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HILLS BANCORPORATION - Quarter Report: 2017 September (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2017

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 check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer  o
Accelerated Filer                     þ   
Non-accelerated filer    o
Small Reporting Company     o
Emerging Growth Company    o
 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 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



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APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date.
 
SHARES OUTSTANDING
CLASS
October 31, 2017
 
 
Common Stock, no par value
9,339,712
 
 
 
 


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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

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HILLS BANCORPORATION CONSOLIDATED BALANCE SHEETS (Amounts In Thousands, Except Share Amounts) 
 
September 30, 2017
 
December 31, 2016
ASSETS
(Unaudited)
 
Cash and cash equivalents
$
36,792

 
$
38,197

Investment securities available for sale at fair value (amortized cost September 30, 2017 $253,689; December 31, 2016 $269,039)
254,984

 
267,537

Stock of Federal Home Loan Bank
16,126

 
12,413

Loans held for sale
6,717

 
9,806

Loans, net of allowance for loan losses (September 30, 2017 $29,350; December 31, 2016 $26,530)
2,391,430

 
2,251,445

Property and equipment, net
37,799

 
37,859

Tax credit real estate investment
10,016

 
10,563

Accrued interest receivable
11,484

 
9,121

Deferred income taxes, net
12,871

 
12,611

Other real estate
144

 
237

Goodwill
2,500

 
2,500

Other assets
2,906

 
3,481

Total Assets
$
2,783,769

 
$
2,655,770

 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

 
 
 
 
Liabilities
 

 
 

Noninterest-bearing deposits
$
349,883

 
$
348,505

Interest-bearing deposits
1,723,159

 
1,687,807

Total deposits
$
2,073,042

 
$
2,036,312

Other borrowings
13,761

 
33,489

Federal Home Loan Bank borrowings
323,000

 
235,000

Accrued interest payable
1,079

 
984

Other liabilities
20,850

 
19,934

Total Liabilities
$
2,431,732

 
$
2,325,719

 
 
 
 
Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)
$
42,471

 
$
40,781

 
 
 
 
STOCKHOLDERS' EQUITY
 

 
 

Common stock, no par value; authorized 20,000,000 shares; issued September 30, 2017 10,318,906 shares; December 31, 2016 10,227,178 shares
$

 
$

Paid in capital
49,194

 
44,606

Retained earnings
337,380

 
319,982

Accumulated other comprehensive loss
(1,339
)
 
(3,359
)
Treasury stock at cost (September 30, 2017 1,000,774 shares; December 31, 2016 962,951 shares)
(33,198
)
 
(31,178
)
Total Stockholders' Equity
$
352,037

 
$
330,051

Less maximum cash obligation related to ESOP shares
42,471

 
40,781

Total Stockholders' Equity Less Maximum Cash Obligations Related to ESOP Shares
$
309,566

 
$
289,270

Total Liabilities & Stockholders' Equity
$
2,783,769

 
$
2,655,770


See Notes to Consolidated Financial Statements.

Page 4

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HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(Amounts In Thousands, Except Per Share Amounts)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
Interest income:
 
 
 
 
 
 
 
Loans, including fees
$
25,643

 
$
23,626

 
$
74,378

 
$
68,974

Investment securities:
 

 
 

 
 
 
 
Taxable
437

 
362

 
1,237

 
1,080

Nontaxable
783

 
786

 
2,425

 
2,414

Federal funds sold
9

 
6

 
145

 
124

Total interest income
$
26,872

 
$
24,780

 
$
78,185

 
$
72,592

Interest expense:
 

 
 

 
 
 
 
Deposits
$
2,319

 
$
1,917

 
$
6,730

 
$
5,742

Short-term borrowings
100

 
70

 
149

 
127

FHLB borrowings
2,233

 
1,935

 
5,938

 
6,224

Total interest expense
$
4,652

 
$
3,922

 
$
12,817

 
$
12,093

Net interest income
$
22,220

 
$
20,858

 
$
65,368

 
$
60,499

Provision for loan losses
130

 
(1,832
)
 
1,827

 
(2,004
)
Net interest income after provision for loan losses
$
22,090

 
$
22,690

 
$
63,541

 
$
62,503

Noninterest income:
 

 
 

 
 
 
 
Net gain on sale of loans
$
423

 
$
602

 
$
1,119

 
$
1,437

Trust fees
1,980

 
1,731

 
5,883

 
5,185

Service charges and fees
2,197

 
2,243

 
6,557

 
6,516

Net gain on sale of other real estate owned and other repossessed assets
33

 
342

 
89

 
376

Other noninterest income
372

 
396

 
1,599

 
1,541

 
$
5,005

 
$
5,314

 
$
15,247

 
$
15,055

 
 
 
 
 
 
 
 
Noninterest expenses:
 

 
 

 
 
 
 
Salaries and employee benefits
$
8,134

 
$
8,158

 
$
24,707

 
$
22,617

Occupancy
1,087

 
1,017

 
3,148

 
3,001

Furniture and equipment
1,491

 
1,350

 
4,356

 
4,111

Office supplies and postage
516

 
436

 
1,487

 
1,282

Advertising and business development
628

 
800

 
2,123

 
2,426

Outside services
2,077

 
1,845

 
5,943

 
5,386

FDIC insurance assessment
217

 
315

 
636

 
938

Other noninterest expense
671

 
510

 
2,033

 
1,585

 
$
14,821

 
$
14,431

 
$
44,433

 
$
41,346

Income before income taxes
$
12,274

 
$
13,573

 
$
34,355

 
$
36,212

Income taxes
3,722

 
4,397

 
10,472

 
11,369

Net income
$
8,552

 
$
9,176

 
$
23,883

 
$
24,843

 
 
 
 
 
 
 
 
Earnings per share:
 

 
 

 
 
 
 
Basic
$
0.92

 
$
0.99

 
$
2.56

 
$
2.67

Diluted
$
0.92

 
$
0.99

 
$
2.56

 
$
2.67

 
See Notes to Consolidated Financial Statements.

Page 5

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

 
Three Months Ended September 30,
Nine Months Ended September 30,
 
2017
 
2016
2017
 
2016
Net income
$
8,552

 
$
9,176

$
23,883

 
$
24,843

 
 
 
 
 
 
 
Other comprehensive income (loss)
 

 
 

 
 
 
Securities:
 

 
 

 
 
 
Net change in unrealized (loss) gain on securities available for sale
$
(302
)
 
$
(1,090
)
$
2,797

 
$
1,104

Reclassification adjustment for net gains realized in net income

 


 

Income taxes
116

 
417

(1,070
)
 
(423
)
Other comprehensive (loss) income on securities available for sale
$
(186
)
 
$
(673
)
$
1,727

 
$
681

Derivatives used in cash flow hedging relationships:
 

 
 

 
 
 
Net change in unrealized gain (loss) on derivatives
$
259

 
$
500

$
474

 
$
(1,931
)
Income taxes
(99
)
 
(192
)
(181
)
 
738

Other comprehensive income (loss) on cash flow hedges
$
160

 
$
308

$
293

 
$
(1,193
)
 
 
 
 
 
 
 
Other comprehensive (loss) income, net of tax
$
(26
)
 
$
(365
)
$
2,020

 
$
(512
)
 
 
 
 
 
 
 
Comprehensive income
$
8,526

 
$
8,811

$
25,903

 
$
24,331

 
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)
 
Treasury Stock
 
Maximum Cash
Obligation Related
To ESOP Shares
 
Total
Balance, December 31, 2015
$
43,697

 
$
294,487

 
$
(1,195
)
 
$
(27,252
)
 
$
(37,562
)
 
$
272,175

Issuance of 7,646 shares of common stock
348

 

 

 

 

 
348

Issuance of 3,482 shares of common stock under the employee stock purchase plan
154

 

 

 

 

 
154

Unearned restricted stock compensation
112

 

 

 

 

 
112

Forfeiture of 1,264 shares of common stock
(52
)
 

 

 

 

 
(52
)
Share-based compensation
22

 

 

 

 

 
22

Income tax benefit related to share-based compensation
64

 

 

 

 

 
64

Change related to ESOP shares

 

 

 

 
(2,220
)
 
(2,220
)
Net income

 
24,843

 

 

 

 
24,843

Cash dividends ($0.65 per share)

 
(6,060
)
 

 

 

 
(6,060
)
Purchase of 62,266 shares of common stock

 

 

 
(2,819
)
 

 
(2,819
)
Other comprehensive loss

 

 
(512
)
 

 

 
(512
)
Balance, September 30, 2016
$
44,345

 
$
313,270

 
$
(1,707
)
 
$
(30,071
)
 
$
(39,782
)
 
$
286,055

 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2016
$
44,606

 
$
319,982

 
$
(3,359
)
 
$
(31,178
)
 
$
(40,781
)
 
$
289,270

Issuance of 92,621 shares of common stock
4,208

 

 

 
55

 

 
4,263

Issuance of 4,483 shares of common stock under the employee stock purchase plan
210

 

 

 

 

 
210

Unearned restricted stock compensation
277

 

 

 

 

 
277

Forfeiture of 2,934 shares of common stock
(118
)
 

 

 

 

 
(118
)
Share-based compensation
11

 

 

 

 

 
11

Change related to ESOP shares

 

 

 

 
(1,690
)
 
(1,690
)
Net income

 
23,883

 

 

 

 
23,883

Cash dividends ($0.70 per share)

 
(6,485
)
 

 

 

 
(6,485
)
Purchase of 40,265 shares of common stock

 

 

 
(2,075
)
 

 
(2,075
)
Other comprehensive income

 

 
2,020

 

 

 
2,020

Balance, September 30, 2017
$
49,194

 
$
337,380

 
$
(1,339
)
 
$
(33,198
)
 
$
(42,471
)
 
$
309,566

 
See Notes to Consolidated Financial Statements.

