Annual Statements Open main menu

HILLS BANCORPORATION - Quarter Report: 2015 September (Form 10-Q)

Index

 
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, 2015

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.


Index

 
SHARES OUTSTANDING
CLASS
October 31, 2015
 
 
Common Stock, no par value
9,335,704
 
 
 
 


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 3

Index



HILLS BANCORPORATION CONSOLIDATED BALANCE SHEETS (Amounts In Thousands, Except Share Amounts) 
 
September 30, 2015
 
December 31, 2014
ASSETS
(Unaudited)
 
Cash and cash equivalents
$
33,985

 
$
29,174

Investment securities available for sale at fair value (amortized cost September 30, 2015 $244,975; December 31, 2014 $256,920)
247,485

 
258,992

Stock of Federal Home Loan Bank
9,641

 
8,248

Loans held for sale
4,395

 
4,476

Loans, net of allowance for loan losses (September 30, 2015 $25,480; December 31, 2014 $24,020)
2,051,349

 
1,961,369

Property and equipment, net
33,694

 
29,071

Tax credit real estate
16,593

 
17,259

Accrued interest receivable
9,700

 
8,276

Deferred income taxes, net
11,527

 
9,938

Other real estate
573

 
1,213

Goodwill
2,500

 
2,500

Other assets
3,563

 
3,802

Total Assets
$
2,425,005

 
$
2,334,318

 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

 
 
 
 
Liabilities
 

 
 

Noninterest-bearing deposits
$
297,676

 
$
288,718

Interest-bearing deposits
1,591,300

 
1,546,351

Total deposits
$
1,888,976

 
$
1,835,069

Other borrowings
36,124

 
47,499

Federal Home Loan Bank borrowings
170,000

 
140,000

Accrued interest payable
750

 
902

Other liabilities
25,098

 
20,749

Total Liabilities
$
2,120,948

 
$
2,044,219

 
 
 
 
Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)
$
35,930

 
$
34,571

 
 
 
 
STOCKHOLDERS' EQUITY
 

 
 

Common stock, no par value; authorized 20,000,000 shares; issued September 30, 2015 10,184,227 shares; December 31, 2014 10,177,854 shares
$

 
$

Paid in capital
43,395

 
42,925

Retained earnings
288,604

 
271,924

Accumulated other comprehensive loss
(1,343
)
 
(448
)
Unearned ESOP shares
(504
)
 
(504
)
Treasury stock at cost (September 30, 2015 851,132 shares; December 31, 2014 797,422 shares)
(26,095
)
 
(23,798
)
Total Stockholders' Equity
$
304,057

 
$
290,099

Less maximum cash obligation related to ESOP shares
35,930

 
34,571

Total Stockholders' Equity Less Maximum Cash Obligations Related to ESOP Shares
$
268,127

 
$
255,528

Total Liabilities & Stockholders' Equity
$
2,425,005

 
$
2,334,318


See Notes to Consolidated Financial Statements.

Page 4

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,
 
2015
 
2014
 
2015
 
2014
Interest income:
 
 
 
 
 
 
 
Loans, including fees
$
22,159

 
$
20,676

 
$
65,139

 
$
60,775

Investment securities:
 

 
 

 
 
 
 
Taxable
321

 
275

 
907

 
815

Nontaxable
813

 
840

 
2,473

 
2,513

Federal funds sold
2

 
3

 
17

 
29

Total interest income
$
23,295

 
$
21,794

 
$
68,536

 
$
64,132

Interest expense:
 

 
 

 
 
 
 
Deposits
$
1,973

 
$
2,245

 
$
6,247

 
$
7,036

Short-term borrowings
55

 
50

 
114

 
97

FHLB borrowings
1,686

 
1,409

 
4,647

 
4,181

Total interest expense
$
3,714

 
$
3,704

 
$
11,008

 
$
11,314

Net interest income
$
19,581

 
$
18,090

 
$
57,528

 
$
52,818

Provision for loan losses
(95
)
 
(1,008
)
 
360

 
(1,209
)
Net interest income after provision for loan losses
$
19,676

 
$
19,098

 
$
57,168

 
$
54,027

Noninterest income:
 

 
 

 
 
 
 
Net gain on sale of loans
$
396

 
$
338

 
$
1,144

 
$
638

Trust fees
1,672

 
1,595

 
4,920

 
4,494

Service charges and fees
2,124

 
2,152

 
6,151

 
6,001

Rental revenue on tax credit real estate
392

 
377

 
1,296

 
1,112

Net gain on sale of other real estate owned and other repossessed assets
22

 
186

 
139

 
426

Other noninterest income
612

 
599

 
2,064

 
1,944

 
$
5,218

 
$
5,247

 
$
15,714

 
$
14,615

 
 
 
 
 
 
 
 
Noninterest expenses:
 

 
 

 
 
 
 
Salaries and employee benefits
$
7,125

 
$
6,400

 
$
20,700

 
$
19,042

Occupancy
919

 
947

 
2,887

 
2,900

Furniture and equipment
1,304

 
1,212

 
3,911

 
3,685

Office supplies and postage
457

 
390

 
1,311

 
1,157

Advertising and business development
854

 
775

 
2,547

 
2,216

Outside services
1,770

 
1,773

 
5,203

 
4,981

Rental expenses on tax credit real estate
558

 
552

 
1,719

 
1,635

FDIC insurance assessment
293

 
282

 
866

 
823

Other noninterest expense
392

 
490

 
1,231

 
1,177

 
$
13,672

 
$
12,821

 
$
40,375

 
$
37,616

Income before income taxes
$
11,222

 
$
11,524

 
$
32,507

 
$
31,026

Income taxes
3,537

 
3,625

 
9,972

 
9,202

Net income
$
7,685

 
$
7,899

 
$
22,535

 
$
21,824

 
 
 
 
 
 
 
 
Earnings per share:
 

 
 

 
 
 
 
Basic
$
0.82

 
$
0.85

 
$
2.41

 
$
2.33

Diluted
$
0.82

 
$
0.84

 
$
2.41

 
$
2.32

 
See Notes to Consolidated Financial Statements.

Page 5

Index

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

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Net income
$
7,685

 
$
7,899

 
$
22,535

 
$
21,824

 
 
 
 
 
 
 
 
Other comprehensive income (loss)
 

 
 

 
 
 
 
Securities:
 

 
 

 
 
 
 
Net change in unrealized gain on securities available for sale
$
1,026

 
$
26

 
$
438

 
$
851

Reclassification adjustment for net gains realized in net income

 

 

 

Income taxes
(392
)
 
(10
)
 
(167
)
 
(325
)
Other comprehensive income on securities available for sale
$
634

 
$
16

 
$
271

 
$
526

Derivatives used in cash flow hedging relationships:
 

 
 

 
 
 
 
Net change in unrealized loss on derivatives
$
(1,637
)
 
$
(37
)
 
$
(1,889
)
 
$
(2,216
)
Income taxes
626

 
14

 
723

 
847

Other comprehensive loss on cash flow hedges
$
(1,011
)
 
$
(23
)
 
$
(1,166
)
 
$
(1,369
)
 
 
 
 
 
 
 
 
Other comprehensive loss, net of tax
$
(377
)
 
$
(7
)
 
$
(895
)
 
$
(843
)
 
 
 
 
 
 
 
 
Comprehensive income
$
7,308

 
$
7,892

 
$
21,640

 
$
20,981

 
See Notes to Consolidated Financial Statements.

Page 6

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, 2013
$
42,194

 
$
250,370

 
$
1,591

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

Issuance of 10,128 shares of common stock
266

 

 

 

 

 

 
266

Issuance of 3,234 shares of common stock under the employee stock purchase plan
121

 

 

 

 

 

 
121

Unearned restricted stock compensation
48

 

 

 

 

 

 
48

Forfeiture of 1,142 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 ($0.575 per share)

 
(5,420
)
 

 

 

 

 
(5,420
)
Purchase of 88,164 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

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2014
$
42,925

 
$
271,924

 
$
(448
)
 
$
(504
)
 
$
(23,798
)
 
$
(34,571
)
 
$
255,528

Issuance of 3,260 shares of common stock
136

 

 

 

 

 

 
136

Issuance of 4,155 shares of common stock under the employee stock purchase plan
172

 

 

 

 

 

 
172

Unearned restricted stock compensation
171

 

 

 

 

 

 
171

Forfeiture of 1,042 shares of common stock
(37
)
 

 

 

 

 

 
(37
)
Share-based compensation
21

 

 

 

 

 

 
21

Income tax benefit related to share-based compensation
7

 

 

 

 

 

 
7

Change related to ESOP shares

 

 

 

 

 
(1,359
)
 
(1,359
)
Net income

 
22,535

 

 

 

 

 
22,535

Cash dividends ($0.625 per share)

 
(5,855
)
 

 

 

 

 
(5,855
)
Purchase of 53,710 shares of common stock

 

 

 

 
(2,297
)
 

 
(2,297
)
Other comprehensive loss

 

 
(895
)
 

 

 

 
(895
)
Balance, September 30, 2015
$
43,395

 
$
288,604

 
$
(1,343
)
 
$
(504
)
 
$
(26,095
)
 
$
(35,930
)
 
$
268,127

 
See Notes to Consolidated Financial Statements.

