$
262,933

 
$
1,923,530

Financial instrument liabilities
 

 
 

 
 

 
 

 
 

Deposits
 

 
 

 
 

 
 

 
 

Noninterest-bearing deposits
$
270,139


$
270,139


$


$
270,139


$

Interest-bearing deposits
1,569,357


1,573,833




1,573,833



Short-term borrowings
36,033


36,033




36,033



Federal Home Loan Bank borrowings
125,000


130,785




130,785



Accrued interest payable
906


906




906



Total financial instrument liabilities
$
2,001,435

 
$
2,011,696

 
$

 
$
2,011,696

 
$

 
 
 
 
 
 
 
 
 
 
 
Face Amount
 
 

 
 

 
 

 
 

Financial instrument with off-balance sheet risk:
 

 
 

 
 

 
 

 
 

Loan commitments
$
380,570

 
$

 
$

 
$

 
$

Letters of credit
14,131

 

 

 

 

Total financial instrument liabilities with off-balance-sheet risk
$
394,701

 
$

 
$

 
$

 
$

 
(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 27

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

The carrying value and estimated fair values of the Company's financial instruments as of December 31, 2013 are as follows:

 
December 31, 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
$
43,702

 
$
43,702

 
$
43,702

 
$

 
$

Investment securities
246,089

 
246,089

 

 
246,089

 

Loans held for sale
4,927

 
4,927

 

 
4,927

 

Loans
 

 
 

 
 

 
 

 
 

Agricultural
79,286

 
86,137

 

 

 
86,137

Commercial and financial
161,369

 
176,385

 

 

 
176,385

Real estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
29,298

 
28,364

 

 

 
28,364

Construction, land development and commercial
67,275

 
65,544

 

 

 
65,544

Mortgage, farmland
140,128

 
137,938

 

 

 
137,938

Mortgage, 1 to 4 family first liens
599,586

 
595,054

 

 

 
595,054

Mortgage, 1 to 4 family junior liens
104,822

 
104,133

 

 

 
104,133

Mortgage, multi-family
242,026

 
240,595

 

 

 
240,595

Mortgage, commercial
312,464

 
310,558

 

 

 
310,558

Loans to individuals
19,554

 
19,710

 

 

 
19,710

Obligations of state and political subdivisions
44,798

 
45,184

 

 

 
45,184

Accrued interest receivable
7,676

 
7,676

 

 
7,676

 

Total financial instrument assets
$
2,103,000

 
$
2,111,996

 
$
43,702

 
$
258,692

 
$
1,809,602

Financial instrument liabilities:
 

 
 

 
 

 
 

 
 

Deposits
 

 
 

 
 

 
 

 
 

Noninterest-bearing deposits
$
256,788

 
$
256,788

 
$

 
$
256,788

 
$

Interest-bearing deposits
1,453,089

 
1,461,454

 

 
1,461,454

 

Short-term borrowings
42,016

 
42,016

 

 
42,016

 

Federal Home Loan Bank borrowings
125,000

 
132,469

 

 
132,469

 

Accrued interest payable
1,102

 
1,102

 

 
1,102

 

Total financial instrument liabilities
$
1,877,995

 
$
1,893,829

 
$

 
$
1,893,829

 
$

 
 
 
 
 
 
 
 
 
 
 
Face Amount
 
 

 
 

 
 

 
 

Financial instrument with off-balance sheet risk:
 

 
 

 
 

 
 

 
 

Loan commitments
$
360,945

 
$

 
$

 
$

 
$

Letters of credit
11,019

 

 

 

 

Total financial instrument liabilities with off-balance-sheet risk
$
371,964

 
$

 
$

 
$

 
$

 
(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 28

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)


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.  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. 

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, 2014.   If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.

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.


Page 29

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

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).

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)

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:

 
September 30, 2014
 
Readily
Available
Market
Prices(1)
 
Observable
Market Prices(2)
 
Company
Determined
Market
Prices(3)
 
Total at Fair
Value
 
(Amounts In Thousands)
U.S. Treasury
$

 
$
19,794

 
$

 
$
19,794

State and political subdivisions

 
154,198

 

 
154,198

Other securities (FHLB, FHLMC and FNMA)

 
69,826

 

 
69,826

Total
$

 
$
243,818

 
$

 
$
243,818


 
December 31, 2013
 
Readily
Available
Market
Prices(1)
 
Observable
Market Prices(2)
 
Company
Determined
Market
Prices(3)
 
Total at Fair
Value
 
(Amounts In Thousands)
U.S. Treasury
$

 
$

 
$

 
$

State and political subdivisions

 
151,366

 

 
151,366

Other securities (FHLB, FHLMC and FNMA)

 
87,144

 

 
87,144

Total
$

 
$
238,510

 
$

 
$
238,510

 
(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, 2014 and the year ended December 31, 2013.



Page 31

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

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 valuation methodologies used to measure these fair value adjustments are described above.    The following tables present the Company’s assets that are measured at fair value on a nonrecurring basis.