Page 7

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

 
Nine Months Ended 
 September 30,
 
2017
 
2016
Cash Flows from Operating Activities
 
 
 
Net income
$
23,883

 
$
24,843

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

 
 

Depreciation
2,270

 
2,182

Provision for loan losses
1,827

 
(2,004
)
Share-based compensation
11

 
22

Forfeiture of common stock
(118
)
 
(52
)
Compensation expensed through issuance of common stock
208

 
348

Excess tax benefits from share-based compensation

 
(64
)
Provision for deferred income taxes
(1,513
)
 
54

Net gain on sale of other real estate owned and other repossessed assets
(89
)
 
(376
)
Increase in accrued interest receivable
(2,363
)
 
(1,867
)
Amortization of premium on investment securities, net
437

 
452

Decrease in other assets
1,049

 
650

Increase (decrease) in accrued interest payable and other liabilities
1,288

 
(92
)
Loans originated for sale
(109,522
)
 
(151,545
)
Proceeds on sales of loans
113,730

 
150,047

Net gain on sales of loans
(1,119
)
 
(1,437
)
Net cash and cash equivalents provided by operating activities
$
29,979

 
$
21,161

 
 
 
 
Cash Flows from Investing Activities
 

 
 

Proceeds from maturities of investment securities available for sale
$
48,937

 
$
46,148

Purchases of investment securities available for sale
(37,735
)
 
(31,456
)
Loans made to customers, net of collections
(141,994
)
 
(97,285
)
Proceeds on sale of other real estate owned and other repossessed assets
364

 
764

Purchases of property and equipment
(2,210
)
 
(4,180
)
Income from tax credit real estate, net
547

 
545

Net cash and cash equivalents used in investing activities
$
(132,091
)
 
$
(85,464
)
 
 
 
 
Cash Flows from Financing Activities
 

 
 

Net increase in deposits
$
36,730

 
$
105,710

Net decrease in other borrowings
(19,728
)
 
(4,148
)
Net increase (decrease) in FHLB borrowings
88,000

 
(15,000
)
Issuance of common stock, net of costs
3,762

 

Stock options exercised
238

 

Excess tax benefits related to share-based compensation

 
64

Issuance of treasury stock
55

 

Purchase of treasury stock
(2,075
)
 
(2,819
)
Proceeds from the issuance of common stock through the employee stock purchase plan
210

 
154

Dividends paid
(6,485
)
 
(6,060
)
Net cash and cash equivalents provided by financing activities
$
100,707

 
$
77,901

 

Page 8

Index

(Continued)

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)
 
Nine Months Ended 
 September 30,
 
2017
 
2016
(Decrease) increase in cash and cash equivalents
$
(1,405
)
 
$
13,598

Cash and cash equivalents:
 

 
 

Beginning of period
38,197

 
35,427

End of period
$
36,792

 
$
49,025

 
 
 
 
Supplemental Disclosures
 

 
 

Cash payments for:
 

 
 

Interest paid to depositors
$
6,635

 
$
5,776

Interest paid on other obligations
6,087

 
6,351

Income taxes paid
10,530

 
10,201

 
 
 
 
Noncash activities:
 

 
 

Increase in maximum cash obligation related to ESOP shares
$
1,690

 
$
2,220

Transfers to other real estate owned
182

 
310

Sale and financing of other real estate owned
262

 
135

 
See Notes to Consolidated Financial Statements.



Page 9

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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, 2017 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2017.  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, 2016 filed with the Securities Exchange Commission on March 3, 2017.  The consolidated balance sheet as of December 31, 2016, 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 has evaluated all of its noninterest income streams and contracts to determine potential impact. The adoption of ASU 2014-09 by the Company will not have a material impact.

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 created Subtopic 321-10, Investments-Equity Securities which is applicable to all entities except those in industries that account for substantially all investments at fair value through earnings or the change in net assets. Under this new subtopic, equity securities are generally required to be measured at fair value with unrealized holding gains and losses reflected in net income. ASU 2016-01 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. The adoption of ASU 2016-01 by the Company is not expected to have a material impact.

In February 2016, the FASB issued ASU No. 2016-02 (Topic 842), Leases. The ASU provides guidance requiring lessees to recognize right-of-use assets and lease liabilities for all leases other than those that meet the definition of short-term leases. For short-term leases, lessees may elect an accounting policy by class of underlying asset under which these assets and liabilities are not recognized and lease payments are generally recognized over the lease term on a straight-line basis. Under this new ASU, lessees will recognize right-of use assets and lease liabilities for most leases currently accounted for as operating leases under generally accepted accounting principles. For public companies, ASU 2016-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is in the process of analyzing a comprehensive list of lease agreements. The adoption of ASU 2016-02 by the Company is not expected to have a material impact.


Page 10

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

In March 2016, the FASB issued ASU No. 2016-04, Liabilities - Extinguishments of Liabilities (Subtopic 405-20), Recognition of Breakage for Certain Prepaid Stored-Value Products. ASU 2016-04 applies to all entities that offer certain prepaid stored - value products. The ASU provides guidance for the derecognition of financial liabilities related to the issuance of these products and aligns the recognition of breakage to current authoritative guidance. For public companies, ASU 2016-04 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. The adoption of ASU 2016-04 by the Company is not expected to have a material impact.

In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718), Improvements to Employee Share-Based Payment Accounting. The ASU simplifies several aspects of the accounting for share-based payment transaction, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. For public companies, ASU 2016-09 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. The Company adopted ASU 2016-09 for the period ending March 31, 2017. There was no material impact on the financial statements.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments (CECL). The ASU changes the way entities recognize impairment of financial assets by requiring immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the "incurred loss" model required under current GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance. For public companies, ASU 2016-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019, early adoption is permitted for the fiscal year beginning after December 15, 2018. The Company is in the process of implementing a software solution to assist in the analysis of historical loan data to determine the CECL model that will be implemented. We expect to recognize a one-time cumulative-effect adjustment to our allowance for loan losses as of the beginning of the first reporting period in which the new standard is adopted. The amount of the one-time cumulative-effect adjustment has not yet been determined.

In January 2017, the FASB issued ASU No. 2017-03, Accounting Changes and Error Corrections (Topic 250) and Investments - Equity Method and Joint Ventures (Topic 323), Amendments to SEC Paragraphs Pursuant to Staff Announcements at the September 22, 2016 and November 17, 2016 EITF Meetings. This ASU adds an SEC paragraph and amends other Topics pursuant to an SEC staff Announcement made at the September 22, 2016 Emerging Issues Task Force (EITF) meeting. The SEC paragraph applies to ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606); ASU No. 2016-02, Leases (Topic 842); and ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The ASU provides that a company should evaluate ASUs that have not yet been adopted to determine the appropriate financial statement disclosures about the potential material effects of those ASUs on the financial statements when adopted. If the company does not know or cannot reasonably estimate the impact that adoption of the ASUs referenced in this announcement is expected to have on the financial statements, then in addition to making a statement to that effect, the company should consider additional qualitative financial statement disclosures to assist the reader in assessing the significance of the impact that the standard will have on the financial statements of the company when adopted. Additional qualitative disclosures should include a description of the effect of the accounting policies that the company expects to apply and a comparison to the company's current accounting policies. Also, the company should describe the status of its process to implement the new standards and the significant implementation matters yet to be addressed.

In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 250), Simplifying the Test for Goodwill Impairment. The ASU simplifies the goodwill impairment test by requiring a company to perform its annual or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized when the carrying amount exceeds fair value. For public companies, ASU 2017-04 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The adoption of ASU No. 2017-04 by the Company is not expected to have a material impact.


Page 11

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

In March 2017, the FASB issued ASU No. 2017-08, Receivable - Nonrefundable Fees and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities. This ASU shortens the amortization period for certain callable debt securities held at a premium. The premium will be amortized to the earliest call date. For public companies, ASU 2017-08 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018. The Company adopted ASU 2017-08 for the period ending March 31, 2017. There was no material impact on the financial statements.

In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities. This ASU requires companies to change the recognition and presentation of the effects of hedge accounting by eliminating the requirement to separately measure and report hedge ineffectiveness and requiring companies to present all of the elements of hedge accounting that affect earnings in the same income statement line as the hedged item. Furthermore, the standard eases the requirements for effectiveness testing, hedge documentation and applying the critical terms match method and introduces new alternatives that will permit companies to reduce the risk of material error corrections if they misapply the shortcut method. For public companies, ASU 2017-12 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018. The adoption of ASU 2017-12 by the Company is not expected to have a material impact.


Note 2.
Earnings Per Share

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

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

 
Three Months Ended September 30,
Nine Months Ended September 30,
 
2017
 
2016
2017
 
2016
Common shares outstanding at the beginning of the period
9,329,514

 
9,283,341

9,264,227

 
9,322,054

Weighted average number of net shares (redeemed) issued
(4,596
)
 
(7,633
)
64,144

 
(31,950
)
Weighted average shares outstanding (basic)
9,324,918

 
9,275,708

9,328,371

 
9,290,104

Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method
3,559

 
6,584

4,874

 
6,357

Weighted average number of shares (diluted)
9,328,477

 
9,282,292

9,333,245

 
9,296,461

Net income (In thousands)
$
8,552

 
$
9,176

$
23,883

 
$
24,843

Earnings per share:
 

 
 

 

 
 

Basic
$
0.92

 
$
0.99

$
2.56

 
$
2.67

Diluted
$
0.92

 
$
0.99

$
2.56

 
$
2.67



Page 12

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

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, 2017 and December 31, 2016:

 
September 30,
2017

December 31, 2016
 
(amounts in thousands)
Net unrealized gain (loss) on available-for-sale securities
$
1,295

 
$
(1,502
)
Net unrealized loss on derivatives used for cash flow hedges
(3,464
)
 
(3,938
)
Tax effect
$
830

 
$
2,081

Net-of-tax amount
$
(1,339
)
 
$
(3,359
)
 
Note 4.
Securities

The carrying values of investment securities at September 30, 2017 and December 31, 2016 are summarized in the following table (dollars in thousands):

 
September 30, 2017
 
December 31, 2016
 
Amount
 
Percent
 
Amount
 
Percent
Securities available for sale
 
 
 
 
 
 
 
U.S. Treasury
$
39,894

 
15.65
%
 
$
27,482

 
10.27
%
Other securities (FHLB, FHLMC and FNMA)
48,759

 
19.12

 
61,660

 
23.05

State and political subdivisions
166,331

 
65.23

 
178,395

 
66.68

Total securities available for sale
$
254,984

 
100.00
%
 
$
267,537

 
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, 2017 or December 31, 2016. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of September 30, 2017 and December 31, 2016 (in thousands):