Page 7

Index

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

 
Nine Months Ended 
 September 30,
 
2015
 
2014
Cash Flows from Operating Activities
 
 
 
Net income
$
22,535

 
$
21,824

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

 
 

Depreciation
2,055

 
1,916

Provision for loan losses
360

 
(1,209
)
Share-based compensation
21

 
21

Forfeiture of common stock
(37
)
 
(40
)
Compensation expensed through issuance of common stock
308

 
286

Excess tax benefits from share-based compensation
(7
)
 
(50
)
Provision for deferred income taxes
(1,033
)
 
37

Net gain on sale of other real estate owned and other repossessed assets
(139
)
 
(426
)
Increase in accrued interest receivable
(1,424
)
 
(1,304
)
Amortization of discount on investment securities, net
498

 
654

Decrease in other assets
246

 
222

Increase in accrued interest payable and other liabilities
2,479

 
2,845

Loans originated for sale
(133,522
)
 
(80,798
)
Proceeds on sales of loans
134,747

 
83,879

Net gain on sales of loans
(1,144
)
 
(638
)
Net cash and cash equivalents provided by operating activities
$
25,943

 
$
27,219

 
 
 
 
Cash Flows from Investing Activities
 

 
 

Proceeds from maturities of investment securities available for sale
$
45,901

 
$
46,252

Purchases of investment securities available for sale
(35,847
)
 
(51,434
)
Loans made to customers, net of collections
(90,695
)
 
(113,409
)
Proceeds on sale of other real estate owned and other repossessed assets
1,134

 
1,609

Purchases of property and equipment
(6,678
)
 
(703
)
Income from tax credit real estate, net
666

 
682

Net cash and cash equivalents used in investing activities
$
(85,519
)
 
$
(117,003
)
 
 
 
 
Cash Flows from Financing Activities
 

 
 

Net increase in deposits
$
53,907

 
$
129,619

Net decrease in other borrowings
(11,375
)
 
(5,983
)
Net increase in FHLB borrowings
30,000

 

Borrowings from FRB
4

 

Payments on FRB borrowings
(4
)
 

Stock options exercised

 
101

Excess tax benefits related to share-based compensation
7

 
50

Purchase of treasury stock
(2,297
)
 
(3,421
)
Dividends paid
(5,855
)
 
(5,420
)
Net cash and cash equivalents provided by financing activities
$
64,387

 
$
114,946

 
(Continued)


Page 8

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)
 
Nine Months Ended 
 September 30,
 
2015
 
2014
Increase in cash and cash equivalents
$
4,811

 
$
25,162

Cash and cash equivalents:
 

 
 

Beginning of year
29,174

 
43,702

End of period
$
33,985

 
$
68,864

 
 
 
 
Supplemental Disclosures
 

 
 

Cash payments for:
 

 
 

Interest paid to depositors
$
6,399

 
$
7,232

Interest paid on other obligations
4,761

 
4,278

Income taxes paid
10,072

 
8,072

 
 
 
 
Noncash activities:
 

 
 

Increase in maximum cash obligation related to ESOP shares
$
1,359

 
$
2,926

Transfers to other real estate owned
355

 
1,726

Sale and financing of other real estate owned
452

 
242

 
See Notes to Consolidated Financial Statements.



Page 9

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, 2015 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, 2014 filed with the Securities Exchange Commission on March 11, 2015.  The consolidated balance sheet as of December 31, 2014, 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 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. In August 2015, FASB issued ASU 2015-14 deferring the effective date for annual periods and interim periods within those annual periods after December 15, 2017. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company is currently reviewing the provisions of this standard to determine the application to financial institutions.

In February 2015, the FASB issued ASU No. 2015-02 (Topic 810), Consolidation. The ASU modifies the evaluation of whether limited partnerships and similar legal entities are variable interest entities (VIE) or voting interest entities (VOE). The standard relaxes existing criteria for determining when fees paid to a decision maker or service provider do not represent a variable interest by focusing on whether those fees are "at market". The ASU eliminates both the consolidation model specific to limited partnerships and the current presumption that a general partner controls a limited partnership. For public companies, ASU 2015-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. The Company is currently reviewing the provisions of this standard to determine the impact on the Company's financial statements.
 
In April 2015, the FASB issued ASU No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30), Simplifying the Presentation of Debt Issuance Costs. ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this update. For public companies, ASU 2015-03 is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted. The Company has determined that the adoption of ASU 2015-03 will not have a material impact on the Company's financial statements.

In April 2015, the FASB issued ASU No. 2015-05, Intangibles – Goodwill and Other Internal-Use Software (Subtopic 350-40), Customer's Accounting for Fees Paid in a Cloud Computing Arrangement.  ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. ASU 2015-05 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015.  The adoption of ASU 2015-05 by the Company is not expected to have a material impact.


Page 10

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.

On March 24, 2015, the Company declared a payment of a 2-for-1 stock split of each issued and unissued share of the Company's common stock outstanding as of April 27, 2015. The additional shares were issued as a result of the stock split and were mailed to the shareholders as of May 4, 2015. All shares and earnings per share numbers have been restated for the stock split.

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,
 
2015
 
2014
 
2015
 
2014
Common shares outstanding at the beginning of the period
9,351,859

 
9,393,182

 
9,365,176

 
9,423,990

Weighted average number of net shares redeemed
(10,342
)
 
(21,346
)
 
(11,936
)
 
(24,980
)
Weighted average shares outstanding (basic)
9,341,517

 
9,371,836

 
9,353,240

 
9,399,010

Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method
5,590

 
4,278

 
5,285

 
4,730

Weighted average number of shares (diluted)
9,347,107

 
9,376,114

 
9,358,525

 
9,403,740

Net income (In thousands)
$
7,685

 
$
7,899

 
$
22,535

 
$
21,824

Earnings per share:
 

 
 

 
 

 
 

Basic
$
0.82

 
$
0.85

 
$
2.41

 
$
2.33

Diluted
$
0.82

 
$
0.84

 
$
2.41

 
$
2.32


Note 3.
Other Comprehensive Income (Loss)

The following table summarizes the balances of each component of accumulated other comprehensive income (AOCI), included in stockholders’ equity, at September 30, 2015 and December 31, 2014:

 
September 30, 2015

December 31, 2014
 
(amounts in thousands)
Net unrealized gain on available-for-sale securities
$
2,510

 
$
2,072

Net unrealized loss on derivatives used for cash flow hedges
(4,685
)
 
(2,796
)
Tax effect
832

 
276

Net-of-tax amount
$
(1,343
)
 
$
(448
)
 





Page 11

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

Note 4.
Securities

The carrying values of investment securities at September 30, 2015 and December 31, 2014 are summarized in the following table (dollars in thousands):

 
September 30, 2015
 
December 31, 2014
 
Amount
 
Percent
 
Amount
 
Percent
Securities available for sale
 
 
 
 
 
 
 
U.S. Treasury
$
22,643

 
9.15
%
 
$
22,333

 
8.62
%
Other securities (FHLB, FHLMC and FNMA)
67,419

 
27.24

 
67,691

 
26.14

State and political subdivisions
157,423

 
63.61

 
168,968

 
65.24

Total securities available for sale
$
247,485

 
100.00
%
 
$
258,992

 
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, 2015 or December 31, 2014. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of September 30, 2015 and December 31, 2014 (in thousands):

 
Amortized Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
(Losses)
 
Estimated Fair
Value
September 30, 2015:
 
 
 
 
 
 
 
U.S. Treasury
$
22,385

 
$
258

 
$

 
$
22,643

Other securities (FHLB, FHLMC and FNMA)
67,095

 
335

 
(11
)
 
67,419

State and political subdivisions
155,495

 
2,210

 
(282
)
 
157,423

Total
$
244,975

 
$
2,803

 
$
(293
)
 
$
247,485

December 31, 2014:
 

 
 

 
 

 
 

U.S. Treasury
$
22,351

 
$
18

 
$
(36
)
 
$
22,333

Other securities (FHLB, FHLMC and FNMA)
67,644

 
147

 
(100
)
 
67,691

State and political subdivisions
166,925

 
2,499

 
(456
)
 
168,968

Total
$
256,920

 
$
2,664

 
$
(592
)
 
$
258,992


The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at September 30, 2015, were as follows (in thousands):
 
 
Amortized
Cost
 
Fair Value
Due in one year or less
$
31,404

 
$
31,517

Due after one year through five years
144,620

 
146,563

Due after five years through ten years
67,597

 
68,048

Due over ten years
1,354

 
1,357

Total
$
244,975

 
$
247,485


As of September 30, 2015 investment securities with a carrying value of $36.12 million were pledged to collateralize repurchase agreements, derivative financial instruments, and other 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, 2015 and December 31, 2014 (in thousands):

 
Less than 12 months
 
12 months or more
 
Total
September 30, 2015
Description of Securities
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
U.S. Treasury

 
$

 
$

 
%
 

 
$

 
$

 
%
 

 
$

 
$

 
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other securities (FHLB, FHLMC and FNMA)
4

 
9,416

 
(11
)
 
0.12

 

 

 

 

 
4

 
9,416

 
(11
)
 
0.12

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and political subdivisions
105

 
23,698

 
(178
)
 
0.75

 
27

 
5,861

 
(104
)
 
1.77

 
132

 
29,559

 
(282
)
 
0.95

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total temporarily impaired securities
109

 
$
33,114

 
$
(189
)
 
0.57
%
 
27

 
$
5,861

 
$
(104
)
 
1.77
%
 
136

 
$
38,975

 
$
(293
)
 
0.75
%

 
Less than 12 months
 
12 months or more
 
Total
December 31, 2014
Description of Securities
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
U.S. Treasury
5

 
$
12,396

 
$
(36
)
 
0.29
%
 

 
$

 
$

 
%
 
5

 
$
12,396

 
$
(36
)
 
0.29
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other securities (FHLB, FHLMC and FNMA)
10

 
24,382

 
(100
)
 
0.41

 

 

 

 

 
10

 
24,382

 
(100
)
 