 
September 30, 2014
 
Three Months Ended September 30, 2014
 
Nine Months Ended September 30, 2014
 
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)
 
 
 
 
Loans (4)
 
 
 
 
 
 
 
 
 
 
 
Agricultural
$

 
$

 
$
1,770

 
$
1,770

 
$

 
$
25

Commercial and financial

 

 
2,727

 
2,727

 
50

 
110

Real Estate:
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential

 

 
150

 
150

 

 

Construction, land development and commercial

 

 
297

 
297

 

 

Mortgage, farmland

 

 
2,246

 
2,246

 

 

Mortgage, 1 to 4 family first liens

 

 
4,556

 
4,556

 
310

 
408

Mortgage, 1 to 4 family junior liens

 

 
488

 
488

 

 
24

Mortgage, multi-family

 

 
5,990

 
5,990

 

 

Mortgage, commercial

 

 
11,846

 
11,846

 

 
140

Loans to individuals

 

 

 

 

 

Foreclosed assets (5)

 

 
38

 
38

 
54

 
77

Total
$

 
$

 
$
30,108

 
$
30,108

 
$
414

 
$
784

 
(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.
(4)
Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully-charged off is zero.
(5)
Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.


Page 32

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

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

 
December 31, 2013
 
Year Ended
December 31, 2013
 
Readily
Available
Market
Prices(1)
 
Observable
Market
Prices(2)
 
Company
Determined
Market
Prices(3)
 
Total at Fair
Value
 
Total Losses
 
(Amounts in Thousands)
 
 
Loans (4)
 
 
 
 
 
 
 
 
 
Agricultural
$

 
$

 
$
117

 
$
117

 
$

Commercial and financial

 

 
2,391

 
2,391

 
53

Real Estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential

 

 
1,270

 
1,270

 

Construction, land development and commercial

 

 
140

 
140

 

Mortgage, farmland

 

 
270

 
270

 

Mortgage, 1 to 4 family first liens

 

 
4,299

 
4,299

 
424

Mortgage, 1 to 4 family junior liens

 

 
177

 
177

 
59

Mortgage, multi-family

 

 
5,876

 
5,876

 
69

Mortgage, commercial

 

 
11,682

 
11,682

 
229

Loans to individuals

 

 

 

 

Foreclosed assets (5)

 

 
427

 
427

 
68

Total
$

 
$

 
$
26,649

 
$
26,649

 
$
902


(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.
(4)
Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully-charged off is zero.
(5)
Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.

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 Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2015.  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 391,351 shares of its common stock in privately negotiated transactions from August 1, 2005 through September 30, 2014.  Of these 391,351 shares, 23,853 shares were purchased during the quarter ended September 30, 2014, at an average price per share of $78.78.


Page 33

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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

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 within the Bank's market area.  Investments in securities issued by state and political subdivisions within the state of Iowa totaled approximately $70.62 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.  While the ultimate outcome of such legal proceedings cannot be predicted with certainty, after reviewing pending and threatened litigation with counsel, management believes at this time that the outcome of such litigation will not have a material adverse effect on the Company's business, financial condition or results of operations.

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, 2014 and December 31, 2013 is as follows:
 
 
September 30, 2014
 
December 31, 2013
 
(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
 
 
 
Home equity loans
$
40,553

 
$
38,243

Credit cards
46,452

 
44,326

Commercial, real estate and home construction
113,481

 
106,241

Commercial lines and real estate purchase loans
180,084

 
172,135

Outstanding letters of credit
14,131

 
11,019

 
Note 9.
Income Taxes

Federal income tax expense for the nine months ended September 30, 2014 and 2013 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, 2013, 2012, and 2011 remain subject to examination by the Internal Revenue Service.  For state tax purposes, the tax years ended December 31, 2013, 2012, and 2011 remain open for examination.  There were no material unrecognized tax benefits at September 30, 2014  and December 31, 2013 and therefore no interest or penalties on unrecognized tax benefits has been recorded.  As of September 30, 2014, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending September 30, 2015.

Income taxes as a percentage of income before taxes were 29.66% for the nine months ended September 30, 2014 and 29.61% for the same period in 2013.  The slight increase in the effective tax rate is due to a decrease in the amount of low-income housing tax credits earned by the Company in 2014.


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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)


Note 10.
Derivative Financial Instruments

In the normal course of business, the Bank may use derivative financial instruments to manage its interest rate risk.  These instruments carry varying degrees of credit, interest rate and market or liquidity risks.  Derivative instruments are recognized as either assets or liabilities in the accompanying financial statement and are measured at fair value.  The Bank’s objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates.  The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amount to be exchanged between the counterparties.  The Bank is exposed to credit risk in the event of nonperformance by counterparties to financial instruments.  The Bank minimizes this risk by entering into derivative contracts with large, stable financial institutions.  The Bank has not experienced any losses from nonperformance by counterparties.  The Bank monitors counterparty risk in accordance with the provisions of ASC 815.  In addition, the Bank’s interest rate-related derivative instruments contain language outlining collateral pledging requirements for each counterparty.  Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty.  The Bank was required to pledge $1.50 million of collateral as of September 30, 2014.