 
Amortized Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated Fair
Value
September 30, 2017:
 
 
 
 
 
 
 
U.S. Treasury
$
39,823

 
$
90

 
$
(19
)
 
$
39,894

Other securities (FHLB, FHLMC and FNMA)
48,992

 
11

 
(244
)
 
48,759

State and political subdivisions
164,874

 
1,721

 
(264
)
 
166,331

Total
$
253,689

 
$
1,822

 
$
(527
)
 
$
254,984

December 31, 2016:
 

 
 

 
 

 
 

U.S. Treasury
$
27,418

 
$
82

 
$
(18
)
 
$
27,482

Other securities (FHLB, FHLMC and FNMA)
62,047

 
65

 
(452
)
 
61,660

State and political subdivisions
179,574

 
626

 
(1,805
)
 
178,395

Total
$
269,039

 
$
773

 
$
(2,275
)
 
$
267,537



Page 13

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

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at September 30, 2017, were as follows (in thousands):
 
 
Amortized
Cost
 
Fair Value
Due in one year or less
$
42,320

 
$
42,423

Due after one year through five years
138,727

 
139,316

Due after five years through ten years
72,022

 
72,625

Due over ten years
620

 
620

Total
$
253,689

 
$
254,984


As of September 30, 2017 investment securities with a carrying value of $30.46 million were pledged to collateralize repurchase agreements, derivative financial instruments, and other borrowings.

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, 2017 and December 31, 2016 (in thousands):

 
Less than 12 months
 
12 months or more
 
Total
September 30, 2017
Description of Securities
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
U.S. Treasury
4

 
$
10,006

 
$
(19
)
 
0.19
%
 

 
$

 
$

 
%
 
4

 
$
10,006

 
$
(19
)
 
0.19
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other securities (FHLB, FHLMC and FNMA)
11

 
26,539

 
(81
)
 
0.31

 
4

 
10,208

 
(163
)
 
1.60

 
15

 
36,747

 
(244
)
 
0.66

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and political subdivisions
45

 
11,566

 
(66
)
 
0.57

 
65

 
15,212

 
(198
)
 
1.30

 
110

 
26,778

 
(264
)
 
0.99

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total temporarily impaired securities
60

 
$
48,111

 
$
(166
)
 
0.35
%
 
69

 
$
25,420

 
$
(361
)
 
1.42
%
 
129

 
$
73,531

 
$
(527
)
 
0.72
%

 
Less than 12 months
 
12 months or more
 
Total
December 31, 2016
Description of Securities
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
U.S. Treasury
2

 
$
4,957

 
$
(18
)
 
0.36
%
 

 
$

 
$

 
%
 
2

 
$
4,957

 
$
(18
)
 
0.36
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other securities (FHLB, FHLMC and FNMA)
14

 
34,648

 
(452
)
 
1.30

 

 

 

 

 
14

 
34,648

 
(452
)
 
1.30

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and political subdivisions
365

 
87,841

 
(1,762
)
 
2.01

 
11

 
1,486

 
(43
)
 
2.89

 
376

 
89,327

 
(1,805
)
 
2.02

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total temporarily impaired securities
381

 
$
127,446

 
$
(2,232
)
 
1.75
%
 
11

 
$
1,486

 
$
(43
)
 
2.89
%
 
392

 
$
128,932

 
$
(2,275
)
 
1.76
%


Page 14

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

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.

Note 5.Loans

Classes of loans are as follows:

 
September 30,
2017
 
December 31,
2016
 
(Amounts In Thousands)
Agricultural
$
76,484

 
$
92,871

Commercial and financial
214,199

 
192,995

Real estate:
 
 
 
Construction, 1 to 4 family residential
73,404

 
57,864

Construction, land development and commercial
107,170

 
121,561

Mortgage, farmland
208,982

 
202,340

Mortgage, 1 to 4 family first liens
823,529

 
767,469

Mortgage, 1 to 4 family junior liens
137,271

 
125,400

Mortgage, multi-family
335,439

 
302,831

Mortgage, commercial
359,332

 
334,198

Loans to individuals
26,223

 
25,157

Obligations of state and political subdivisions
57,861

 
54,462

 
$
2,419,894

 
$
2,277,148

Net unamortized fees and costs
886

 
827

 
$
2,420,780

 
$
2,277,975

Less allowance for loan losses
29,350

 
26,530

 
$
2,391,430

 
$
2,251,445



Page 15

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, 2017 were as follows:
 
Three Months Ended September 30, 2017
 
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
$
2,341

 
$
4,586

 
$
3,165

 
$
4,009

 
$
8,340

 
$
5,414

 
$
1,095

 
$
28,950

Charge-offs
(27
)
 
(21
)
 

 
(3
)
 
(55
)
 
(86
)
 
(113
)
 
(305
)
Recoveries
56

 
219

 
33

 

 
203

 
7

 
57

 
575

Provision
92

 
(43
)
 
(182
)
 
2

 
98

 
107

 
56

 
130

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
2,462

 
$
4,741

 
$
3,016

 
$
4,008

 
$
8,586

 
$
5,442

 
$
1,095

 
$
29,350

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

Nine Months Ended September 30, 2017
 
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
$
2,947

 
$
4,531

 
$
2,890

 
$
3,417

 
$
7,677

 
$
4,045

 
$
1,023

 
$
26,530

Charge-offs
(66
)
 
(478
)
 
(114
)
 
(3
)
 
(263
)
 
(130
)
 
(410
)
 
(1,464
)
Recoveries
123

 
882

 
443

 

 
570

 
236

 
203

 
2,457

Provision
(542
)
 
(194
)
 
(203
)
 
594

 
602

 
1,291

 
279

 
1,827

 


 


 


 


 


 


 


 


Ending balance
$
2,462

 
$
4,741

 
$
3,016

 
$
4,008

 
$
8,586

 
$
5,442

 
$
1,095

 
$
29,350

 

 

 

 

 

 

 

 

Ending balance, individually evaluated for impairment
$
653

 
$
913

 
$
46

 
$
784

 
$
110

 
$
409

 
$
85

 
$
3,000

 

 

 

 

 

 

 

 

Ending balance, collectively evaluated for impairment
$
1,809

 
$
3,828

 
$
2,970

 
$
3,224

 
$
8,476

 
$
5,033

 
$
1,010

 
$
26,350

 


 


 


 


 


 


 


 


Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
76,484

 
$
214,199

 
$
180,574

 
$
208,982

 
$
960,800

 
$
694,771

 
$
84,084

 
$
2,419,894

 


 


 


 


 


 


 


 


Ending balance, individually evaluated for impairment
$
6,181

 
$
2,985

 
$
1,161

 
$
8,179

 
$
7,097

 
$
8,097

 
$
85

 
$
33,785

 

 

 

 

 

 

 

 

Ending balance, collectively evaluated for impairment
$
70,303

 
$
211,214

 
$
179,413

 
$
200,803

 
$
953,703

 
$
686,674

 
$
83,999

 
$
2,386,109


Page 16

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, 2016 were as follows:
 
Three Months Ended September 30, 2016
 
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
$
2,997

 
$
4,011

 
$
2,898

 
$
3,927

 
$
8,226

 
$
4,201

 
$
1,030

 
$
27,290

Charge-offs
(19
)
 
(38
)
 

 
(105
)
 
(176
)
 

 
(140
)
 
(478
)
Recoveries

 
289

 
186

 

 
276

 
358

 
51

 
1,160

Provision
201

 
(252
)
 
(75
)
 
(204
)
 
(425
)
 
(589
)
 
(86
)
 
(1,832
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
2,777

 
$
4,010

 
$
3,009

 
$
3,618

 
$
7,901

 
$
3,970

 
$
855

 
$
26,140

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30, 2016
 
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
$
3,082

 
$
4,517

 
$
2,280

 
$
3,342

 
$
8,172

 
$
4,223

 
$
894

 
$
26,510

Charge-offs
(44
)
 
(172
)
 

 
(116
)
 
(704
)
 
(66
)
 
(416
)
 
(1,518
)
Recoveries
173

 
910

 
792

 

 
767

 
379

 
132

 
3,153

Provision
(434
)
 
(1,245
)
 
(63
)
 
392

 
(334
)
 
(566
)
 
246

 
(2,004
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
2,777

 
$
4,010

 
$
3,009

 
$
3,618

 
$
7,901

 
$
3,970

 
$
855

 
$
26,140

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance, individually evaluated for impairment
$
746

 
$
221

 
$
223

 
$
549

 
$
283

 
$
62

 
$
29

 
$
2,113

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance, collectively evaluated for impairment
$
2,031

 
$
3,789

 
$
2,786

 
$
3,069

 
$
7,618

 
$
3,908

 
$
826

 
$
24,027

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
88,104

 
$
188,365

 
$
178,820

 
$
193,819

 
$
883,693

 
$
619,214

 
$
74,917

 
$
2,226,932

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance, individually evaluated for impairment
$
12,276

 
$
2,529

 
$
2,877

 
$
8,371

 
$
6,497

 
$
3,356

 
$
29

 
$
35,935

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance, collectively evaluated for impairment
$
75,828

 
$
185,836

 
$
175,943

 
$
185,448

 
$
877,196

 
$
615,858

 
$
74,888

 
$
2,190,997




Page 17

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, 2017 and December 31, 2016, 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, 2017
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
2,502

 
$
10,234

 
$
548

 
$
2,950

Good
12,073

 
47,103

 
6,773

 
26,216

Satisfactory
37,109

 
117,612

 
49,639

 
41,317

Monitor
14,622

 
28,619

 
15,248

 
33,226

Special Mention
4,653

 
5,410

 
897

 
2,607

Substandard
5,525

 
5,221

 
299

 
854

Total
$
76,484

 
$
214,199

 
$
73,404

 
$
107,170


 
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, 2017
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
5,102

 
$
2,064

 
$
494

 
$
5,712

Good
52,634

 
29,490

 
3,569

 
82,368

Satisfactory
105,155

 
681,699

 
124,625

 
188,549

Monitor
34,985

 
77,461

 
4,869

 
52,341

Special Mention
2,434

 
11,136

 
1,328

 