0.41

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and political subdivisions
91

 
21,724

 
(124
)
 
0.57

 
78

 
16,154

 
(332
)
 
2.06

 
169

 
37,878

 
(456
)
 
1.20

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total temporarily impaired securities
106

 
$
58,502

 
$
(260
)
 
0.44
%
 
78

 
$
16,154

 
$
(332
)
 
2.06
%
 
184

 
$
74,656

 
$
(592
)
 
0.79
%

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,
2015
 
December 31,
2014
 
(Amounts In Thousands)
Agricultural
$
93,533

 
$
97,645

Commercial and financial
173,029

 
174,738

Real estate:
 
 
 
Construction, 1 to 4 family residential
54,706

 
45,949

Construction, land development and commercial
91,742

 
77,020

Mortgage, farmland
179,981

 
162,503

Mortgage, 1 to 4 family first liens
715,575

 
672,674

Mortgage, 1 to 4 family junior liens
115,657

 
110,284

Mortgage, multi-family
251,512

 
245,213

Mortgage, commercial
323,454

 
321,601

Loans to individuals
22,960

 
21,342

Obligations of state and political subdivisions
53,930

 
55,729

 
$
2,076,079

 
$
1,984,698

Net unamortized fees and costs
750

 
691

 
$
2,076,829

 
$
1,985,389

Less allowance for loan losses
25,480

 
24,020

 
$
2,051,349

 
$
1,961,369



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, 2015 were as follows:

 
Three Months Ended September 30, 2015
 
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
$
2,783

 
$
4,698

 
$
3,025

 
$
2,825

 
$
7,396

 
$
4,111

 
$
962

 
$
25,800

Charge-offs
(69
)
 
(18
)
 
(100
)
 

 
(135
)
 
(305
)
 
(137
)
 
(764
)
Recoveries
32

 
318

 
40

 

 
92

 
4

 
53

 
539

Provision
117

 
(303
)
 
(379
)
 
107

 
70

 
320

 
(27
)
 
(95
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
2,863

 
$
4,695

 
$
2,586

 
$
2,932

 
$
7,423

 
$
4,130

 
$
851

 
$
25,480




Nine Months Ended September 30, 2015
 
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
$
2,515

 
$
4,231

 
$
2,241

 
$
2,672

 
$
7,419

 
$
4,195

 
$
747

 
$
24,020

Charge-offs
(325
)
 
(334
)
 
(247
)
 

 
(803
)
 
(486
)
 
(287
)
 
(2,482
)
Recoveries
115

 
1,053

 
343

 
6

 
652

 
1,274

 
139

 
3,582

Provision
558

 
(255
)
 
249

 
254

 
155

 
(853
)
 
252

 
360

 


 


 


 


 


 


 


 


Ending balance
$
2,863

 
$
4,695

 
$
2,586

 
$
2,932

 
$
7,423

 
$
4,130

 
$
851

 
$
25,480

 


 


 


 


 


 


 


 


Ending balance, individually evaluated for impairment
$
2

 
$
471

 
$
12

 
$

 
$
102

 
$
50

 
$
26

 
$
663

 


 


 


 


 


 


 


 


Ending balance, collectively evaluated for impairment
$
2,861

 
$
4,224

 
$
2,574

 
$
2,932

 
$
7,321

 
$
4,080

 
$
825

 
$
24,817

 


 


 


 


 


 


 


 


Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
93,533

 
$
173,029

 
$
146,448

 
$
179,981

 
$
831,232

 
$
574,966

 
$
76,890

 
$
2,076,079

 


 


 


 


 


 


 


 


Ending balance, individually evaluated for impairment
$
1,611

 
$
2,364

 
$
1,231

 
$
2,298

 
$
4,259

 
$
3,069

 
$
26

 
$
14,858

 


 


 


 


 


 


 


 


Ending balance, collectively evaluated for impairment
$
91,922

 
$
170,665

 
$
145,217

 
$
177,683

 
$
826,973

 
$
571,897

 
$
76,864

 
$
2,061,221


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, 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 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, 2015 and December 31, 2014, 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, 2015
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
1,803

 
$
2,742

 
$

 
$
263

Good
11,212

 
33,727

 
2,810

 
10,841

Satisfactory
36,958

 
100,810

 
34,963

 
65,205

Monitor
14,695

 
20,543

 
10,777

 
2,721

Special Mention
26,050

 
10,846

 
5,331

 
10,179

Substandard
2,815

 
4,361

 
825

 
2,533

Total
$
93,533

 
$
173,029

 
$
54,706

 
$
91,742


 
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, 2015
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
2,783

 
$
439

 
$

 
$
6,747

Good
31,664

 
16,872

 
3,012

 
69,168

Satisfactory
106,512

 
616,904

 
104,706

 
144,510

Monitor
27,079

 
48,408

 
4,570

 
25,419

Special Mention
8,627

 
16,314

 
1,811

 
5,122

Substandard
3,316

 
16,638

 
1,558

 
546

Total
$
179,981

 
$
715,575

 
$
115,657

 
$
251,512


 
Real Estate:
Mortgage,
commercial
 
Loans to
individuals
 
Obligations of state and
political subdivisions
 
Total
September 30, 2015
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
12,733

 
$

 
$
2,385

 
$
29,895

Good
83,272

 
77

 
40,960

 
303,615

Satisfactory
187,838

 
22,228

 
10,049

 
1,430,683

Monitor
27,690

 
286

 
518

 
182,706

Special Mention
7,910

 
195

 
18

 
92,403

Substandard
4,011

 
174

 

 
36,777

Total
$
323,454

 
$
22,960

 
$
53,930

 
$
2,076,079

 

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, 2014
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
1,375

 
$
4,820

 
$

 
$
276

Good
13,214

 
37,941

 
6,893

 
13,875

Satisfactory
51,107

 
94,158

 
27,738

 
47,852

Monitor
15,243

 
20,445

 
8,435

 
2,811

Special Mention
13,070

 
11,031

 
1,881

 
11,870

Substandard
3,636

 
6,343

 
1,002

 
336

Total
$
97,645

 
$
174,738

 
$
45,949

 
$
77,020


 
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, 2014
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
2,867

 
$
474

 
$

 
$
7,011

Good
36,680

 
22,094

 
2,875

 
73,852

Satisfactory
103,552

 
571,546

 
99,095

 
111,650

Monitor
11,754

 
41,805

 
3,377

 
35,812

Special Mention
4,721

 
18,428

 
2,520

 
16,611

Substandard
2,929

 
18,327

 
2,417

 
277

Total
$
162,503

 
$
672,674

 
$
110,284

 
$
245,213


 
Real Estate:
Mortgage,
commercial
 
Loans to
individuals
 
Obligations of state and
political subdivisions
 
Total
December 31, 2014
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
15,416

 
$
87

 
$
2,440

 
$
34,766

Good
87,612

 
94

 
43,108

 
338,238

Satisfactory
178,069

 
20,465

 
10,181

 
1,315,413

Monitor
25,165

 
251

 

 
165,098

Special Mention
9,371

 
353

 

 
89,856

Substandard
5,968

 
92

 

 
41,327

Total
$
321,601

 
$
21,342

 
$
55,729

 
$
1,984,698



Page 18

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

The below are descriptions of the credit quality indicators:

Excellent – Excellent rated loans are prime quality loans covered by highly liquid collateral with generous margins or supported by superior current financial conditions reflecting substantial net worth, relative to total credit extended, and based on assets of a stable and non-speculative nature whose values can be readily verified. Identified repayment source or cash flow is abundant and assured.

Good – Good rated loans are adequately secured by readily marketable collateral or good financial condition characterized by liquidity, flexibility and sound net worth. Loans are supported by sound primary and secondary payment sources and timely and accurate financial information.

Satisfactory – Satisfactory rated loans are loans to borrowers of average financial means not especially vulnerable to changes in economic or other circumstances, where the major support for the extension is sufficient collateral of a marketable nature, and the primary source of repayment is seen to be clear and adequate.

Monitor – Monitor rated loans are identified by management as warranting special attention for a variety of reasons that may bear on ultimate collectability. This may be due to adverse trends, a particular industry, loan structure, or repayment that is dependent on projections, or a one-time occurrence.

Special Mention – Special mention rated loans are supported by a marginal payment capacity and are marginally protected by collateral.  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.