Cash Flow Hedges:

The Bank executed two forward-starting interest rate swap transactions on November 7, 2013.  One of the interest rate swap transactions has an effective date of November 9, 2015, and an expiration date of November 9, 2020, to effectively convert $25.00 million of variable rate debt to fixed rate debt.  The other interest rate swap transaction has an effective date of November 7, 2016 and an expiration date of November 7, 2023, also to effectively convert $25.00 million of variable rate debt to fixed rate debt.  For accounting purposes, these swap transactions are designated as a cash flow hedge of the changes in cash flows attributable to changes in three-month LIBOR, the benchmark interest rate being hedged, associated with the interest payments made on an amount of the Bank’s debt principal equal to the then-outstanding swap notional amount.  At inception, the Bank asserted that the underlying principal balance would remain outstanding throughout the hedge transaction making it probable that sufficient LIBOR-based interest payments would exist through the maturity date of the swaps.

The table below identifies the balance sheet category and fair values of the Bank’s derivative instruments designated as cash flow hedges as of September 30, 2014 and December 31, 2013:

 
Notional
Amount
 
Fair
Value
 
Balance
Sheet
Category
 
Maturity
 
(Amounts in Thousands)
 
 
September 30, 2014
 
 
 
 
 
 
    
Interest rate swap
$
25,000

 
$
(372
)
 
Other Liabilities
 
11/9/2020
Interest rate swap
25,000

 
(1,075
)
 
Other Liabilities
 
11/7/2023
 
 
 
 
 
 
 
 
December 31, 2013
 

 
 

 
 
 
    
Interest rate swap
$
25,000

 
$
357

 
Other Assets
 
11/9/2020
Interest rate swap
25,000

 
412

 
Other Assets
 
11/7/2023



Page 35

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

The table below identifies the gains and losses recognized on the Bank’s derivative instruments designated as cash flow hedges as of September 30, 2014 and December 31, 2013:

 
Effective Portion
 
Ineffective Portion
 
Recognized
in OCI
 
Reclassifed from AOCI into
Income
 
Recognized in Income on
Derivatives
 
Amount of
Gain (Loss)
 
Category
 
Amount
of Gain
(Loss)
 
Category
 
Amount
of Gain
(Loss)
 
(Amounts in Thousands)
September 30, 2014
 
 
 
 
 
 
 
 
 
Interest rate swap
$
(450
)
 
Interest Expense
 
$

 
Other Income
 
$

Interest rate swap
(919
)
 
Interest Expense
 

 
Other Income
 

 
 
 
 
 
 
 
 
 
 
December 31, 2013
 

 
 
 
 

 
 
 
 

Interest rate swap
$
220

 
Interest Expense
 
$

 
Other Income
 
$

Interest rate swap
255

 
Interest Expense
 

 
Other Income
 


Note 11.        Subsequent Events

On October 29, 2014, a potential commercial and financial loan impairment was brought to the Company’s attention related to one of the Company's borrowing relationships. The Company is in the early stages of determining what, if any, loss might exist within that relationship. The Company is in the process of working with the borrower to verify and gather collateral to mitigate any potential loss. The borrower relationship consists of 7 loans totaling $1.97 million. At this time, the Company does not anticipate that the total outstanding loan balance will be a loss but cannot reasonably estimate the amount of any loss as of the date of this filing. If, after management's review of the overall lending relationship, including the fair value of the collateral and consideration of other payment sources, the Company does not believe the loans will be fully repaid, additional specific reserves may be necessary in the future.


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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 recent 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.

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


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HILLS BANCORPORATION

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.  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, 2014 and December 31, 2013 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.

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, 2014, the Bank has seventeen full-service locations.


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HILLS BANCORPORATION

Net income for the nine month period ended September 30, 2014 was $21.82 million compared to $20.35 million for the same nine months of 2013, an increase of 7.25%.  The $1.48 million increase in net income was caused by a number of factors.  The principal factors in the increase in net income for the first nine months of 2014 are an increase in net interest income of $2.73 million and a decrease in the provision for loan losses of $0.90 million.  These changes were offset by an increase in income tax expense of $0.64 million, a decrease in noninterest income of $0.76 million and an increase in noninterest expenses of $0.75 million.

The Company achieved a return on average assets of 1.26% and a return on average equity of 11.58% for the twelve months ended September 30, 2014, compared to the twelve months ended September 30, 2013, which were 1.23% and 11.36%, respectively.  Dividends of $1.15 per share were paid in January 2014 to 2,204 shareholders.  The 2013 dividend was $1.10 per share.

The Company’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 Company achieved a net interest margin on a tax-equivalent basis of 3.49% for the nine months ended September 30, 2014 compared to 3.51% for the same nine months of 2013.  Average earning assets were $2.106 billion in 2014 and $1.985 billion in 2013.