Substandard
8,672

 
21,679

 
2,386

 
6,469

Total
$
208,982

 
$
823,529

 
$
137,271

 
$
335,439


 
Real Estate:
Mortgage,
commercial
 
Loans to
individuals
 
Obligations of state and
political subdivisions
 
Total
September 30, 2017
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
18,735

 
$

 
$
8,961

 
$
57,302

Good
103,662

 
476

 
29,137

 
393,501

Satisfactory
183,140

 
24,962

 
16,186

 
1,569,993

Monitor
44,316

 
349

 
3,577

 
309,613

Special Mention
7,037

 
216

 

 
35,718

Substandard
2,442

 
220

 

 
53,767

Total
$
359,332

 
$
26,223

 
$
57,861

 
$
2,419,894

 

Page 18

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, 2016
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
4,205

 
$
4,241

 
$

 
$
244

Good
13,611

 
43,472

 
1,701

 
25,337

Satisfactory
40,008

 
108,800

 
44,138

 
46,758

Monitor
12,699

 
20,023

 
8,896

 
44,487

Special Mention
8,381

 
11,177

 
972

 
4,250

Substandard
13,967

 
5,282

 
2,157

 
485

Total
$
92,871

 
$
192,995

 
$
57,864

 
$
121,561


 
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, 2016
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
2,916

 
$
1,196

 
$
65

 
$
5,970

Good
47,569

 
15,725

 
3,002

 
71,822

Satisfactory
105,971

 
647,191

 
113,433

 
180,651

Monitor
29,778

 
66,164

 
4,877

 
40,444

Special Mention
7,004

 
12,914

 
1,566

 
3,636

Substandard
9,102

 
24,279

 
2,457

 
308

Total
$
202,340

 
$
767,469

 
$
125,400

 
$
302,831


 
Real Estate:
Mortgage,
commercial
 
Loans to
individuals
 
Obligations of state and
political subdivisions
 
Total
December 31, 2016
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
15,873

 
$

 
$

 
$
34,710

Good
89,801

 
65

 
37,539

 
349,644

Satisfactory
185,650

 
24,446

 
16,417

 
1,513,463

Monitor
34,979

 
293

 
506

 
263,146

Special Mention
3,797

 
195

 

 
53,892

Substandard
4,098

 
158

 

 
62,293

Total
$
334,198

 
$
25,157

 
$
54,462

 
$
2,277,148



Page 19

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 20

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

Past due loans as of September 30, 2017 and December 31, 2016 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, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
Agricultural
$
3

 
$
23

 
$
1,367

 
$
1,393

 
$
75,091

 
$
76,484

 
$
1,121

Commercial and financial
380

 
262

 
264

 
906

 
213,293

 
214,199

 
200

Real estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential

 
22

 

 
22

 
73,382

 
73,404

 

Construction, land development and commercial
3,320

 

 

 
3,320

 
103,850

 
107,170

 

Mortgage, farmland

 
1,355

 
83

 
1,438

 
207,544

 
208,982

 

Mortgage, 1 to 4 family first liens
733

 
1,578

 
2,235

 
4,546

 
818,983

 
823,529

 
412

Mortgage, 1 to 4 family junior liens
201

 
137

 
62

 
400

 
136,871

 
137,271

 
58

Mortgage, multi-family

 

 

 

 
335,439

 
335,439

 

Mortgage, commercial
142

 

 
16

 
158

 
359,174

 
359,332

 

Loans to individuals
38

 
67

 

 
105

 
26,118

 
26,223

 

Obligations of state and political subdivisions

 

 

 

 
57,861

 
57,861

 

 
$
4,817

 
$
3,444

 
$
4,027

 
$
12,288

 
$
2,407,606

 
$
2,419,894

 
$
1,791

 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2016
 

 
 

 
 

 
 

 
 

 
 

 
 

Agricultural
$
56

 
$

 
$
302

 
$
358

 
$
92,513

 
$
92,871

 
$

Commercial and financial
24

 
121

 
718

 
863

 
192,132

 
192,995

 

Real estate:
 
 
 
 
 
 
 

 
 
 
 

 
 

Construction, 1 to 4 family residential

 

 

 

 
57,864

 
57,864

 

Construction, land development and commercial

 
231

 
85

 
316

 
$
121,245

 
121,561

 

Mortgage, farmland
319

 

 

 
319

 
202,021

 
202,340

 

Mortgage, 1 to 4 family first liens
5,649

 
978

 
1,943

 
8,570

 
$
758,899

 
767,469

 
192

Mortgage, 1 to 4 family junior liens
330

 
51

 
579

 
960

 
124,440

 
125,400

 
443

Mortgage, multi-family

 

 
40

 
40

 
$
302,791

 
302,831

 

Mortgage, commercial
371

 

 
207

 
578

 
333,620

 
334,198

 

Loans to individuals
203

 
32

 

 
235

 
$
24,922

 
25,157

 

Obligations of state and political subdivisions

 

 

 

 
54,462

 
54,462

 

 
$
6,952

 
$
1,413

 
$
3,874

 
$
12,239

 
$
2,264,909

 
$
2,277,148

 
$
635

 

Page 21

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, 2017 and December 31, 2016, was as follows:

 
September 30, 2017
 
December 31, 2016
 
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
$
1,656

 
$
1,121

 
$
2,446

 
$
1,741

 
$

 
$
91

Commercial and financial
947

 
200

 
1,839

 
1,354

 

 
1,057

Real estate:
 

 
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential

 

 

 

 

 
265

Construction, land development and commercial

 

 
341

 
85

 

 
118

Mortgage, farmland
1,454

 

 
1,462

 
1,205

 

 
1,389

Mortgage, 1 to 4 family first liens
4,415

 
412

 
1,399

 
4,097

 
192

 
1,375

Mortgage, 1 to 4 family junior liens
12

 
58

 
26

 
136

 
443

 
26

Mortgage, multi-family
223

 

 

 
243

 

 

Mortgage, commercial
630

 

 
1,057

 
1,077

 

 
1,087

 
$
9,337

 
$
1,791

 
$
8,570

 
$
9,938

 
$
635

 
$
5,408


(1)
There were $3.76 million and $4.23 million of TDR loans included within nonaccrual loans as of September 30, 2017 and December 31, 2016, respectively.

Loans 90 days or more past due that are still accruing interest increased $1.16 million from December 31, 2016 to September 30, 2017 due to an increase in the number of loans past due greater than 90 days including a $1.12 agricultural relationship. As of September 30, 2017 there were 10 accruing loans past due 90 days or more. The average balance of accruing loans past due as of September 30, 2017 are $0.18 million. There were 6 accruing loans past due 90 days or more as of December 31, 2016 and the average loan balance was $0.11 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 22

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

Below is a summary of information for TDR loans as of September 30, 2017 and December 31, 2016:

 
September 30, 2017
 
December 31, 2016
 
Number
of
contracts
 
Recorded
investment
 
Commitments
outstanding
 
Number
of
contracts
 
Recorded
investment
 
Commitments
outstanding
 
 
 
(Amounts In Thousands)
 
 
 
(Amounts In Thousands)
Agricultural
9

 
$
3,762

 
$
267

 
4

 
$
1,460

 
$
167

Commercial and financial
15

 
2,526

 
157

 
14

 
2,053

 
117

Real estate:
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential

 

 
193

 
3

 
265

 
1,225

Construction, land development and commercial
2

 
341

 
721

 
1

 
118

 
107

Mortgage, farmland
7

 
2,834

 

 
7

 
2,594

 

Mortgage, 1 to 4 family first liens
13

 
1,486

 

 
12

 
1,471

 

Mortgage, 1 to 4 family junior liens
1

 
26

 
54

 
1

 
26

 
65

Mortgage, multi-family

 

 

 

 

 

Mortgage, commercial
8

 
1,355

 

 
10

 
1,650

 

Loans to individuals

 

 

 

 

 

 
55

 
$
12,330

 
$
1,392

 
52

 
$
9,637

 
$
1,681


The following is a summary of TDR loans that were modified during the three and nine months ended September 30, 2017:

 
Three Months Ended September 30, 2017
Nine Months Ended September 30, 2017
 
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

 
$

 
$

6

 
$
10,890

 
$
10,890

Commercial and financial
3

 
1,451

 
1,451

4

 
1,546

 
1,546

Real estate:
 

 
 

 
 

 

 
 

 
 
Construction, 1 to 4 family residential

 

 


 

 

Construction, land development and commercial

 

 

1

 
231

 
231

Mortgage, farmland

 

 

2

 
598

 
598

Mortgage, 1 to 4 family first lien
1

 
106

 
106

1

 
106

 
106

Mortgage, 1 to 4 family junior liens

 

 


 

 

Mortgage, multi-family

 

 

1

 
249

 
249

Mortgage, commercial

 

 


 

 

 
4

 
$
1,557

 
$
1,557

15

 
$
13,620

 
$
13,620


Page 23

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

The Company had commitments to lend $1.39 million in additional borrowings to restructured loan customers as of September 30, 2017.  The Company had commitments to lend $1.68 million in additional borrowings to restructured loan customers as of December 31, 2016.  These commitments were in the normal course of business.  The additional borrowings were not used to facilitate payments on these loans.

There were no TDR loans that were in payment default (defined as past due 90 days or more) during the period ended September 30, 2017 and year ended December 31, 2016.