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, 2015 and December 31, 2014 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, 2015
 
 
 
 
 
 
 
 
 
 
 
 
 
Agricultural
$
263

 
$
326

 
$

 
$
589

 
$
92,944

 
$
93,533

 
$

Commercial and financial
688

 
1,182

 
172

 
2,042

 
170,987

 
173,029

 

Real estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential
192

 
214

 

 
406

 
54,300

 
54,706

 
42

Construction, land development and commercial

 
123

 
79

 
202

 
91,540

 
91,742

 
79

Mortgage, farmland
420

 

 

 
420

 
179,561

 
179,981

 

Mortgage, 1 to 4 family first liens
655

 
841

 
1,322

 
2,818

 
712,757

 
715,575

 
305

Mortgage, 1 to 4 family junior liens
205

 
68

 
140

 
413

 
115,244

 
115,657

 
105

Mortgage, multi-family
51

 

 

 
51

 
251,461

 
251,512

 

Mortgage, commercial
190

 
541

 
105

 
836

 
322,618

 
323,454

 

Loans to individuals
102

 
68

 

 
170

 
22,790

 
22,960

 

Obligations of state and political subdivisions

 

 

 

 
53,930

 
53,930

 

 
$
2,766

 
$
3,363

 
$
1,818

 
$
7,947

 
$
2,068,132

 
$
2,076,079

 
$
531

 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2014
 

 
 

 
 

 
 

 
 

 
 

 
 

Agricultural
$
310

 
$
99

 
$

 
$
409

 
$
97,236

 
$
97,645

 
$

Commercial and financial
397

 
14

 
1,048

 
1,459

 
173,279

 
174,738

 

Real estate:
 
 
 
 
 
 
 

 
 
 
 

 
 

Construction, 1 to 4 family residential

 

 

 

 
45,949

 
45,949

 

Construction, land development and commercial
937

 

 

 
937

 
$
76,083

 
77,020

 

Mortgage, farmland
753

 

 

 
753

 
161,750

 
162,503

 

Mortgage, 1 to 4 family first liens
3,594

 
1,656

 
1,582

 
6,832

 
$
665,842

 
672,674

 
348

Mortgage, 1 to 4 family junior liens
181

 
12

 
244

 
437

 
109,847

 
110,284

 

Mortgage, multi-family

 
21

 

 
21

 
$
245,192

 
245,213

 

Mortgage, commercial
359

 
557

 
34

 
950

 
320,651

 
321,601

 

Loans to individuals
27

 

 

 
27

 
$
21,315

 
21,342

 

Obligations of state and political subdivisions

 

 

 

 
55,729

 
55,729

 

 
$
6,558

 
$
2,359

 
$
2,908

 
$
11,825

 
$
1,972,873

 
$
1,984,698

 
$
348

 

Page 20

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

The Company does not have a material 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, 2015 and December 31, 2014, was as follows:

 
September 30, 2015
 
December 31, 2014
 
Non-accrual
loans (1)
 
Accruing loans
past due 90 days
or more
 
TDR loans
 
Non-
accrual
loans (1)
 
Accruing loans
past due 90 days
or more
 
TDR loans
 
(Amounts In Thousands)
 
(Amounts In Thousands)
Agricultural
$

 
$

 
$
1,611

 
$

 
$

 
$
1,942

Commercial and financial
1,717

 

 
647

 
1,343

 

 
1,366

Real estate:
 

 
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
173

 
42

 
468

 

 

 
431

Construction, land development and commercial

 
79

 
469

 
127

 

 

Mortgage, farmland

 

 
2,298

 

 

 
2,220

Mortgage, 1 to 4 family first liens
2,349

 
305

 
1,318

 
1,912

 
348

 
1,199

Mortgage, 1 to 4 family junior liens
155

 
105

 
27

 
369

 

 

Mortgage, multi-family
242

 

 

 
55

 

 
5,470

Mortgage, commercial
1,174

 

 
1,653

 
2,275

 

 
1,712

Loans to individuals

 

 

 

 

 

 
$
5,810

 
$
531

 
$
8,491

 
$
6,081

 
$
348

 
$
14,340


(1)
There were $2.72 million and $2.14 million of TDR loans included within nonaccrual loans as of September 30, 2015 and December 31, 2014, respectively.

Loans 90 days or more past due that are still accruing interest increased $0.02 million from December 31, 2014 to September 30, 2015 due to an increase in the number of loans past due greater than 90 days. As of September 30, 2015 there were 8 accruing loans past due 90 days or more. The average accruing loans past due as of September 30, 2015 are $0.07 million. The average accruing loans past due 90 days or more as of December 31, 2014 was $0.07 million. 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, 2015 and December 31, 2014:

 
September 30, 2015
 
December 31, 2014
 
Number
of
contracts
 
Recorded
investment
 
Commitments
outstanding
 
Number
of
contracts
 
Recorded
investment
 
Commitments
outstanding
 
 
 
(Amounts In Thousands)
 
 
 
(Amounts In Thousands)
Agricultural
6

 
$
1,610

 
$
118

 
9

 
$
1,942

 
$
272

Commercial and financial
10

 
2,072

 
290

 
13

 
2,202

 
53

Real estate:
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential
3

 
641

 
18

 
3

 
431

 
111

Construction, land development and commercial
2

 
469

 
4

 
1

 
127

 

Mortgage, farmland
5

 
2,298

 

 
4

 
2,220

 

Mortgage, 1 to 4 family first liens
13

 
1,536

 

 
11

 
1,467

 

Mortgage, 1 to 4 family junior liens
2

 
38

 

 
1

 
225

 
65

Mortgage, multi-family
1

 
71

 

 
2

 
5,470

 

Mortgage, commercial
10

 
2,473

 

 
8

 
2,398

 

Loans to individuals

 

 

 

 

 

 
52

 
$
11,208

 
$
430

 
52

 
$
16,482

 
$
501


The following is a summary of TDR loans that were modified during the three and nine months ended September 30, 2015:

 
Three Months Ended September 30, 2015
 
Nine Months Ended September 30, 2015
 
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)
 
 
 
(Amounts In Thousands)
Agricultural

 
$

 
$

 
5

 
$
394

 
$
278

Commercial and financial
1

 
486

 
486

 
2

 
677

 
663

Real estate:
 

 
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
1

 
276

 
276

 

 
276

 
276

Construction, land development and commercial
1

 
350

 
350

 

 
350

 
350

Mortgage, farmland






3


644


531

Mortgage, 1 to 4 family first lien

 

 

 
4

 
264

 
264

Mortgage, 1 to 4 family junior liens

 

 

 
2

 
42

 
42

Mortgage, multi-family

 

 

 
1

 
71

 
71

Mortgage, commercial

 

 

 
2

 
222

 
190

 
3

 
$
1,112

 
$
1,112

 
19

 
$
2,940

 
$
2,665



Page 22

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

The Company had commitments to lend $0.43 million in additional borrowings to restructured loan customers as of September 30, 2015.  The Company had commitments to lend $0.50 million in additional borrowings to restructured loan customers as of December 31, 2014.  These commitments were in the normal course of business.  The additional borrowings were not used to facilitate payments on these loans.

There were $0.00 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, 2015 and December 31, 2014.





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, 2015 is as follows:
 
September 30, 2015
 
Three Months Ended 
 September 30, 2015
 
Nine Months Ended 
 September 30, 2015
 
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
$
1,507

 
$
1,669

 
$

 
$
1,462

 
$
18

 
$
1,569

 
$
58

Commercial and financial
1,353

 
2,003

 

 
1,371

 
1

 
1,472

 
4

Real estate:
 

 
 

 
 

 
 

 
 
 
 
 
 
Construction, 1 to 4 family residential
192

 
192

 

 
190

 
2

 
140

 
2

Construction, land development and commercial
469

 
563

 

 
296

 
3

 
298

 
7

Mortgage, farmland
2,298

 
2,412

 

 
2,306

 
28

 
2,338

 
83

Mortgage, 1 to 4 family first liens
3,123

 
3,846

 

 
3,145

 
12

 
3,291

 
38

Mortgage, 1 to 4 family junior liens
120

 
414

 

 
122

 

 
132

 

Mortgage, multi-family
171

 
230

 

 
175

 

 
182

 

Mortgage, commercial
2,105

 
3,326

 

 
2,129

 
12

 
2,158

 
36

Loans to individuals

 
20

 

 

 

 

 

 
$
11,338

 
$
14,675

 
$

 
$
11,196

 
$
76

 
$
11,580

 
$
228

 
 
 
 
 
 
 
 
 
 
 
 
 
 
With an allowance recorded:
 

 
 

 
 

 
 

 
 

 
 
 
 
Agricultural
$
104

 
$
104

 
$
2

 
$
105

 
$
1

 
$
107

 
$
3

Commercial and financial
1,011

 
1,011

 
471

 
1,044

 
7

 
1,072

 
23

Real estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential
491

 
502

 
11

 
491

 
4

 
480

 
7

Construction, land development and commercial
79

 
79

 
1

 
79

 
1

 
77

 
3

Mortgage, farmland

 

 

 

 

 

 

Mortgage, 1 to 4 family first liens
849

 
879

 
93

 
854

 
7

 
856

 
21

Mortgage, 1 to 4 family junior liens
167

 
167

 
9

 
167

 
1

 
149

 
4

Mortgage, multi-family
71

 
109

 
7

 
71

 

 
91

 

Mortgage, commercial
722

 
722

 
43

 
726

 
9

 
734

 
27

Loans to individuals
26

 
26

 
26

 
20

 
1

 
14

 
1

 
$
3,520

 
$
3,599

 
$
663

 
$
3,557

 
$
31

 
$
3,580

 
$
89

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total:
 

 
 

 
 

 
 

 
 

 
 
 
 
Agricultural
$
1,611

 
$
1,773

 
$
2

 
$
1,567

 
$
19

 
$
1,676

 
$
61

Commercial and financial
2,364

 
3,014

 
471

 
2,415

 
8

 
2,544

 
27

Real estate:
 

 
 

 
 

 
 

 
 

 
 
 
 
Construction, 1 to 4 family residential
683

 
694

 
11

 
681

 
6

 
620

 
9

Construction, land development and commercial
548

 
642

 
1

 
375

 
4

 
375

 
10

Mortgage, farmland
2,298

 
2,412

 

 
2,306

 
28

 
2,338

 
83

Mortgage, 1 to 4 family first liens
3,972

 
4,725

 
93

 
3,999

 
19

 
4,147

 
59

Mortgage, 1 to 4 family junior liens
287

 
581

 
9

 
289

 
1

 
281

 
4

Mortgage, multi-family
242

 
339

 
7

 
246

 

 
273

 

Mortgage, commercial
2,827

 
4,048

 
43

 
2,855

 
21

 
2,892

 
63

Loans to individuals
26

 
46

 
26

 
20

 
1

 
14

 
1

 
$
14,858

 
$
18,274

 
$
663

 
$
14,753

 
$
107

 
$
15,160

 
$
317


Page 24

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

Information regarding impaired loans as of December 31, 2014 is as follows:

 
Recorded
Investment
 
Unpaid Principal
Balance
 
Related
Allowance
With no related allowance recorded:
(Amounts In Thousands)
Agricultural
$
1,634

 
$
1,696

 
$

Commercial and financial
2,076

 
3,695

 

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
89

 
89

 

Construction, land development and commercial
128

 
220

 

Mortgage, farmland
2,040

 
2,040

 

Mortgage, 1 to 4 family first liens
2,951

 
3,705

 

Mortgage, 1 to 4 family junior liens
369

 
673

 

Mortgage, multi-family
5,525

 
5,632

 

Mortgage, commercial
3,290

 
4,588

 

Loans to individuals

 
20

 

 
$
18,102

 
$
22,358

 
$

 
 
 
 
 
 
With an allowance recorded:
 

 
 

 
 

Agricultural
$
210

 
$
247

 
$
44

Commercial and financial
633

 
633

 
9

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
343

 
354

 
28

Construction, land development and commercial

 

 

Mortgage, farmland
278

 
278

 
12

Mortgage, 1 to 4 family first liens
506

 
596

 
52

Mortgage, 1 to 4 family junior liens

 

 

Mortgage, multi-family

 

 

Mortgage, commercial
697

 
697

 
9

Loans to individuals

 

 

 
$
2,667

 
$
2,805

 
$
154

 
 
 
 
 
 
Total:
 

 
 

 
 

Agricultural
$
1,844

 
$
1,943

 
$
44

Commercial and financial
2,709

 
4,328

 
9

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
432

 
443

 
28

Construction, land development and commercial
128

 
220

 

Mortgage, farmland
2,318

 
2,318

 
12

Mortgage, 1 to 4 family first liens
3,457

 
4,301

 
52

Mortgage, 1 to 4 family junior liens
369

 
673

 

Mortgage, multi-family
5,525

 
5,632

 

Mortgage, commercial
3,987

 
5,285

 
9

Loans to individuals

 
20

 

 
$
20,769

 
$
25,163

 
$
154



Page 25

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

Impaired loans decreased $5.94 million from December 31, 2014 to September 30, 2015.  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 0.71% of loans held for investment as of September 30, 2015 and 1.05% as of December 31, 2014.  The decrease in impaired loans is due mainly to a decrease in nonaccrual loans of $0.27 million and a decrease in TDR loans of $5.85 million from December 31, 2014 to September 30, 2015.

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, 2015 are as follows:
 
September 30, 2015
 
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
$
33,985

 
$
33,985

 
$
33,985

 
$

 
$

Investment securities
257,126

 
257,126

 

 
257,126

 

Loans held for sale
4,395

 
4,395

 

 
4,395

 

Loans
 

 
 

 
 

 
 

 
 

Agricultural
90,670

 
90,740

 

 

 
90,740

Commercial and financial
168,334

 
168,794

 

 

 
168,794

Real estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
53,746

 
53,722

 

 

 
53,722

Construction, land development and commercial
90,116

 
90,077

 

 

 
90,077

Mortgage, farmland
177,049

 
177,168

 

 

 
177,168

Mortgage, 1 to 4 family first liens
709,309

 
708,961

 

 

 
708,961

Mortgage, 1 to 4 family junior liens
114,500

 
119,346

 

 

 
119,346

Mortgage, multi-family
249,974

 
252,792

 

 

 
252,792

Mortgage, commercial
320,862

 
320,030

 

 

 
320,030

Loans to individuals
22,514

 
22,491

 

 

 
22,491

Obligations of state and political subdivisions
53,525

 
53,313

 

 

 
53,313

Accrued interest receivable
9,700

 
9,700

 

 
9,700

 

Total financial instrument assets
$
2,355,805

 
$
2,362,640

 
$
33,985

 
$
271,221

 
$
2,057,434

Financial instrument liabilities
 

 
 

 
 

 
 

 
 

Deposits
 

 
 

 
 

 
 

 
 

Noninterest-bearing deposits
$
297,676

 
$
297,676

 
$

 
$
297,676

 
$

Interest-bearing deposits
1,591,300

 
1,592,144

 

 
1,592,144

 

Other borrowings
36,124

 
36,124

 

 
36,124

 

Federal Home Loan Bank borrowings
170,000

 
174,864

 

 
174,864

 

Interest rate swaps
4,685

 
4,685

 

 
4,685

 

Accrued interest payable
750

 
750

 

 
750

 

Total financial instrument liabilities
$
2,100,535

 
$
2,106,243

 
$

 
$
2,106,243

 
$

 
 
 
 
 
 
 
 
 
 
 
Face Amount
 
 

 
 

 
 

 
 

Financial instrument with off-balance sheet risk:
 

 
 

 
 

 
 

 
 

Loan commitments
$
375,418

 
$

 
$

 
$

 
$

Letters of credit
8,959

 

 

 

 

Total financial instrument liabilities with off-balance-sheet risk
$
384,377

 
$

 
$

 
$

 
$

(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, 2014 are as follows:

 
December 31, 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
$
29,174

 
$
29,174

 
$
29,174

 
$

 
$

Investment securities
267,240

 
267,240

 

 
267,240

 

Loans held for sale
4,476

 
4,476

 

 
4,476

 

Loans
 

 
 

 
 

 
 

 
 

Agricultural
95,130

 
95,126

 

 

 
95,126

Commercial and financial
170,507

 
171,081

 

 

 
171,081

Real estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
45,139

 
45,159

 

 

 
45,159

Construction, land development and commercial
75,589

 
75,623

 

 

 
75,623

Mortgage, farmland
159,831

 
159,623

 

 

 
159,623

Mortgage, 1 to 4 family first liens
666,406

 
665,428

 

 

 
665,428

Mortgage, 1 to 4 family junior liens
109,133

 
115,726

 

 

 
115,726

Mortgage, multi-family
243,723

 
246,191

 

 

 
246,191

Mortgage, commercial
318,896

 
318,211

 

 

 
318,211

Loans to individuals
21,043

 
21,016

 

 

 
21,016

Obligations of state and political subdivisions
55,281

 
54,800

 

 

 
54,800

Accrued interest receivable
8,276

 
8,276

 

 
8,276

 

Total financial instrument assets
$
2,269,844

 
$
2,277,150

 
$
29,174

 
$
279,992

 
$
1,967,984

Financial instrument liabilities:
 

 
 

 
 

 
 

 
 

Deposits
 

 
 

 
 

 
 

 
 

Noninterest-bearing deposits
$
288,718

 
$
288,718

 
$

 
$
288,718

 
$

Interest-bearing deposits
1,546,351

 
1,550,974

 

 
1,550,974

 

Other borrowings
47,499

 
47,499

 

 
47,499

 

Federal Home Loan Bank borrowings
140,000

 
145,210

 

 
145,210

 

Interest rate swaps
2,796

 
2,796

 

 
2,796

 

Accrued interest payable
902

 
902

 

 
902

 

Total financial instrument liabilities
$
2,026,266

 
$
2,036,099

 
$

 
$
2,036,099

 
$

 
 
 
 
 
 
 
 
 
 
 
Face Amount
 
 

 
 

 
 

 
 

Financial instrument with off-balance sheet risk:
 

 
 

 
 

 
 

 
 

Loan commitments
$
334,100

 
$

 
$

 
$

 
$

Letters of credit
12,437

 

 

 

 

Total financial instrument liabilities with off-balance-sheet risk
$
346,537

 
$

 
$

 
$

 
$

 
(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, 2015.   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.

Other borrowings:  Other 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). Other 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 analysis, 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.

Interest Rate Swap Agreements: The fair value is estimated using forward-looking interest rate curves and is calculated using discounted cash flows that are observable or that can be corroborated by observable market data (Level 2).

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, 2015
 
Readily
Available
Market
Prices(1)
 
Observable
Market Prices(2)
 
Company
Determined
Market
Prices(3)
 
Total at Fair
Value
Securities available for sale
(Amounts In Thousands)
U.S. Treasury
$

 
$
22,643

 
$

 
$
22,643

State and political subdivisions

 
157,423

 

 
157,423

Other securities (FHLB, FHLMC and FNMA)

 
67,419

 

 
67,419

Derivative Financial Instruments
 
 
 
 
 
 
 
Interest rate swaps
$

 
(4,685
)
 
$

 
(4,685
)
Total
$

 
$
242,800

 
$

 
$
242,800


 
December 31, 2014
 
Readily
Available
Market
Prices(1)
 
Observable
Market Prices(2)
 
Company
Determined
Market
Prices(3)
 
Total at Fair
Value
Securities available for sale
(Amounts In Thousands)
U.S. Treasury
$

 
$
22,333

 
$

 
$
22,333

State and political subdivisions

 
168,968

 

 
168,968

Other securities (FHLB, FHLMC and FNMA)

 
67,691

 

 
67,691

Derivative Financial Instruments
 
 
 
 
 
 
 
Interest rate swaps

 
(2,796
)
 

 
(2,796
)
Total
$

 
$
256,196

 
$

 
$
256,196

 
(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, 2015 and the year ended December 31, 2014.