Highlights noted on the balance sheet as of September 30, 2014 for the Company included the following:

Total assets were $2.308 billion, an increase of $140.49 million since December 31, 2013.
Cash and cash equivalents were $68.86 million, an increase of $25.16 million since December 31, 2013.
Net loans were $1.917 billion, an increase of $110.45 million since December 31, 2013.  Loans held for sale decreased $2.44 million since December 31, 2013.
Deposit growth of $129.62 million since December 31, 2013.  Deposit growth included $58.36 million of temporary public funds.

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.

Financial Condition

The following table sets forth the composition of the loan portfolio as of September 30, 2014 and December 31, 2013:

 
September 30, 2014
 
December 31, 2013
 
Amount
 
Percent
 
Amount
 
Percent
 
(Amounts In Thousands)
 
(Amounts In Thousands)
Agricultural
$
86,243

 
4.45
%
 
$
82,138

 
4.50
%
Commercial and financial
179,872

 
9.28

 
166,102

 
9.10

Real estate:
 
 


 
 

 
 

Construction, 1 to 4 family residential
39,551

 
2.04

 
30,309

 
1.66

Construction, land development and commercial
80,273

 
4.14

 
69,182

 
3.79

Mortgage, farmland
145,070

 
7.49

 
142,685

 
7.81

Mortgage, 1 to 4 family first liens
658,766

 
33.99

 
605,687

 
33.16

Mortgage, 1 to 4 family junior liens
107,443

 
5.54

 
105,785

 
5.79

Mortgage, multi-family
241,768

 
12.48

 
244,090

 
13.37

Mortgage, commercial
322,714

 
16.65

 
315,187

 
17.26

Loans to individuals
20,324

 
1.05

 
19,824

 
1.09

Obligations of state and political subdivisions
55,940

 
2.89

 
45,167

 
2.47

 
$
1,937,964

 
100.00
%
 
$
1,826,156

 
100.00
%
Net unamortized fees and costs
675

 
 

 
641

 
 

 
$
1,938,639

 
 

 
$
1,826,797

 
 

Less allowance for loan losses
24,500

 
 

 
25,550

 
 

 
$
1,914,139

 
 

 
$
1,801,247

 
 



Page 39

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HILLS BANCORPORATION

Loan demand has been steady and is expected to remain steady or increase throughout the year ending December 31, 2014 and into 2015.  As indicated above growth in the commercial and financial, construction, 1 to 4 family real estate loans, obligation of state and political subdivisions loan portfolios as well as real estate loans secured by commercial property have been primarily responsible for the increase in total loans.  Management expects overall portfolio loan growth to increase as a result of general improvement in market conditions resulting in increased loan demand.

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.

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.


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HILLS BANCORPORATION

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, 2014 and December 31, 2013:
 
 
September 30, 2014
 
December 31, 2013
 
Amount
 
% of Total
Allowance
 
% of Loans to
Total Loans
 
Amount
 
% of Total
Allowance
 
% of Loans to
Total Loans
 
(In Thousands)
 
 
 
 
 
(In Thousands)
 
 
 
 
Agricultural
$
2,694

 
11.00
%
 
4.45
%
 
$
2,852

 
11.17
%
 
4.50
%
Commercial and financial
4,702

 
19.19

 
9.28

 
4,733

 
18.52

 
9.10

Real estate:
 

 
 
 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
1,080

 
4.41

 
2.04

 
1,011

 
3.96

 
1.66

Construction, land development and commercial
1,905

 
7.77

 
4.14

 
1,907

 
7.46

 
3.79

Mortgage, farmland
2,576

 
10.51

 
7.49

 
2,557

 
10.01

 
7.81

Mortgage, 1 to 4 family first liens
6,184

 
25.24

 
33.99

 
6,101

 
23.87

 
33.16

Mortgage, 1 to 4 family junior liens
917

 
3.74

 
5.54

 
963

 
3.77

 
5.79

Mortgage, multi-family
1,533

 
6.26

 
12.48

 
2,064

 
8.08

 
13.37

Mortgage, commercial
2,207

 
9.01

 
16.65

 
2,723

 
10.66

 
17.26

Loans to individuals
352

 
1.44

 
1.05

 
369

 
1.44

 
1.09

Obligations of state and political subdivisions
350

 
1.43

 
2.89

 
270

 
1.06

 
2.47

 
$
24,500

 
100.00
%
 
100.00
%
 
$
25,550

 
100.00
%
 
100.00
%

The allowance for loan losses totaled $24.50 million at September 30, 2014 compared to $25.55 million at December 31, 2013.  The percentage of the allowance to outstanding loans was 1.26% and 1.40% at September 30, 2014 and December 31, 2013, 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 decrease in the allowance in 2014 is the result of a change in the composition and allocation of loans within credit quality ratings.

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, 2014, 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.


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HILLS BANCORPORATION

Investment securities available for sale held by the Company increased by $5.31 million from December 31, 2013 to September 30, 2014.  The fair value of securities available for sale was $2.66 million more than the amortized cost of such securities as of September 30, 2014.  At December 31, 2013, the fair value of the securities available for sale was $1.81 million more than the amortized cost of such securities.