Page 24

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, 2017 is as follows:
 
September 30, 2017
 
Three Months Ended 
 September 30, 2017
Nine Months Ended 
 September 30, 2017
 
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
$
1,739

 
$
1,981

 
$

 
$
1,778

 
$
3

$
1,767

 
$
1

Commercial and financial
1,333

 
2,047

 

 
1,598

 
17

1,375

 
5

Real estate:
 

 
 

 
 

 
 

 
 
 

 
 

Construction, 1 to 4 family residential
116

 
151

 

 
116

 
4

116

 
1

Construction, land development and commercial
341

 
374

 

 
345

 
10

342

 
3

Mortgage, farmland
2,598

 
2,925

 

 
2,513

 
42

2,603

 
14

Mortgage, 1 to 4 family first liens
5,268

 
6,640

 

 
5,434

 
37

5,336

 
13

Mortgage, 1 to 4 family junior liens
12

 
485

 

 
25

 

13

 

Mortgage, multi-family
223

 
357

 

 
233

 

226

 

Mortgage, commercial
1,607

 
2,300

 

 
1,727

 
34

1,670

 
11

Loans to individuals

 
14

 

 

 


 

 
$
13,237

 
$
17,274

 
$

 
$
13,769

 
$
147

$
13,448

 
$
48

 
 
 
 
 
 
 
 
 
 
 
 
 
With an allowance recorded:
 

 
 

 
 

 
 

 
 

 

 
 

Agricultural
$
4,442

 
$
4,503

 
$
653

 
$
4,897

 
$
169

$
4,491

 
$
53

Commercial and financial
1,652

 
1,698

 
913

 
1,732

 
62

1,743

 
21

Real estate:
 
 
 
 
 
 
 
 
 
 
 
 

Construction, 1 to 4 family residential
199

 
199

 
13

 
136

 
5

180

 
2

Construction, land development and commercial
505

 
505

 
33

 
321

 
11

354

 
4

Mortgage, farmland
5,581

 
5,581

 
784

 
5,667

 
183

5,584

 
61

Mortgage, 1 to 4 family first liens
1,734

 
1,861

 
106

 
1,761

 
54

1,743

 
17

Mortgage, 1 to 4 family junior liens
83

 
83

 
4

 
86

 
3

83

 
1

Mortgage, multi-family
6,187

 
6,187

 
407

 
6,251

 
210

6,228

 
71

Mortgage, commercial
80

 
80

 
2

 
81

 
3

80

 
1

Loans to individuals
85

 
85

 
85

 
88

 
7

90

 
3

 
$
20,548

 
$
20,782

 
$
3,000

 
$
21,020

 
$
707

$
20,576

 
$
234

 
 
 
 
 
 
 
 
 
 
 
 
 
Total:
 

 
 

 
 

 
 

 
 

 

 
 

Agricultural
$
6,181

 
$
6,484

 
$
653

 
$
6,675

 
$
172

$
6,258

 
$
54

Commercial and financial
2,985

 
3,745

 
913

 
3,330

 
79

3,118

 
26

Real estate:
 

 
 

 
 

 
 

 
 

 

 
 

Construction, 1 to 4 family residential
315

 
350

 
13

 
252

 
9

296

 
3

Construction, land development and commercial
846

 
879

 
33

 
666

 
21

696

 
7

Mortgage, farmland
8,179

 
8,506

 
784

 
8,180

 
225

8,187

 
75

Mortgage, 1 to 4 family first liens
7,002

 
8,501

 
106

 
7,195

 
91

7,079

 
30

Mortgage, 1 to 4 family junior liens
95

 
568

 
4

 
111

 
3

96

 
1

Mortgage, multi-family
6,410

 
6,544

 
407

 
6,484

 
210

6,454

 
71

Mortgage, commercial
1,687

 
2,380

 
2

 
1,808

 
37

1,750

 
12

Loans to individuals
85

 
99

 
85

 
88

 
7

90

 
3

 
$
33,785

 
$
38,056

 
$
3,000

 
$
34,789

 
$
854

$
34,024

 
$
282


Page 25

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

Information regarding impaired loans as of December 31, 2016 is as follows:

 
Recorded
Investment
 
Unpaid Principal
Balance
 
Related
Allowance
With no related allowance recorded:
(Amounts In Thousands)
Agricultural
$
800

 
$
971

 
$

Commercial and financial
1,540

 
2,175

 

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
117

 
151

 

Construction, land development and commercial
204

 
290

 

Mortgage, farmland
2,594

 
2,887

 

Mortgage, 1 to 4 family first liens
5,011

 
6,137

 

Mortgage, 1 to 4 family junior liens
153

 
646

 

Mortgage, multi-family
243

 
362

 

Mortgage, commercial
1,901

 
2,727

 

Loans to individuals

 
19

 

 
$
12,563

 
$
16,365

 
$

 
 
 
 
 
 
With an allowance recorded:
 

 
 

 
 

Agricultural
$
10,920

 
$
10,978

 
$
856

Commercial and financial
937

 
955

 
718

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
815

 
815

 
105

Construction, land development and commercial

 

 

Mortgage, farmland
5,434

 
5,434

 
390

Mortgage, 1 to 4 family first liens
1,266

 
1,374

 
79

Mortgage, 1 to 4 family junior liens
612

 
667

 
11

Mortgage, multi-family

 

 

Mortgage, commercial
967

 
1,004

 
34

Loans to individuals
150

 
150

 
150

 
$
21,101

 
$
21,377

 
$
2,343

 
 
 
 
 
 
Total:
 

 
 

 
 

Agricultural
$
11,720

 
$
11,949

 
$
856

Commercial and financial
2,477

 
3,130

 
718

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
932

 
966

 
105

Construction, land development and commercial
204

 
290

 

Mortgage, farmland
8,028

 
8,321

 
390

Mortgage, 1 to 4 family first liens
6,277

 
7,511

 
79

Mortgage, 1 to 4 family junior liens
765

 
1,313

 
11

Mortgage, multi-family
243

 
362

 

Mortgage, commercial
2,868

 
3,731

 
34

Loans to individuals
150

 
169

 
150

 
$
33,664

 
$
37,742

 
$
2,343



Page 26

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

Impaired loans increased $0.12 million from December 31, 2016 to September 30, 2017.  Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans.  Impaired loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement.  Impaired loans were 1.40% of loans held for investment as of September 30, 2017 and 1.48% as of December 31, 2016.  The increase in impaired loans is due mainly to an increase in TDR loans of $3.16 million and an increase in accruing loans past due 90 days or more of $1.16 million from December 31, 2016 to September 30, 2017, and is offset by a decrease in nonaccrual loans of $0.60 million, and a decrease of $3.60 million in relationships with a specific allowance for losses.

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 may recognize a charge off or record a specific allowance 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 27

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, 2017 are as follows:
 
September 30, 2017
 
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
$
36,792

 
$
36,792

 
$
36,792

 
$

 
$

Investment securities
271,110

 
271,110

 

 
271,110

 

Loans held for sale
6,717

 
6,717

 

 
6,717

 

Loans
 

 
 

 
 

 
 

 
 

Agricultural
74,022

 
73,954

 

 

 
73,954

Commercial and financial
209,458

 
209,387

 

 

 
209,387

Real estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
72,141

 
72,151

 

 

 
72,151

Construction, land development and commercial
105,417

 
105,340

 

 

 
105,340

Mortgage, farmland
204,974

 
205,401

 

 

 
205,401

Mortgage, 1 to 4 family first liens
817,072

 
813,125

 

 

 
813,125

Mortgage, 1 to 4 family junior liens
136,028

 
140,222

 

 

 
140,222

Mortgage, multi-family
332,893

 
330,677

 

 

 
330,677

Mortgage, commercial
356,436

 
354,673

 

 

 
354,673

Loans to individuals
25,591

 
25,575

 

 

 
25,575

Obligations of state and political subdivisions
57,398

 
56,681

 

 

 
56,681

Accrued interest receivable
11,484

 
11,484

 

 
11,484

 

Total financial instrument assets
$
2,717,533

 
$
2,713,289

 
$
36,792

 
$
289,311

 
$
2,387,186

Financial instrument liabilities
 

 
 

 
 

 
 

 
 

Deposits
 

 
 

 
 

 
 

 
 

Noninterest-bearing deposits
$
349,883

 
$
349,883

 
$

 
$
349,883

 
$

Interest-bearing deposits
1,723,159

 
1,727,433

 

 
1,727,433

 

Other borrowings
13,761

 
13,761

 

 
13,761

 

Federal Home Loan Bank borrowings
323,000

 
312,026

 

 
312,026

 

Interest rate swaps
3,464

 
3,464

 

 
3,464

 

Accrued interest payable
1,079

 
1,079

 

 
1,079

 

Total financial instrument liabilities
$
2,414,346

 
$
2,407,646

 
$

 
$
2,407,646

 
$

 
 
 
 
 
 
 
 
 
 
 
Face Amount
 
 

 
 

 
 

 
 

Financial instrument with off-balance sheet risk:
 

 
 

 
 

 
 

 
 

Loan commitments
$
413,805

 
$

 
$

 
$

 
$

Letters of credit
11,398

 

 

 

 

Total financial instrument liabilities with off-balance-sheet risk
$
425,203

 
$

 
$

 
$

 
$

(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 28

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, 2016 are as follows:

 
December 31, 2016
 
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
$
38,197

 
$
38,197

 
$
38,197

 
$

 
$

Investment securities
279,950

 
279,950

 

 
279,950

 

Loans held for sale
9,806

 
9,806

 

 
9,806

 

Loans
 

 
 

 
 

 
 

 
 

Agricultural
89,924

 
89,862

 

 

 
89,862

Commercial and financial
188,464

 
188,292

 

 

 
188,292

Real estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
56,841

 
56,715

 

 

 
56,715

Construction, land development and commercial
119,694

 
119,716

 

 

 
119,716

Mortgage, farmland
198,923

 
199,043

 

 

 
199,043

Mortgage, 1 to 4 family first liens
760,909

 
764,174

 

 

 
764,174

Mortgage, 1 to 4 family junior liens
124,283

 
129,339

 

 

 
129,339

Mortgage, multi-family
301,162

 
297,646

 

 

 
297,646

Mortgage, commercial
331,822

 
328,948

 

 

 
328,948

Loans to individuals
24,515

 
24,499

 

 

 
24,499

Obligations of state and political subdivisions
54,081

 
52,860

 

 

 
52,860

Accrued interest receivable
9,121

 
9,121

 

 
9,121

 

Total financial instrument assets
$
2,587,692

 
$
2,588,168

 
$
38,197

 
$
298,877

 
$
2,251,094

Financial instrument liabilities:
 

 
 

 
 

 
 

 
 

Deposits
 

 
 

 
 

 
 

 
 