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, 2015
 
Three Months Ended September 30, 2015
 
Nine Months Ended September 30, 2015
 
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
$

 
$

 
$
1,409

 
$
1,409

 
$

 
$
116

Commercial and financial

 

 
1,251

 
1,251

 
11

 
39

Real Estate:
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential

 

 
440

 
440

 
100

 
161

Construction, land development and commercial

 

 
345

 
345

 

 

Mortgage, farmland

 

 
2,298

 
2,298

 

 

Mortgage, 1 to 4 family first liens

 

 
3,036

 
3,036

 
106

 
441

Mortgage, 1 to 4 family junior liens

 

 
175

 
175

 
3

 
152

Mortgage, multi-family

 

 
236

 
236

 

 
38

Mortgage, commercial

 

 
997

 
997

 

 
140

Loans to individuals

 

 

 

 

 

Foreclosed assets (5)

 

 
303

 
303

 
19

 
59

Total
$

 
$

 
$
10,490

 
$
10,490

 
$
239

 
$
1,146

 
(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, 2014
 
Year Ended December 31, 2014
 
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
$

 
$

 
$
1,679

 
$
1,679

 
$
25

Commercial and financial

 

 
1,709

 
1,709

 
206

Real Estate:
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential

 

 
315

 
315

 

Construction, land development and commercial

 

 

 

 

Mortgage, farmland

 

 
2,040

 
2,040

 

Mortgage, 1 to 4 family first liens

 

 
2,500

 
2,500

 
576

Mortgage, 1 to 4 family junior liens

 

 
369

 
369

 
24

Mortgage, multi-family

 

 
5,525

 
5,525

 

Mortgage, commercial

 

 
1,918

 
1,918

 
328

Loans to individuals

 

 

 

 

Foreclosed assets (5)

 

 
301

 
301

 
210

Total
$

 
$

 
$
16,356

 
$
16,356

 
$
1,369


(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 1,500,000 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, 2016.  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 851,132 shares of its common stock in privately negotiated transactions from August 1, 2005 through September 30, 2015.  Of these 851,132 shares, 33,679 shares were purchased during the quarter ended September 30, 2015, at an average price per share of $43.32.

Page 33

Index


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 $76.29 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, 2015 and December 31, 2014 is as follows:
 
 
September 30, 2015
 
December 31, 2014
 
(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
 
 
 
Home equity loans
$
42,856

 
$
40,484

Credit cards
40,984

 
46,573

Commercial, real estate and home construction
103,993

 
81,613

Commercial lines and real estate purchase loans
187,585

 
165,430

Outstanding letters of credit
8,959

 
12,437

 
Note 9.
Income Taxes

Federal income tax expense for the nine months ended September 30, 2015 and 2014 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, 2014, 2013, and 2012 remain subject to examination by the Internal Revenue Service.  For state tax purposes, the tax years ended December 31, 2014, 2013, and 2012 remain open for examination.  There were no material unrecognized tax benefits at September 30, 2015  and December 31, 2014 and therefore no interest or penalties on unrecognized tax benefits has been recorded.  As of September 30, 2015, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending March 31, 2016.

Income taxes as a percentage of income before taxes were 30.68% for the nine months ended September 30, 2015 and 29.66% for the same period in 2014.  The 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 2015.


Page 34

Index
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 $4.69 million of collateral as of September 30, 2015.

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, 2015 and December 31, 2014:

 
Notional
Amount
 
Fair
Value
 
Balance
Sheet
Category
 
Maturity
 
(Amounts in Thousands)
 
 
September 30, 2015
 
 
 
 
 
 
    
Interest rate swap
$
25,000

 
$
(1,781
)
 
Other Liabilities
 
11/9/2020
Interest rate swap
25,000

 
(2,905
)
 
Other Liabilities
 
11/7/2023
 
 
 
 
 
 
 
 
December 31, 2014
 

 
 

 
 
 
    
Interest rate swap
$
25,000

 
$
(864
)
 
Other Liabilities
 
11/9/2020
Interest rate swap
25,000

 
(1,932
)
 
Other Liabilities
 
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, 2015 and December 31, 2014:

 
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, 2015
 
 
 
 
 
 
 
 
 
Interest rate swap
$
(566
)
 
Interest Expense
 
$

 
Other Income
 
$

Interest rate swap
(600
)
 
Interest Expense
 

 
Other Income
 

 
 
 
 
 
 
 
 
 
 
December 31, 2014
 

 
 
 
 

 
 
 
 

Interest rate swap
$
(754
)
 
Interest Expense
 
$

 
Other Income
 
$

Interest rate swap
(1,448
)
 
Interest Expense
 

 
Other Income
 


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.


Page 36

Index

HILLS BANCORPORATION

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.

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.


Page 37

Index

HILLS BANCORPORATION

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, 2015 and December 31, 2014 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, Marion, and Washington, Iowa.  At September 30, 2015, the Bank has eighteen full-service locations.

Net income for the nine month period ended September 30, 2015 was $22.54 million compared to $21.82 million for the same nine months of 2014, an increase of 3.26%.  The $0.71 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 2015 are an increase in net interest income of $4.71 million and an increase in noninterest income of $1.10 million.  These changes were offset by an increase in income tax expense of $0.77 million, an increase in noninterest expenses of $2.76 million, and an increase in the provision for loan losses of $1.57 million.

The Company achieved a return on average assets of 1.19% and a return on average equity of 10.73% for the twelve months ended September 30, 2015, compared to the twelve months ended September 30, 2014, which were 1.26% and 11.22%, respectively.  Dividends of $0.625 per share were paid in January 2015 to 2,284 shareholders.  The 2014 dividend was $0.575 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 3.53% for the nine months ended September 30, 2015 compared to 3.49% for the same nine months of 2014.  Average earning assets were $2.260 billion year to date in 2015 and $2.106 billion in 2014.


Page 38

Index

HILLS BANCORPORATION

Highlights noted on the balance sheet as of September 30, 2015 for the Company included the following:

Total assets were $2.425 billion, an increase of $90.69 million since December 31, 2014.
Cash and cash equivalents were $33.99 million, an increase of $4.81 million since December 31, 2014.
Net loans were $2.056 billion, an increase of $89.90 million since December 31, 2014.  Loans held for sale decreased $0.08 million since December 31, 2014.
Deposits increased $53.91 million since December 31, 2014. Deposit growth included approximately $75.00 million of temporary public funds.
Federal Home Loan Bank borrowings increased $30.00 million since December 31, 2014.

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, 2015 and December 31, 2014:

 
September 30, 2015
 
December 31, 2014
 
Amount
 
Percent
 
Amount
 
Percent
 
(Amounts In Thousands)
 
(Amounts In Thousands)
Agricultural
$
93,533

 
4.51
%
 
$
97,645

 
4.92
%
Commercial and financial
173,029

 
8.33

 
174,738

 
8.80

Real estate:
 

 


 
 

 
 

Construction, 1 to 4 family residential
54,706

 
2.64

 
45,949

 
2.32

Construction, land development and commercial
91,742

 
4.42

 
77,020

 
3.88

Mortgage, farmland
179,981

 
8.67

 
162,503

 
8.19

Mortgage, 1 to 4 family first liens
715,575

 
34.46

 
672,674

 
33.88

Mortgage, 1 to 4 family junior liens
115,657

 
5.57

 
110,284

 
5.56

Mortgage, multi-family
251,512

 
12.11

 
245,213

 
12.36

Mortgage, commercial
323,454

 
15.58

 
321,601

 
16.20

Loans to individuals
22,960

 
1.11

 
21,342

 
1.08

Obligations of state and political subdivisions
53,930

 
2.60

 
55,729

 
2.81

 
$
2,076,079

 
100.00
%
 
$
1,984,698

 
100.00
%
Net unamortized fees and costs
750

 
 

 
691

 
 

 
$
2,076,829

 
 

 
$
1,985,389

 
 

Less allowance for loan losses
25,480

 
 

 
24,020

 
 

 
$
2,051,349

 
 

 
$
1,961,369

 
 



Page 39

Index

HILLS BANCORPORATION

Loan demand has been steady and is expected to remain steady or increase throughout the year ending December 31, 2015 and into 2016.  As indicated in the table above growth in the construction, farmland and 1 to 4 family real estate loans 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.


Page 40

Index

HILLS BANCORPORATION

The following table presents the allowance for loan losses on loans by loan category, the percentage of the allowance for each category to the total allowance, and the percentage of all loans in each category to total loans as of September 30, 2015 and December 31, 2014:
 
 
September 30, 2015
 
December 31, 2014
 
Amount
 
% of Total
Allowance
 
% of Loans to
Total Loans
 
Amount
 
% of Total
Allowance
 
% of Loans to
Total Loans
 
(In Thousands)
 
 
 
 
 
(In Thousands)
 
 
 
 
Agricultural
$
2,863

 
11.24
%
 
4.51
%
 
$
2,515

 
10.47
%
 
4.92
%
Commercial and financial
4,695

 
18.43

 
8.33

 
4,231

 
17.61

 
8.80

Real estate:
 

 
 
 
 
 
 

 
 

 
 

Construction, 1 to 4 family residential
960

 
3.77

 
2.64

 
810

 
3.37

 
2.32

Construction, land development and commercial
1,626

 
6.38

 
4.42

 
1,431

 
5.96

 
3.88

Mortgage, farmland
2,932

 
11.51

 
8.67

 
2,672

 
11.12

 
8.19

Mortgage, 1 to 4 family first liens
6,266

 
24.59

 
34.46

 
6,268

 
26.11

 
33.88

Mortgage, 1 to 4 family junior liens
1,157

 
4.54

 
5.57

 
1,151

 
4.79

 
5.56

Mortgage, multi-family
1,538

 
6.03

 
12.11

 
1,490

 
6.20

 
12.36

Mortgage, commercial
2,592

 
10.17

 
15.58

 
2,705

 
11.26

 
16.20

Loans to individuals
446

 
1.75

 
1.11

 
299

 
1.24

 
1.08

Obligations of state and political subdivisions
405

 
1.59

 
2.60

 
448

 
1.87

 
2.81

 
$
25,480

 
100.00
%
 
100.00
%
 
$
24,020

 
100.00
%
 
100.00
%

The allowance for loan losses totaled $25.48 million at September 30, 2015 compared to $24.02 million at December 31, 2014.  The percentage of the allowance to outstanding loans was 1.23% and 1.21% at September 30, 2015 and December 31, 2014, 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 increase in the allowance in 2015 is the result of an increase in net loans and 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, 2015, 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.