Deposit growth was $129.62 million in the first nine months of 2014. Repurchase agreements decreased $5.98 million since December 31, 2014.  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 $59.18 million as of September 30, 2014 with an average rate of 0.39%.  Brokered deposits were $57.77 million as of December 31, 2013 with an average interest rate of 0.44%.  As of September 30, 2014 and December 31, 2013, brokered deposits were 3.22% and 3.38% of total deposits, respectively.

Dividends and Equity

In January 2014, Hills Bancorporation paid a dividend of $5.42 million or $1.15 per share.  The dividend was $1.10 per share in January 2013.  After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of September 30, 2014 totaled $253.47 million.  Under risk-based capital rules, the total amount of Tier 1 risk-based capital was 16.22% and 16.19% as of September 30, 2014 and December 31, 2013, respectively.  The Tier 1 risk-based capital was in excess of the required minimum of 8.00%.  Risk-based capital was 17.47% and 17.44% as of September 30, 2014 and December 31, 2013, respectively. As of September 30, 2014, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  There are no conditions or events since that notification that management believes have changed the Company’s category.

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.

Discussion of operations for the nine months ended September 30, 2014 and 2013

Net Income Overview

Net income increased $1.48 million for the nine months ended September 30, 2014 compared to the first nine months of 2013.  Total net income was $21.82 million in 2014 and $20.35 million in the comparable period in 2013, an increase of 7.25%.  The changes in net income in 2014 from the first nine months of 2013 were primarily the result of the following:

Net interest income increased by $2.73 million, before provision expense, as a result of growth in the volume of earning assets and reductions in interest expense.
The provision for loan losses decreased by $0.90 million.
Noninterest income decreased by $0.76 million.
Noninterest expenses increased by $0.75 million.
Income tax expense increased by $0.64 million.
 
For the nine month period ended September 30, 2014 and September 30, 2013 basic earning per share was $4.65 and $4.32, respectively. Diluted earnings per share was $4.64 for the nine months ended September 30, 2014 compared to $4.31 for the same period in 2013.


Page 42

Index

HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2014 and 2013

The Company’s net income continues to be driven primarily by three important factors.  The first important factor is the interaction between changes in net interest margin and changes in average volumes of the Bank's earnings assets.  Net interest income of $52.82 million for the first nine months of 2014 was derived from the Company’s $2.106 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.49%.  Average earning assets in the nine months ended September 30, 2013 were $1.985 billion and the tax-equivalent net interest margin was 3.55%.  The importance of net interest margin is illustrated by the fact that an increase or decrease in the net interest margin of 10 basis points would have resulted approximately in a $1.58 million change in income before income taxes in the nine month period ended September 30, 2014 .  Net interest income for the Company increased as a result of growth in the volume of earning assets and a decrease in net interest expense due to the mix of interest bearing liabilities of the Company as well as a reduction in dollar amount and rate on time deposits.  The Company expects continued net interest compression to impact earnings for the foreseeable future.  The Company believes growth in net interest income will be contingent on the growth of the Company’s earnings assets.

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $1.917 billion at September 30, 2014.  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 of expense of $1.21 million in 2014 compared to a reduction of expense of $0.31 million in 2013.  The Company believes that the provision for loan losses will remain stable for the foreseeable future resulting from projected increases in the size of the Company’s loan portfolio offset by continued improvement in credit quality subject to the circumstances discussed in Note 11.

The third significant factor affecting the Company’s net income is income tax expense.  Federal and state income tax expenses were $9.20 million and $8.56 million for the nine months ended September 30, 2014 and 2013, respectively.  Income taxes as a percentage of income before taxes were 29.66% in 2014 and 29.61% in 2013.


Page 43

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HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2014 and 2013

Net Interest Income

Net interest income increased for the nine months ended September 30, 2014 compared to the comparable period in 2013.  The increase was as a result of growth in the volume of earning assets and a decrease in net interest expense due to the mix of interest bearing liabilities of the Company as well as a reduction in dollar amount and rate on time deposits.  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 average volume of earning assets for the period and the net interest margin.  The net interest margin for the first nine months of 2014 was 3.49% compared to 3.51% in 2013 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 2014 compared to the comparable period in 2013 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
$
121,405

 
(0.20
)%
 
$
4,199

 
$
(2,689
)
 
$
1,510

Taxable securities
(4,471
)
 
(0.14
)
 
(33
)
 
(109
)
 
(142
)
Nontaxable securities
18,514

 
(0.47
)
 
547

 
(521
)
 
26

Federal funds sold
(14,697
)
 

 
(28
)
 

 
(28
)
 
$
120,751

 
 

 
$
4,685

 
$
(3,319
)
 
$
1,366

 
 
 
 
 
 
 
 
 
 
Interest expense:
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
$
33,512

 
(0.06
)%
 
$
(52
)
 
$
177

 
$
125

Savings deposits
90,144

 
(0.03
)
 
(154
)
 
111

 
(43
)
Time deposits
(49,830
)
 
(0.19
)
 