Noninterest-bearing deposits
$
348,505

 
$
348,505

 
$

 
$
348,505

 
$

Interest-bearing deposits
1,687,807

 
1,691,679

 

 
1,691,679

 

Other borrowings
33,489

 
33,489

 

 
33,489

 

Federal Home Loan Bank borrowings
235,000

 
231,232

 

 
231,232

 

Interest rate swaps
3,938

 
3,938

 
 
 
3,938

 
 
Accrued interest payable
984

 
984

 

 
984

 

Total financial instrument liabilities
$
2,309,723

 
$
2,309,827

 
$

 
$
2,309,827

 
$

 
 
 
 
 
 
 
 
 
 
 
Face Amount
 
 

 
 

 
 

 
 

Financial instrument with off-balance sheet risk:
 

 
 

 
 

 
 

 
 

Loan commitments
$
388,666

 
$

 
$

 
$

 
$

Letters of credit
9,024

 

 

 

 

Total financial instrument liabilities with off-balance-sheet risk
$
397,690

 
$

 
$

 
$

 
$

 
(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 29

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, 2017.   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 30

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 31

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, 2017
 
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
$

 
$
39,894

 
$

 
$
39,894

State and political subdivisions

 
166,331

 

 
166,331

Other securities (FHLB, FHLMC and FNMA)

 
48,759

 

 
48,759

Derivative Financial Instruments
 
 
 
 
 
 
 
Interest rate swaps
$

 
(3,464
)
 
$

 
(3,464
)
Total
$

 
$
251,520

 
$

 
$
251,520


 
December 31, 2016
 
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
$

 
$
27,482

 
$

 
$
27,482

State and political subdivisions

 
178,395

 

 
178,395

Other securities (FHLB, FHLMC and FNMA)

 
61,660

 

 
61,660

Derivative Financial Instruments
 
 
 
 
 
 
 
Interest rate swaps

 
(3,938
)
 

 
(3,938
)
Total
$

 
$
263,599

 
$

 
$
263,599

 
(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, 2017 and the year ended December 31, 2016.



Page 32

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, 2017
 
Three Months Ended September 30, 2017
Nine Months Ended September 30, 2017
 
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
$

 
$

 
$
4,350

 
$
4,350

 
$

$
23

Commercial and financial

 

 
1,667

 
1,667

 
8

135

Real Estate:
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential

 

 
186

 
186

 


Construction, land development and commercial

 

 
697

 
697

 


Mortgage, farmland

 

 
6,862

 
6,862

 


Mortgage, 1 to 4 family first liens

 

 
6,214

 
6,214

 
31

150

Mortgage, 1 to 4 family junior liens

 

 
34

 
34

 
71

88

Mortgage, multi-family

 

 
6,003

 
6,003

 


Mortgage, commercial

 

 
1,101

 
1,101

 
86

111

Loans to individuals

 

 

 

 
10

20

Foreclosed assets (5)

 

 

 

 


Total
$

 
$

 
$
27,114

 
$
27,114

 
$
206

$
527

 
(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 33

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

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

 
December 31, 2016
 
Year Ended December 31, 2016
 
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
$

 
$

 
$
10,773

 
$
10,773

 
$

Commercial and financial

 

 
1,397

 
1,397

 
143

Real Estate:
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential

 

 
827

 
827

 

Construction, land development and commercial

 

 
85

 
85

 

Mortgage, farmland

 

 
7,077

 
7,077

 

Mortgage, 1 to 4 family first liens

 

 
5,424

 
5,424

 
756

Mortgage, 1 to 4 family junior liens

 

 
194

 
194

 

Mortgage, multi-family

 

 
244

 
244

 

Mortgage, commercial

 

 
1,541

 
1,541

 
65

Loans to individuals

 

 

 

 

Foreclosed assets (5)

 

 
75

 
75

 
20

Total
$

 
$

 
$
27,637

 
$
27,637

 
$
984


(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, 2018.  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 1,003,216 shares of its common stock in privately negotiated transactions from August 1, 2005 through September 30, 2017.  Of these 1,003,216 shares, 14,538 shares were purchased during the quarter ended September 30, 2017, at an average price per share of $52.80.

Page 34

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

Note 8.
Commitments and Contingencies

Concentrations of credit risk:  The Bank’s loans, commitments to extend credit, unused lines of credit and outstanding letters of credit have been granted to customers within the Bank's market area.  Investments in securities issued by state and political subdivisions within the state of Iowa totaled approximately $68.95 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, 2017 and December 31, 2016 is as follows:
 
 
September 30, 2017
 
December 31, 2016
 
(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
 
 
 
Home equity loans
$
54,200

 
$
48,785

Credit cards
49,107

 
45,738

Commercial, real estate and home construction
138,982

 
113,251

Commercial lines and real estate purchase loans
171,516

 
180,892

Outstanding letters of credit
11,398

 
9,024

 
Note 9.
Income Taxes

Federal income tax expense for the nine months ended September 30, 2017 and 2016 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, 2016, 2015, and 2014 remain subject to examination by the Internal Revenue Service.  For state tax purposes, the tax years ended December 31, 2016, 2015, and 2014 remain open for examination.  There were no material unrecognized tax benefits at September 30, 2017  and December 31, 2016 and therefore no interest or penalties on unrecognized tax benefits has been recorded.  As of September 30, 2017, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending September 30, 2018. Income taxes as a percentage of income before taxes were 30.48% for the nine months ended September 30, 2017 and 31.40% for the same period in 2016


Page 35

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 $3.46 million of collateral as of September 30, 2017.

Cash Flow Hedges:

The Bank executed two forward-starting interest rate swap transactions on November 7, 2013.  One of the interest rate swap transactions had an effective date of November 9, 2015, and an expiration date of November 9, 2020, effectively converting $25.00 million of variable rate debt to fixed rate debt.  The other interest rate swap transaction had an effective date of November 7, 2016 and an expiration date of November 7, 2023, effectively converting $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, 2017 and December 31, 2016:

 
Notional
Amount
 
Fair
Value
 
Balance
Sheet
Category
 
Maturity
 
(Amounts in Thousands)
 
 
September 30, 2017
 
 
 
 
 
 
    
Interest rate swap
$
25,000

 
$
(853
)
 
Other Liabilities
 
11/9/2020
Interest rate swap
25,000

 
(2,611
)
 
Other Liabilities
 
11/7/2023
 
 
 
 
 
 
 
 
December 31, 2016
 

 
 

 
 
 
    
Interest rate swap
$
25,000

 
$
(1,097
)
 
Other Liabilities
 
11/9/2020
Interest rate swap
25,000

 
(2,841
)
 
Other Liabilities
 
11/7/2023



Page 36

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 for the nine months ended September 30, 2017 and the year ended December 31, 2016:

 
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, 2017
 
 
 
 
 
 
 
 
 
Interest rate swap
$
151

 
Interest Expense
 
$

 
Other Income
 
$

Interest rate swap
142

 
Interest Expense
 

 
Other Income
 

 
 
 
 
 
 
 
 
 
 
December 31, 2016
 

 
 
 
 

 
 
 
 

Interest rate swap
$
250

 
Interest Expense
 
$

 
Other Income
 
$

Interest rate swap
(101
)
 
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.


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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.


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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, 2017 and December 31, 2016 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, 2017, the Bank has nineteen full-service locations.

Net income for the nine month period ended September 30, 2017 was $23.88 million compared to $24.84 million for the same nine months of 2016, a decrease of 3.86%.  The $0.96 million decrease in net income was caused by a number of factors.  The principal factors in the decrease in net income for the first nine months of 2017 are an increase in noninterest expenses of $3.09 million and an increase in provision for loan losses of $3.83 million. These changes were offset by an increase in net interest income of $4.87 million, an increase in noninterest income of $0.19 million, and a decrease in income tax expense of $0.90 million.

The Company achieved a return on average assets of 1.14% and a return on average equity of 10.39% for the twelve months ended September 30, 2017, compared to the twelve months ended September 30, 2016, which were 1.23% and 11.59%, respectively.  Dividends of $0.70 per share were paid in January 2017 to 2,390 shareholders.  The 2016 dividend was $0.65 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 3.46% for the nine months ended September 30, 2017 compared to 3.42% for the same nine months of 2016.  Average earning assets were $2.611 billion year to date in 2017 and $2.435 billion in 2016.


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Highlights noted on the balance sheet as of September 30, 2017 for the Company included the following:

Total assets were $2.784 billion, an increase of $128.00 million since December 31, 2016.
Cash and cash equivalents were $36.79 million, a decrease of $1.41 million since December 31, 2016.
Net loans were $2.398 billion, an increase of $136.90 million since December 31, 2016.  Loans held for sale decreased $3.09 million since December 31, 2016.
Deposits increased $36.73 million since December 31, 2016. $74.00 million of deposit growth are temporary public funds.
Federal Home Loan Bank borrowings were $323.00 million, an increase of $88.00 million since December 31, 2016.

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

Loan demand has been increasing and is expected to remain steady throughout the year ending December 31, 2017 and into 2018.  As indicated in the table below, growth in the real estate loan categories have been primarily responsible for the increase in total loans. 

The following table sets forth the composition of the loan portfolio as of September 30, 2017 and December 31, 2016:

 
September 30, 2017
 
December 31, 2016
 
Amount
 
Percent
 
Amount
 
Percent
 
(Amounts In Thousands)
 
(Amounts In Thousands)
Agricultural
$
76,484

 
3.16
%
 
$
92,871

 
4.08
%
Commercial and financial
214,199

 
8.85

 
192,995

 
8.47

Real estate:
 

 
 
 
 

 
 
Construction, 1 to 4 family residential
73,404

 
3.03

 
57,864

 
2.54

Construction, land development and commercial
107,170

 
4.43

 
121,561

 
5.34

Mortgage, farmland
208,982

 
8.64

 
202,340

 
8.89

Mortgage, 1 to 4 family first liens
823,529

 
34.04

 
767,469

 
33.70

Mortgage, 1 to 4 family junior liens
137,271

 
5.67

 
125,400

 
5.51

Mortgage, multi-family
335,439

 
13.86

 
302,831

 
13.30

Mortgage, commercial
359,332

 
14.85

 
334,198

 
14.68

Loans to individuals
26,223

 
1.08

 
25,157

 
1.10

Obligations of state and political subdivisions
57,861

 
2.39

 
54,462

 
2.39

 
$
2,419,894

 
100.00
%
 
$
2,277,148

 
100.00
%
Net unamortized fees and costs
886

 
 

 
827

 
 

 
$
2,420,780

 
 

 
$
2,277,975

 
 

Less allowance for loan losses
29,350

 
 

 
26,530

 
 

 
$
2,391,430

 
 

 
$
2,251,445

 
 



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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 may be downgraded and the uncollectible amount charged-off or recorded as a specific allowance for losses.  The Bank’s credit and legal departments undertake a thorough and ongoing analysis to determine if additional impairment and/or charge-offs are appropriate and to begin a workout plan for the loan to minimize actual losses.