Page 41

Index

HILLS BANCORPORATION


Investment securities available for sale held by the Company decreased by $11.51 million from December 31, 2014 to September 30, 2015.  The fair value of securities available for sale was $2.51 million more than the amortized cost of such securities as of September 30, 2015.  At December 31, 2014, the fair value of the securities available for sale was $2.07 million more than the amortized cost of such securities.

Deposits increased $53.91 million in the first nine months of 2015. Deposit growth included approximately $75.00 million of temporary public funds. Repurchase agreements decreased $11.38 million and Federal Home Loan Bank borrowings increased $30.00 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 $58.37 million as of September 30, 2015 with an average rate of 0.40%.  Brokered deposits were $64.49 million as of December 31, 2014 with an average interest rate of 0.39%. As of September 30, 2015 and December 31, 2014, brokered deposits were 3.09% and 3.51% of total deposits, respectively.

Dividends and Equity

In January 2015, Hills Bancorporation paid a dividend of $5.85 million or $0.625 per share.  The dividend was $0.575 per share in January 2014.  After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of September 30, 2015 totaled $268.13 million. On January 1, 2015, the final rules of the Federal Reserve Board went into effect implementing in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Under the final rule, minimum requirements increased for both the quality and quantity of capital held by banking organizations. The rule requires a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.50% and a common equity tier 1 capital conservation buffer of 2.50% of risk-weighted assets that will apply to all supervised financial institutions. The rule also raises the minimum ratio of tier 1 capital to risk-weighted assets from 4.00% to 6.00% and includes a minimum leverage ratio of 4.00% for all banking organizations.

The Company continues to be well-capitalized in accordance with Federal regulatory capital requirements as the capital ratios below show:

 
September 30, 2015
Common equity tier 1 capital ratio
14.59
%
Tier 1 capital ratio
14.59
%
Total capital ratio
15.81
%
Leverage ratio
12.66
%



Page 42

Index

HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2015 and 2014

Net Income Overview

Net income increased $0.71 million for the nine months ended September 30, 2015 compared to the first nine months of 2014.  Total net income was $22.54 million in 2015 and $21.82 million in the comparable period in 2014, an increase of 3.26%.  The changes in net income in 2015 from the first nine months of 2014 were primarily the result of the following:

Net interest income increased by $4.71 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 increased by $1.57 million.
Noninterest income increased by $1.10 million.
Noninterest expenses increased by $2.76 million.
Income tax expense increased by $0.77 million.
 
For the nine month period ended September 30, 2015 and September 30, 2014 basic earning per share was $2.41 and $2.33, respectively. Diluted earnings per share was $2.41 for the nine months ended September 30, 2015 compared to $2.32 for the same period in 2014.

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 $57.53 million for the first nine months of 2015 was derived from the Company’s $2.260 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.53%.  Average earning assets in the nine months ended September 30, 2014 were $2.106 billion and the tax-equivalent net interest margin was 3.49%.  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 $1.70 million change in income before income taxes in the nine month period ended September 30, 2015.  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 net interest compression to continue 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 $2.056 billion at September 30, 2015.  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 an expense of $0.36 million in 2015 compared to a reduction of expense of $1.21 million in 2014.  The Company believes that the provision for loan losses will steadily increase for the foreseeable future resulting from projected increases in the size of the Company’s loan portfolio.

The third significant factor affecting the Company’s net income is income tax expense.  Federal and state income tax expenses were $9.97 million and $9.20 million for the nine months ended September 30, 2015 and 2014, respectively.  Income taxes as a percentage of income before taxes were 30.68% in 2015 and 29.66% in 2014.


Page 43

Index

HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2015 and 2014

Net Interest Income

Net interest income increased for the nine months ended September 30, 2015 compared to the comparable period in 2014.  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 2015 was 3.53% compared to 3.49% in 2014 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 2015 compared to the comparable period in 2014 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
$
146,868

 
(0.03
)%
 
$
7,164

 
$
(2,763
)
 
$
4,401

Taxable securities
3,655

 
0.08

 
72

 
20

 
92

Nontaxable securities
10,049

 
(0.27
)
 
261

 
(322
)
 
(61
)
Federal funds sold
(6,702
)
 

 
(12
)
 

 
(12
)
 
$
153,870

 
 

 
$
7,485

 
$
(3,065
)
 
$
4,420

 
 
 
 
 
 
 
 
 
 
Interest expense:
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
$
57,245

 
 %
 
$
(65
)
 
$
9

 
$
(56
)
Savings deposits
38,017

 
(0.01
)
 
(54
)
 
36

 
(18
)
Time deposits
(26,164
)
 
(0.16
)
 
290

 
572

 
862

Other borrowings
7,547

 
(0.01
)
 
(24
)
 
11

 
(13
)
FHLB borrowings
22,554

 
(0.26
)
 
(754
)
 
288

 
(466
)
Interest-bearing other liabilities
(48
)
 
0.23

 

 
(4
)
 
(4
)
 
$
99,151

 
 

 
$
(607
)
 
$
912

 
$
305

Change in net interest income
 

 
 

 
$
6,878

 
$
(2,153
)
 
$
4,725


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)
 
2015
 
2014
Yield on average interest-earning assets
 
4.18
%
 
4.20
%
Rate on average interest-bearing liabilities
 
0.83

 
0.91

Net interest spread
 
3.35
%
 
3.29
%
Effect of noninterest-bearing funds
 
0.18

 
0.20

Net interest margin (tax equivalent interest income divided by average interest-earning assets)
 
3.53
%
 
3.49
%

Page 44

Index

HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2015 and 2014

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates.  The Federal Open Market Committee met six times during the first nine months of 2015.  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, 2015, the rate indexes for the one, three and five year indexes were 0.34%, 0.99% and 1.47%, respectively.  The one year index increased 240.00% from 0.10% at September 30, 2014, the three year index decreased 6.60% and the five year index decreased 17.88%.  The three year index was 1.06% and the five year index was 1.79% at September 30, 2014.  The targeted federal funds rate was 0.25% at September 30, 2015 and 2014.  The Company anticipates possible increases in short term and long term rates in the indexes for 2015.

Provision for Loan Losses

The provision for loan losses was an expense of $0.36 million for the nine months ended September 30, 2015 compared to a reduction of expense of $1.21 million in 2014, an expense increase of $1.57 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 increase in expense in 2015 is the result of an increase in net loans and a change in the composition and allocation of loans within credit quality ratings.

The allowance for loan losses increased $1.46 million during the first nine months of 2015.  In the first nine months of 2015, there was an increase of $0.18 million due to the volume and composition of loans outstanding and a $1.28 million increase in the amount allocated to the allowance due to credit quality.

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, 2015 and 2014, recoveries were $3.58 million and $1.57 million, respectively; and charge-offs were $2.48 million in 2015 and $1.57 million in 2014.  The allowance for loan losses totaled $25.48 million at September 30, 2015 compared to $24.02 million at December 31, 2014.  The allowance represented 1.23% and 1.21% of loans held for investment at September 30, 2015 and December 31, 2014.





Page 45

Index

HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2015 and 2014

Noninterest Income

The following table sets forth the various categories of noninterest income for the nine months ended September 30, 2015 and 2014.

 
Nine Months Ended September 30,
 
 
 
 
 
2015
 
2014
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Net gain on sale of loans
$
1,144

 
$
638

 
$
506

 
79.31
 %
Trust fees
4,920

 
4,494

 
426

 
9.48

Service charges and fees
6,151

 
6,001

 
150

 
2.50

Rental revenue on tax credit real estate
1,296

 
1,112

 
184

 
16.55

Net gain on sale of other real estate owned and other repossessed assets
139

 
426

 
(287
)
 
(67.37
)
Other noninterest income
2,064

 
1,944

 
120

 
6.17

 
$
15,714

 
$
14,615

 
$
1,099

 
7.52


Loans originated for sale in the first nine months of 2015 totaled $133.52 million compared to $80.80 million in the same period in 2014, an increase of 65.25%.  In the nine months ended September 30, 2015 and 2014, the net gain on sale of loans was $$1.14 million and $0.64 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.

The net gain on sale of other real estate owned and other repossessed assets decreased $0.29 million to a net gain of $0.14 million for the nine months ended September 30, 2015.  The total net gain on sale of other real estate owned for the nine months ended consisted of a $0.20 million net gain on the sale of 13 properties offset by a $0.06 million fair market value adjustment on 4 properties.  During the same period in 2014, the gain consisted of a $0.50 million net gain on sale of 13 properties offset by a $0.07 million fair market value adjustment on one property.

Trust fees increased $0.43 million in the nine months ended September 30, 2015 compared to September 30, 2014 due to new trust relationships.


Page 46

Index

HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2015 and 2014

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the nine months ended September 30, 2015 and 2014.