625

 
745

 
1,370

Short-term borrowings
10,015

 
(0.01
)
 
(27
)
 
8

 
(19
)
FHLB borrowings

 

 

 

 

Interest-bearing other liabilities
(53
)
 
(1.16
)
 

 
24

 
24

 
$
83,788

 
 

 
$
392

 
$
1,065

 
$
1,457

Change in net interest income
 

 
 

 
$
5,077

 
$
(2,254
)
 
$
2,823


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)
 
2014
 
2013
Yield on average interest-earning assets
 
4.20
%
 
4.36
%
Rate on average interest-bearing liabilities
 
0.91

 
1.08

Net interest spread
 
3.29
%
 
3.28
%
Effect of noninterest-bearing funds
 
0.20

 
0.23

Net interest margin (tax equivalent interest income divided by average interest-earning assets)
 
3.49
%
 
3.51
%

Page 44

Index

HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2014 and 2013

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 seven times during the first nine months of 2014.  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, 2014, the rate indexes for the one, three and five year indexes were 0.10%, 1.06% and 1.79%, respectively.  The one year index decreased 9.09% from 0.11% at September 30, 2013, the three year index increased 45.21% and the five year index increased 16.23%.  The three year index was 0.73% and the five year index was 1.54% at September 30, 2013.  The targeted federal funds rate was 0.25% at September 30, 2014 and 2013.  The Company anticipates no increases in short term rates and possible increases in long term rates in the indexes for 2014.

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $1.21 million in 2014 compared to a reduction of expense of $0.31 million in 2013, an expense reduction of $0.90 million.  The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio.  The provision expense taken to fund the allowance for loan losses 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 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.  The decrease in expense in 2014 is the result of a change in the composition and allocation of loans within credit quality ratings.

The allowance for loan losses decreased $1.05 million during the first nine months of 2014.  In the first nine months of 2014, there was an increase of $0.05 million due to the volume and composition of loans outstanding and a $1.10 million decrease in the amount allocated to the allowance due to a combination of credit quality improvements.

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, 2014 and 2013, recoveries were $2.31 million and $2.02 million, respectively; and charge-offs were $2.15 million in 2014 and $2.12 million in 2013.  The allowance for loan losses totaled $24.50 million at September 30, 2014 compared to $25.55 million at December 31, 2013.  The allowance represented 1.26% and 1.40% of loans held for investment at September 30, 2014 and December 31, 2013, respectively.





Page 45

Index

HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2014 and 2013

Noninterest Income

The following table sets forth the various categories of noninterest income for the nine months ended September 30, 2014 and 2013.

 
Nine Months Ended September 30,
 
 
 
 
 
2014
 
2013
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Net gain on sale of loans
$
638

 
$
1,793

 
$
(1,155
)
 
(64.42
)%
Trust fees
4,494

 
3,740

 
754

 
20.16

Service charges and fees
6,001

 
6,616

 
(615
)
 
(9.30
)
Rental revenue on tax credit real estate
1,112

 
1,114

 
(2
)
 
(0.18
)
Net gain on sale of other real estate owned and other reposessed assets
426

 
168

 
258

 
153.57

Other noninterest income
1,944

 
1,939

 
5

 
0.26

 
$
14,615

 
$
15,370

 
$
(755
)
 
(4.91
)

Loans originated for sale in the first nine months of 2014 totaled $80.80 million compared to $178.87 million in the same period in 2013, a decrease of 54.83%.  In the nine months ended September 30, 2014 and 2013, the net gain on sale of loans was $0.64 million and $1.79 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.  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 $0.75 million in the first nine months of 2014 as a result of assets under management increasing to $1.251 billion as of September 30, 2014 from $1.126 billion as of September 30, 2013 due to market conditions and new trust relationships.

Service charges and fees decreased $0.62 million in the first nine months of 2014 from their level for the comparable period in 2013.  Credit card merchant fees are included in service charges and fees, and that component decreased during the same period by $0.98 million due to a change to an agent program utilized by the Bank.  This decrease was offset by an increase of $0.32 million in credit card, debit card and POS Pin interchange income due to increased volume in transactions during the period.

The net gain on sale of other real estate owned and other repossessed assets increased $0.26 million to a net gain of $0.43 million for the nine months ended September 30, 2014.  The total net gain on sale of other real estate owned for the nine months ended consisted of a $0.50 million net gain on the sale of 13 properties offset by a $0.07 million fair market value adjustment on one property.  During the same period in 2013, the gain consisted of a $0.19 million net gain on sale of 11 properties offset by a $0.02 million fair market value adjustment on one property.


Page 46

Index

HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2014 and 2013

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the nine months ended September 30, 2014 and 2013.