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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, 2017 and December 31, 2016:
 
 
September 30, 2017
 
December 31, 2016
 
Amount
 
% of Total
Allowance
 
% of Loans to
Total Loans
 
Amount
 
% of Total
Allowance
 
% of Loans to
Total Loans
 
(In Thousands)
 
 
 
 
 
(In Thousands)
 
 
 
 
Agricultural
$
2,462

 
8.39
%
 
3.16
%
 
$
2,947

 
11.11
%
 
4.08
%
Commercial and financial
4,741

 
16.15

 
8.85

 
4,531

 
17.08

 
8.47

Real estate:
 

 
 
 
 
 
 

 
 

 
 
Construction, 1 to 4 family residential
1,263

 
4.30

 
3.03

 
1,023

 
3.86

 
2.54

Construction, land development and commercial
1,753

 
5.97

 
4.43

 
1,867

 
7.04

 
5.34

Mortgage, farmland
4,008

 
13.66

 
8.64

 
3,417

 
12.88

 
8.89

Mortgage, 1 to 4 family first liens
7,343

 
25.02

 
34.04

 
6,560

 
24.72

 
33.70

Mortgage, 1 to 4 family junior liens
1,243

 
4.24

 
5.67

 
1,117

 
4.21

 
5.51

Mortgage, multi-family
2,546

 
8.67

 
13.86

 
1,669

 
6.29

 
13.30

Mortgage, commercial
2,896

 
9.87

 
14.85

 
2,376

 
8.95

 
14.68

Loans to individuals
632

 
2.15

 
1.08

 
642

 
2.42

 
1.10

Obligations of state and political subdivisions
463

 
1.58

 
2.39

 
381

 
1.44

 
2.39

 
$
29,350

 
100.00
%
 
100.00
%
 
$
26,530

 
100.00
%
 
100.00
%

The allowance for loan losses totaled $29.35 million at September 30, 2017 compared to $26.53 million at December 31, 2016.  The percentage of the allowance to outstanding loans was 1.21% and 1.17% at September 30, 2017 and December 31, 2016, 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 2017 is the result of $136.90 million million in loan growth 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, 2017, 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.


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

Investment securities available for sale held by the Company decreased by $12.55 million from December 31, 2016 to September 30, 2017.  The fair value of securities available for sale was $1.30 million more than the amortized cost of such securities as of September 30, 2017.  At December 31, 2016, the fair value of the securities available for sale was $1.50 million less than the amortized cost of such securities.

Deposits increased $36.73 million in the first nine months of 2017. Repurchase agreements decreased $19.73 million since December 31, 2016.  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 $73.09 million as of September 30, 2017 with an average rate of 0.99%.  Brokered deposits were $112.70 million as of December 31, 2016 with an average interest rate of 0.59%. As of September 30, 2017 and December 31, 2016, brokered deposits were 3.53% and 5.53% of total deposits, respectively.

FHLB Borrowings increased $88.00 million to $323.00 million for the nine months ended September 30, 2017. This increase was primarily used to fund the $136.90 million of loan growth for the nine months ended September 30, 2017.

Dividends and Equity

In January 2017, Hills Bancorporation paid a dividend of $6.49 million or $0.70 per share.  The dividend was $0.65 per share in January 2016.  After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of September 30, 2017 totaled $309.57 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. The final rule also adopted changes to the agencies’ regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Under the BASEL III rules, the minimum capital ratios are 4% for Tier 1 Leverage Capital Ratio, 4.5% for the Common Equity Tier 1 Capital Ratio, 6% for the Tier 1 Risk-Based Capital Ratio and 8% for the Total Risk-Based Capital Ratio. A new capital conservation buffer is being phased in beginning January 1, 2016, at 0.625% of risk-weighted assets and increased each subsequent year by an additional 0.625% until reaching 2.5% on January 1, 2019. As of September 30, 2017 and December 31, 2016 the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements. The actual amounts and capital ratios as of September 30, 2017 and December 31, 2016 are presented below (amounts in thousands):

 
Actual
 
For Capital Adequacy Purposes
 
To Be Well Capitalized Under Prompt Corrective Action Provisions
 
Amount
 
Ratio
 
Ratio
 
Ratio
As of September 30, 2017:
 
 
 
 
 
 
 
Company:
 
 
 
 
 
 
 
Total risk-based capital
$
379,401

 
16.63
%
 
8.000
%
 
10.000
%
Tier 1 risk-based capital
350,876

 
15.38

 
6.000

 
8.000

Tier 1 common equity
350,876

 
15.38

 
4.500

 
6.500

Leverage ratio
350,876

 
12.76

 
4.000

 
5.000

Bank:
 

 
 

 
 

 
 

Total risk-based capital
380,050

 
16.67

 
8.000

 
10.000

Tier 1 risk-based capital
351,549

 
15.42

 
6.000

 
8.000

Tier 1 common equity
351,549

 
15.42

 
4.500

 
6.500

Leverage ratio
351,549

 
12.79

 
4.000

 
5.000



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HILLS BANCORPORATION

 
Actual
 
For Capital Adequacy Purposes
 
To Be Well Capitalized Under Prompt Corrective Action Provisions
 
Amount
 
Ratio
 
Ratio
 
Ratio
As of December 31, 2016:
 
 
 
 
 
 
 
Company:
 
 
 
 
 
 
 
Total risk-based capital
$
357,440

 
16.17
%
 
8.00
%
 
10.00
%
Tier 1 risk-based capital
330,910

 
14.97

 
6.00

 
8.00

Tier 1 common equity
330,910

 
14.97

 
4.50

 
6.50

Leverage ratio
330,910

 
12.63

 
4.00

 
5.00

Bank:
 

 
 

 
 

 
 

Total risk-based capital
357,895

 
16.20

 
8.00

 
10.00

Tier 1 risk-based capital
331,365

 
15.00

 
6.00

 
8.00

Tier 1 common equity
331,365

 
15.00

 
4.50

 
6.50

Leverage ratio
331,365

 
12.66

 
4.00

 
5.00





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HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2017 and 2016

Net Income Overview

Net income decreased $0.96 million for the nine months ended September 30, 2017 compared to the first nine months of 2016.  Total net income was $23.88 million in 2017 and $24.84 million in the comparable period in 2016, an decrease of 3.86%.  The changes in net income in 2017 from the first nine months of 2016 were primarily the result of the following:

Net interest income increased by $4.87 million, before provision expense. Total interest income increased by $5.70 million as a result of growth in the volume of earning assets.
The provision for loan losses increased by $3.83 million.
Noninterest income increased by $0.19 million.
Noninterest expenses increased by $3.09 million.
Income tax expense decreased by $0.90 million.
 
For the nine month period ended September 30, 2017 and September 30, 2016 basic earnings per share was $2.56 and $2.67, respectively. Diluted earnings per share was $2.56 for the nine months ended September 30, 2017 compared to $2.67 for the same period in 2016.

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 $65.37 million for the first nine months of 2017 was derived from the Company’s $2.611 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.46%.  Average earning assets in the nine months ended September 30, 2016 were $2.435 billion and the tax-equivalent net interest margin was 3.42%.  Net interest margin is the yield generated from earning assets minus interest expense represented as a percentage of the Bank's earning assets. 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 $1.96 million change in income before income taxes in the nine month period ended September 30, 2017.  Net interest income for the Company increased primarily as a result of growth in the volume of earning assets.  The Company expects net interest income to remain stable through 2017 and net interest compression to impact earnings in future years.  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 $2.398 billion at September 30, 2017.  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 $1.83 million in 2017 compared to a reduction of expense of $2.00 million in 2016.  The majority of the increase was the result of $14.09 million in loans in which a specific reserve of $1.47 million was allocated. The Company believes that the provision for loan losses may 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 $10.47 million and $11.37 million for the nine months ended September 30, 2017 and 2016, respectively.  Income taxes as a percentage of income before taxes were 30.48% in 2017 and 31.40% in 2016.


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Discussion of operations for the nine months ended September 30, 2017 and 2016

Net Interest Income

Net interest income increased for the nine months ended September 30, 2017 compared to the comparable period in 2016.  The increase was as a result of growth in the average volume of earning assets.  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 2017 was 3.46% compared to 3.42% in 2016 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 2017 compared to the comparable period in 2016 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
$
178,712

 
(0.01
)%
 
$
5,544

 
$
(92
)
 
$
5,452

Taxable securities
3,507

 
0.15

 
58

 
99

 
157

Nontaxable securities
6,405

 
(0.10
)
 
146

 
(129
)
 
17

Federal funds sold
(12,386
)
 
0.45

 
(48
)
 
69

 
21

 
$
176,238

 
 

 
$
5,700

 
$
(53
)
 
$
5,647

 
 
 
 
 
 
 
 
 
 
Interest expense:
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
$
29,000

 
0.01
 %
 
$
(30
)
 
$
(65
)
 
$
(95
)
Savings deposits
80,031

 
0.10

 
(131
)
 
(548
)
 
(679
)
Time deposits
1,080

 
0.07

 
5

 
(219
)
 
(214
)
Other borrowings
(1,163
)
 

 

 

 

FHLB borrowings
28,718

 
(0.52
)
 
(749
)
 
1,035

 
286

Interest-bearing other liabilities
(21,623
)
 
0.30

 
39

 
(61
)
 
(22
)
 
$
116,043

 
 

 
$
(866
)
 
$
142

 
$
(724
)
Change in net interest income
 

 
 

 
$
4,834

 
$
89

 
$
4,923


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)
 
2017
 
2016
Yield on average interest-earning assets
 
4.11
%
 
4.08
%
Rate on average interest-bearing liabilities
 
0.85

 
0.84

Net interest spread
 
3.26
%
 
3.24
%
Effect of noninterest-bearing funds
 
0.20

 
0.18

Net interest margin (tax equivalent interest income divided by average interest-earning assets)
 
3.46
%
 
3.42
%

Page 46

Index

HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2017 and 2016

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 2017.  The target rate was increased in June, 2017 at 1.25%.  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, 2017, the rate indexes for the one, three and five year indexes were 1.31%, 1.62% and 1.92%, respectively.  The one year index increased 122.03% from 0.59% at September 30, 2016, the three year index increased 84.10% and the five year index increased 68.42%.  The three year index was 0.88% and the five year index was 1.14% at September 30, 2016.  The targeted federal funds rate was 1.25% and 0.50% at September 30, 2017 and 2016, respectively.  The Company anticipates possible increases in short term and long term rates in the indexes for the remainder of 2017.