 
Nine Months Ended September 30,
 
 
 
 
 
2015
 
2014
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Salaries and employee benefits
$
20,700

 
$
19,042

 
$
1,658

 
8.71
 %
Occupancy
2,887

 
2,900

 
(13
)
 
(0.45
)
Furniture and equipment
3,911

 
3,685

 
226

 
6.13

Office supplies and postage
1,311

 
1,157

 
154

 
13.31

Advertising and business development
2,547

 
2,216

 
331

 
14.94

Outside services
5,203

 
4,981

 
222

 
4.46

Rental expenses on tax credit real estate
1,719

 
1,635

 
84

 
5.14

FDIC insurance assessment
866

 
823

 
43

 
5.22

Other noninterest expense
1,231

 
1,177

 
54

 
4.59

 
$
40,375

 
$
37,616

 
$
2,759

 
7.33


In the nine months ended September 30, 2015 and 2014, salaries and employee benefits expense increased $1.66 million. The increase is primarily the result of annual salary adjustments and additional employees.

Advertising and business development expense increased $0.33 million in the first nine months of 2015 compared to 2014 as a result of $0.37 million increase in business and product promotions.  Other noninterest expense categories experienced marginal period-to-period fluctuations for the nine months ended September 30, 2015.


Page 47

Index

HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2015 and 2014

Net Income Overview

Net income decreased $0.21 million for the three months ended September 30, 2015 compared to the same period in 2014.  Total net income was $7.69 million in 2015 and $7.90 million in the comparable period in 2014, a decrease of 2.71%.  For the three month period ended September 30, 2015 and September 30, 2014 basic earning per share was $0.82 and $0.85, respectively. Diluted earnings per share was $0.82 for the three months ended September 30, 2015 compared to $0.84 for the same period in 2014.

Net Interest Income

Net interest income increased for the three months ended September 30, 2015 compared to the comparable period in 2014.  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, 2015 was 3.52% compared to 3.49% in 2014 for the same period.  The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable.  The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2015 compared to the comparable period in 2014 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
$
144,980

 
(0.02
)%
 
$
2,462

 
$
(982
)
 
$
1,480

Taxable securities
6,690

 
0.11

 
29

 
17

 
46

Nontaxable securities
3,175

 
(0.18
)
 
27

 
(69
)
 
(42
)
Federal funds sold
(2,940
)
 
0.01

 
(1
)
 

 
(1
)
 
$
151,905

 
 

 
$
2,517

 
$
(1,034
)
 
$
1,483

 
 
 
 
 
 
 
 
 
 
Interest expense:
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
$
60,705

 
 %
 
$
(21
)
 
$
(10
)
 
$
(31
)
Savings deposits
28,175

 
0.01

 
(11
)
 
(11
)
 
(22
)
Time deposits
(36,890
)
 
(0.16
)
 
133

 
192

 
325

Short-term borrowings
10,725

 
0.01

 
(10
)
 
2

 
(8
)
FHLB borrowings
38,226

 
(0.37
)
 
(431
)
 
154

 
(277
)
Interest-bearing other liabilities
(47
)
 
(0.52
)
 

 
3

 
3

 
$
100,894

 
 
 
$
(340
)
 
$
330

 
$
(10
)
Change in net interest income
 

 
 

 
$
2,177

 
$
(704
)
 
$
1,473


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.



Page 48

Index

HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2015 and 2014

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

(Tax Equivalent Basis)
 
2015
 
2014
Yield on average interest-earning assets
 
4.16
%
 
4.18
%
Rate on average interest-bearing liabilities
 
0.83

 
0.88

Net interest spread
 
3.33
%
 
3.30
%
Effect of noninterest-bearing funds
 
0.19

 
0.19

Net interest margin (tax equivalent interest income divided by average interest-earning assets)
 
3.52
%
 
3.49
%

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $0.10 million for the three months ended September 30, 2015 compared to a reduction of expense of $1.01 million in 2014, an expense increase of $0.91 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 $0.32 million during the three months ended September 30, 2015.  In the three months ended September 30, 2015, there was a decrease of $0.28 million due to the composition of loans outstanding and a $0.04 million decrease in the amount allocated to the allowance due to 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, 2015 and 2014, recoveries were $0.54 million and $0.74 million, respectively; and charge-offs were $0.76 million in 2015 and $0.58 million in 2014.  The allowance for loan losses totaled $25.48 million at September 30, 2015 compared to $24.02 million at December 31, 2014.  The allowance represented 1.23% and 1.21% of loans held for investment at September 30, 2015 and December 31, 2014, respectively.





Page 49

Index

HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2015 and 2014

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended September 30, 2015 and 2014.

 
Three Months Ended September 30,
 
 
 
 
 
2015
 
2014
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Net gain on sale of loans
$
396

 
$
338

 
$
58

 
17.16
 %
Trust fees
1,672

 
1,595

 
77

 
4.83

Service charges and fees
2,124

 
2,152

 
(28
)
 
(1.30
)
Rental revenue on tax credit real estate
392

 
377

 
15

 
3.98

Net gain on sale of other real estate owned and other repossessed assets
22

 
186

 
(164
)
 
(88.17
)
Other noninterest income
612

 
599

 
13

 
2.17

 
$
5,218

 
$
5,247

 
$
(29
)
 
(0.55
)

In the three months ended September 30, 2015 and 2014, the net gain on sale of loans was $0.40 million and $0.34 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 $0.08 million in the three months ended September 30, 2015 compared to September 30, 2014 due to new trust relationships.


Page 50

Index

HILLS BANCORPORATION

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended September 30, 2015 and 2014.

 
Three Months Ended 
 September 30,
 
 
 
 
 
2015
 
2014
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Salaries and employee benefits
$
7,125

 
$
6,400

 
$
725

 
11.33
 %
Occupancy
919

 
947

 
(28
)
 
(2.96
)
Furniture and equipment
1,304

 
1,212

 
92

 
7.59

Office supplies and postage
457

 
390

 
67

 
17

Advertising and business development
854

 
775

 
79

 
10.19

Outside services
1,770

 
1,773

 
(3
)
 
(0.17
)
Rental expenses on tax credit real estate
558

 
552

 
6

 
1.09

FDIC insurance assessment
293

 
282

 
11

 
3.90

Other noninterest expense
392

 
490

 
(98
)
 
(20.00
)
 
$
13,672

 
$
12,821

 
$
851

 
6.64


In the three months ended September 30, 2015 and 2014, salaries and employee benefits expense increased $0.73 million. The increase is primarily the result of annual salary adjustments and additional employees.

Advertising and business development expenses increased $0.08 million in the three months ended September 30, 2015 from their level for the comparable period in 2014 as a result of a increase of $0.06 in business and product promotions. Other noninterest expense categories experienced marginal period-to-period increases for the three months ended September 30, 2015.

Page 51

Index

HILLS BANCORPORATION


Income Taxes

Federal and state income tax expenses were $3.54 million and $3.63 million for the three months ended September 30, 2015 and 2014, respectively.  Income taxes as a percentage of income before taxes were 31.52% in 2015 and 31.46% in 2014.

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 10.21% of the Company’s total assets at September 30, 2015 compared to 11.09% at December 31, 2014.

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, 2015, the Company had borrowed $170.00 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 $463.98 million at September 30, 2015.

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 $227.78 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, 2015.

As of September 30, 2015, investment securities with a carrying value of $62.38 million were pledged to collateralize public and trust deposits, repurchase agreements, derivative financial instruments, and other borrowings.  As of December 31, 2014, investment securities with a carrying value of $68.12 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, 2014.

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 indicates 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.


Page 52

Index

HILLS BANCORPORATION

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.

The Bank's interest rate risk, as monitored by management, has not changed materially from December 31, 2014.

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, 2015 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.


Page 53

Index

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 filed an application for interlocutory appeal to the Iowa Supreme Court, which the Court denied. The parties and District Court have put the case on hold pending a ruling by the Iowa Supreme Court in an appeal filed by West Bank on a similar issue under dispute in the Hills Bank case. 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, 2014.

Page 54

Index



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, 2015:

Period
Total number of shares
purchased
Average price paid per
share
Total number of shares
purchased as part of publicly
announced plans or programs
Maximum number of
shares that may yet be
purchased under the
plans or programs (1)
July 1 to July 31
1,035

$
42.50

818,488

681,512

August 1 to August 31
7,143

42.80

825,631

674,369

September 1 to September 30
25,501

43.50

851,132

648,868

Total
33,679

$
43.32

851,132

648,868

 
(1)  On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 1,500,000 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, 2016. 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 2015, the Company issued 3,260 shares of restricted stock under the 2010 Stock Option and Incentive Plan.  The restricted shares were issued to officers of the company for no cash consideration and will vest over a five-year period from the date of grant.  The issuance of these shares was exempt from the registration requirements of the SEC pursuant to Section 4(2) of the Securities Act of 1933.

Item 3.
Defaults upon Senior Securities
 
Hills Bancorporation has no senior securities.

Item 4.
Mine Safety Disclosure
 
Not applicable.

Item 5.
Other Information

None


Page 55

Index

Item 6.
Exhibits

3.1
Restated Articles of Incorporation of Hills Bancorporation, as amended, incorporated by reference to Exhibit 3.1 to the Company's Form 10-Q files with the Commission on May 6, 2015.
3.2
Amended and Restated By-laws of Hills Bancorporation, incorporated by reference to Exhibit 3.2 to the Company’s Form 10-K filed with the Commission on March 11, 2015.
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.

Page 56

Index

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 4, 2015
 
By:  /s/ Dwight O. Seegmiller
 
 
 
Dwight O. Seegmiller, Director, President and Chief Executive Officer
 
 
 
 
Date:
November 4, 2015
 
By:  /s/ Shari DeMaris
 
 
 
Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer


Page 57

Index

HILLS BANCORPORATION
QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED SEPTEMBER 30, 2015
Exhibit
Number
Description
Page Number In The Sequential
Numbering System September 30, 2015 Form 10-Q
 
 
 
31
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
59-60

 
 
 
32
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
61



Page 58