 
Nine Months Ended September 30,
 
 
 
 
 
2014
 
2013
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Salaries and employee benefits
$
19,042

 
$
18,312

 
$
730

 
3.99
 %
Occupancy
2,900

 
2,780

 
120

 
4.32

Furniture and equipment
3,685

 
3,650

 
35

 
0.96

Office supplies and postage
1,157

 
1,163

 
(6
)
 
(1
)
Advertising and business development
2,216

 
1,895

 
321

 
16.94

Outside services
4,981

 
5,437

 
(456
)
 
(8.39
)
Rental expenses on tax credit real estate
1,635

 
1,571

 
64

 
4.07

FDIC insurance assessment
823

 
760

 
63

 
8.29

Other noninterest expense
1,177

 
1,298

 
(121
)
 
(9.32
)
 
$
37,616

 
$
36,866

 
$
750

 
2.03


Advertising and business development expense increased $0.32 million in the first nine months of 2014 compared to 2013 as a result of $0.07 million increase in mail processing expense, $0.12 million in business promotions and $0.08 million in charitable contributions. Outside services expenses decreased $0.46 million in the first nine months of 2014 from their level for the comparable period in 2013.  Merchant card processing charges are included in outside services expense, and that component decreased during the same period by $0.91 million due to a change to an agent program utilized by the Bank.  Most other noninterest expense categories experienced marginal period-to-period fluctuations for the nine months ended September 30, 2014.


Page 47

Index

HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2014 and 2013

Net Income Overview

Net income increased $1.28 million for the three months ended September 30, 2014 compared to the same period in 2013.  Total net income was $7.90 million in 2014 and $6.62 million in the comparable period in 2013, an increase of 19.25%.  For the three month period ended September 30, 2014 and September 30, 2013 basic earning per share was $1.69 and $1.41, respectively. Diluted earnings per share was $1.68 for the three months ended September 30, 2014 compared to $1.40 for the same period in 2013.

Net Interest Income

Net interest income increased for the three months ended September 30, 2014 compared to the comparable period in 2013.  The increase was primarily the result of growth in the volume of earning assets and a decrease in net interest expense due to the mix of interest bearing liabilities of the Company as well as a reduction in dollar amount and rate on time deposits  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 net interest margin for the three months ended September 30, 2014 was 3.49%, which remained unchanged from the same period for 2013.  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 2014 compared to the comparable period in 2013 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
$
139,727

 
(0.17
)%
 
$
1,643

 
$
(810
)
 
$
833

Taxable securities
(4,431
)
 
(0.06
)
 
(3
)
 
(25
)
 
(28
)
Nontaxable securities
19,043

 
(0.42
)
 
185

 
(157
)
 
28

Federal funds sold
(11,796
)
 

 
(8
)
 

 
(8
)
 
$
142,543

 
 

 
$
1,817

 
$
(992
)
 
$
825

 
 
 
 
 
 
 
 
 
 
Interest expense:
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
$
28,825

 
(0.06
)%
 
$
(14
)
 
$
64

 
$
50

Savings deposits
91,902

 
(0.04
)
 
(53
)
 
57

 
4

Time deposits
(40,929
)
 
(0.17
)
 
165

 
220

 
385

Short-term borrowings
20,935

 

 
(9
)
 
(6
)
 
(15
)
FHLB borrowings

 

 

 

 

Interest-bearing other liabilities
(57
)
 
(0.86
)
 

 
6

 
6

 
$
100,676

 
 
 
$
89

 
$
341

 
$
430

Change in net interest income
 

 
 

 
$
1,906

 
$
(651
)
 
$
1,255


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.


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HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2014 and 2013

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

(Tax Equivalent Basis)
 
2014
 
2013
Yield on average interest-earning assets
 
4.18
%
 
4.31
%
Rate on average interest-bearing liabilities
 
0.88

 
1.04

Net interest spread
 
3.30
%
 
3.27
%
Effect of noninterest-bearing funds
 
0.19

 
0.22

Net interest margin (tax equivalent interest income divided by average interest-earning assets)
 
3.49
%
 
3.49
%

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $1.01 million in 2014 compared to an expense of $0.11 million in 2013, an expense reduction of $1.12 million. The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio.  The provision expense taken to fund the allowance for loan losses 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 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. 
 
The allowance for loan losses decreased $0.85 million during the three months ended September 30, 2014.  In the three months ended September 30, 2014, there was a decrease of $0.02 million due to the volume and composition of loans outstanding and a $0.83 million decrease in the amount allocated to the allowance due to an improvement in credit quality.

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, 2014 and 2013, recoveries were $0.74 million and $0.69 million, respectively; and charge-offs were $0.58 million in 2014 and $0.45 million in 2013.  The allowance for loan losses totaled $24.50 million at September 30, 2014 compared to $25.55 million at December 31, 2013.  The allowance represented 1.26% and 1.40% of loans held for investment at September 30, 2014 and December 31, 2013, respectively.





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HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2014 and 2013

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended September 30, 2014 and 2013.

 
Three Months Ended 
 September 30, 2014
 
 
 
 
 
2014
 
2013
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Net gain on sale of loans
$
338

 
$
531

 
$
(193
)
 
(36.35
)%
Trust fees
1,595

 
1,185

 
410

 
34.60

Service charges and fees
2,152

 
2,240

 
(88
)
 
(3.93
)
Rental revenue on tax credit real estate
377

 
398

 
(21
)
 
(5.28
)
Net gain on sale of other real estate owned and other reposessed assets
186

 
18

 
168

 
933.33

Other noninterest income
599

 
591

 
8

 
1.35

 
$
5,247

 
$
4,963

 
$
284

 
5.72


In the three months ended September 30, 2014 and 2013, the net gain on sale of loans was $0.34 million and $0.53 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.  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 $0.41 million in the three months ended September 30, 2014 as a result of assets under management increasing to $1.251 billion as of September 30, 2014 from $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 increased $0.17 million to a net gain of $0.19 million for the three months ended September 30, 2014.  The total net gain on sale of other real estate owned for the three months ended September 30, 2014 consisted of a $0.24 million net gain on the sale of 4 properties and a $0.05 million fair market value adjustment on three properties.  During the same period in 2013, the gain consisted of a $0.04 net gain on sale of 3 properties and a $0.02 million fair market value adjustment on one property.


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HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2014 and 2013

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended September 30, 2014 and 2013.

 
Three Months Ended 
 September 30,
 
 
 
 
 
2014
 
2013
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Salaries and employee benefits
$
6,400

 
$
6,158

 
$
242

 
3.93
 %
Occupancy
947

 
907

 
40

 
4.41

Furniture and equipment
1,212

 
1,183

 
29

 
2.45

Office supplies and postage
390

 
445

 
(55
)
 
(12
)
Advertising and business development
775

 
624

 
151

 
24.20

Outside services
1,773

 
1,819

 
(46
)
 
(2.53
)
Rental expenses on tax credit real estate
552

 
614

 
(62
)
 
(10.10
)
FDIC insurance assessment
282

 
229

 
53

 
23.14

Other noninterest expense
490

 
432

 
58

 
13.43

 
$
12,821

 
$
12,411

 
$
410

 
3.30


Advertising and business development expenses increased $0.15 million in the three months ended September 30, 2014 from their level for the comparable period in 2013 as a result of a $0.07 increase in mail processing expense and $0.11 in business promotions. Most other noninterest expense categories experienced marginal period-to-period increases for the three months ended September 30, 2014.

Income Taxes

Federal and state income tax expenses were $3.63 million and $2.71 million for the three months ended September 30, 2014 and 2013, respectively.  Income taxes as a percentage of income before taxes were 31.46% in 2014 and 29.00% in 2013.

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 10.56% of the Company’s total assets at September 30, 2014 compared to 11.00% at December 31, 2013.

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, 2014, 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 $478.73 million at September 30, 2014.

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 $216.65 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, 2014.


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HILLS BANCORPORATION

As of September 30, 2014, investment securities with a carrying value of $36.03 million were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as permitted by law.  As of December 31, 2013, investment securities with a carrying value of $42.02 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, 2013.

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.


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HILLS BANCORPORATION

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, 2014 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
 
In the normal course of business, the Company and its subsidiaries are subject to pending and threatened legal actions, some of which seek substantial relief or damages.  While the ultimate outcome of such legal proceedings cannot be predicted with certainty, after reviewing pending and threatened litigation with counsel, management believes at this time that the outcome of such litigation will not have a material adverse effect on the Company’s business, financial condition or results of operations.

On April 24, 2014, a suit was filed against the Bank in the Iowa District Court for Johnson County by a customer alleging that the fees associated with the Bank’s automated overdraft program in connection with its debit and ATM cards constitute unlawful interest in violation of Iowa’s usury laws and that the collection of such interest violates the Iowa Debt Collection Practices Act. The suit seeks class-action status for Bank customers who have paid overdraft fees arising from debit or ATM card transactions on their consumer accounts.  The Bank filed a motion to dismiss the case, which the Court denied. The Bank is appealing the District Court's ruling on the motion to dismiss through the filing of an application for interlocutory appeal to the Iowa Supreme Court.  At this stage of the proceedings, it is not possible for management of the Bank to determine the probability of a material adverse outcome or reasonably estimate the amount of any potential loss.
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, 2013.

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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, 2014:

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
7,480

$
77.50

374,978

375,022

August 1 to August 31
7,159

78.83

382,137

367,863

September 1 to September 30
9,214

80.00

391,351

358,649

Total
23,853

$
78.78

391,351

358,649

 
(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 through December 31, 2015. 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.  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 Board reviews the overall results of the 2005 Stock Repurchase Program on a quarterly basis.

During the first nine months of 2014, the Company issued 2,124 shares of restricted stock under the 2010 Stock Option and Incentive Plan, 831 shares of which were issued in the third quarter.  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

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 6, 2014
 
By:  /s/ Dwight O. Seegmiller
 
 
 
Dwight O. Seegmiller, Director, President and Chief Executive Officer
 
 
 
 
Date:
November 6, 2014
 
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, 2014
Exhibit
Number
Description
Page Number In The Sequential
Numbering System September 30, 2014 Form 10-Q
 
 
 
31
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
60-61

 
 
 
32
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
62



Page 58