Provision for Loan Losses

The provision for loan losses was an expense of $1.83 million for the nine months ended September 30, 2017 compared to a reduction of expense of $2.00 million in 2016, an expense increase of $3.83 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 2017 is the net result of an increase in net loans, a change in the composition and allocation of loans within credit quality ratings, and a specific allowance of $1.47 million recorded for $14.09 million in 2 loan relationships.

The allowance for loan losses increased $2.82 million during the first nine months of 2017.  In the first nine months of 2017, there was a increase of $2.93 million due to increases in average balances and composition of loans outstanding and a $0.11 million decrease in the amount allocated to the allowance due to declines in 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, 2017 and 2016, recoveries were $2.46 million and $3.15 million respectively; and charge-offs were $1.46 million in 2017 and $1.52 million in 2016.  The allowance for loan losses totaled $29.35 million at September 30, 2017 compared to $26.53 million at December 31, 2016.  The allowance represented 1.21% and 1.17% of loans held for investment at September 30, 2017 and December 31, 2016.

Noninterest Income

The following table sets forth the various categories of noninterest income for the nine months ended September 30, 2017 and 2016.

 
Nine Months Ended September 30,
 
 
 
 
 
2017
 
2016
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Net gain on sale of loans
$
1,119

 
$
1,437

 
$
(318
)
 
(22.13
)%
Trust fees
5,883

 
5,185

 
698

 
13.46

Service charges and fees
6,557

 
6,516

 
41

 
0.63

Net gain on sale of other real estate owned and other repossessed assets
89

 
376

 
(287
)
 
(76.33
)
Other noninterest income
1,599

 
1,541

 
58

 
3.76

 
$
15,247

 
$
15,055

 
$
192

 
1.28



Page 47

Index

HILLS BANCORPORATION


Discussion of operations for the nine months ended September 30, 2017 and 2016

Loans originated for sale in the first nine months of 2017 totaled $109.52 million compared to $151.55 million in the same period in 2016, a decrease of 27.73%.  In the nine months ended September 30, 2017 and 2016, the net gain on sale of loans was $1.12 million and $1.44 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 $0.70 million in the nine months ended September 30, 2017 compared to September 30, 2016 due to new trust relationships.

Net gain on sale of other real estate owned and other repossessed assets decreased $0.28 million in the nine months ended September 30, 2017 compared to September 30, 2016 due to a decrease in the amount of other real estate owned by the Company.

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the nine months ended September 30, 2017 and 2016.

 
Nine Months Ended September 30,
 
 
 
 
 
2017
 
2016
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Salaries and employee benefits
$
24,707

 
$
22,617

 
$
2,090

 
9.24
 %
Occupancy
3,148

 
3,001

 
147

 
4.90

Furniture and equipment
4,356

 
4,111

 
245

 
5.96

Office supplies and postage
1,487

 
1,282

 
205

 
15.99

Advertising and business development
2,123

 
2,426

 
(303
)
 
(12.49
)
Outside services
5,943

 
5,386

 
557

 
10.34

FDIC insurance assessment
636

 
938

 
(302
)
 
(32.20
)
Other noninterest expense
2,033

 
1,585

 
448

 
28.26

 
$
44,433

 
$
41,346

 
$
3,087

 
7.47


In the nine months ended September 30, 2017 and 2016, salaries and employee benefits expense increased $2.09 million. The increase is primarily the result of annual salary adjustments and hiring of additional employees to staff branch growth. Other noninterest expense categories experienced marginal period-to-period fluctuations for the nine months ended September 30, 2017.

Discussion of operations for the three months ended September 30, 2017 and 2016

Net Income Overview

Net income decreased $0.62 million for the three months ended September 30, 2017 compared to the same period in 2016.  Total net income was $8.55 million in 2017 and $9.18 million in the comparable period in 2016, a decrease of 6.80%.  For the three month period ended September 30, 2017 and September 30, 2016 basic earning per share was $0.92 and $0.99, respectively. Diluted earnings per share was $0.92 for the three months ended September 30, 2017 compared to $0.99 for the same period in 2016.


Page 48

Index

HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2017 and 2016

Net Interest Income

Net interest income increased for the three months ended September 30, 2017 compared to the comparable period in 2016.  The increase was primarily the result of growth in the volume of earning assets.  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, 2017 was 3.44% compared to 3.49% in 2016 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 2017 compared to the comparable period in 2016 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
$
190,297

 
 %
 
$
2,056

 
$
(16
)
 
$
2,040

Taxable securities
5,589

 
0.20

 
35

 
40

 
75

Nontaxable securities
4,163

 
(0.09
)
 
32

 
(35
)
 
(3
)
Federal funds sold
(12,386
)
 
0.12

 
(2
)
 
5

 
3

 
$
187,663

 
 

 
$
2,121

 
$
(6
)
 
$
2,115

 
 
 
 
 
 
 
 
 
 
Interest expense:
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
$
41,015

 
0.02
 %
 
$
(14
)
 
$
(32
)
 
$
(46
)
Savings deposits
35,918

 
0.10

 
(16
)
 
(190
)
 
(206
)
Time deposits
15,780

 
0.09

 
(49
)
 
(99
)
 
(148
)
Other borrowings

 

 

 

 

FHLB borrowings
86,774

 
(0.60
)
 
(767
)
 
469

 
(298
)
Interest-bearing other liabilities
(31,851
)
 
0.62

 
22

 
(52
)
 
(30
)
 
$
147,636

 
 
 
$
(824
)
 
$
96

 
$
(728
)
Change in net interest income
 

 
 

 
$
1,297

 
$
90

 
$
1,387


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)
 
2017
 
2016
Yield on average interest-earning assets
 
4.13
%
 
4.12
%
Rate on average interest-bearing liabilities
 
0.90

 
0.82

Net interest spread
 
3.23
%
 
3.30
%
Effect of noninterest-bearing funds
 
0.21

 
0.19

Net interest margin (tax equivalent interest income divided by average interest-earning assets)
 
3.44
%
 
3.49
%


Page 49

Index

HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2017 and 2016

Provision for Loan Losses

The provision for loan losses was an expense of $0.13 million for the three months ended September 30, 2017 compared to a reduction of expense of $1.83 million in 2016, an expense increase of $1.96 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 increased $0.40 million during the three months ended September 30, 2017.  In the three months ended September 30, 2017, there was a $0.32 million decrease in the amount allocated to the allowance due to credit quality and a $0.72 million increase due to the composition of loans outstanding.

In addition to provision expense, 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, 2017 and 2016, recoveries were $0.58 million and $1.16 million, respectively; and charge-offs were $0.31 million in 2017 and $0.48 million in 2016

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended September 30, 2017 and 2016.

 
Three Months Ended September 30,
 
 
 
 
 
2017
 
2016
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Net gain on sale of loans
$
423

 
$
602

 
$
(179
)
 
(29.73
)%
Trust fees
1,980

 
1,731

 
249

 
14.38

Service charges and fees
2,197

 
2,243

 
(46
)
 
(2.05
)
Net gain on sale of other real estate owned and other repossessed assets
33

 
342

 
(309
)
 

Other noninterest income
372

 
396

 
(24
)
 
(6.06
)
 
$
5,005

 
$
5,314

 
$
(309
)
 
(5.81
)

In the three months ended September 30, 2017 and 2016, the net gain on sale of loans was $0.42 million and $0.60 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 $0.25 million in the three months ended September 30, 2017 compared to September 30, 2016 due to new trust relationships.

Net gain on sale of other real estate owned and other repossessed assets decreased $0.31 million in the three months ended September 30, 2017 compared to September 30, 2016 due to a decrease in the amount of other real estate owned by the Company.


Page 50

Index

HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2017 and 2016

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended September 30, 2017 and 2016.

 
Three Months Ended 
 September 30,
 
 
 
 
 
2017
 
2016
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Salaries and employee benefits
$
8,134

 
$
8,158

 
$
(24
)
 
(0.29
)%
Occupancy
1,087

 
1,017

 
70

 
6.88

Furniture and equipment
1,491

 
1,350

 
141

 
10.44

Office supplies and postage
516

 
436

 
80

 
18

Advertising and business development
628

 
800

 
(172
)
 
(21.50
)
Outside services
2,077

 
1,845

 
232

 
12.57

FDIC insurance assessment
217

 
315

 
(98
)
 
(31.11
)
Other noninterest expense
671

 
510

 
161

 
31.57

 
$
14,821

 
$
14,431

 
$
390

 
2.70


Income Taxes

Federal and state income tax expenses were $3.72 million and $4.40 million for the three months ended September 30, 2017 and 2016, respectively.  Income taxes as a percentage of income before taxes were 30.32% in 2017 and 32.40% in 2016.

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 9.16% of the Company’s total assets at September 30, 2017 compared to 10.07% at December 31, 2016.

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, 2017, the Company had borrowed $323.00 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 $457.59 million at September 30, 2017.

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 $244.70 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, 2017.

As of September 30, 2017, investment securities with a carrying value of $30.46 million were pledged to collateralize public and trust deposits, repurchase agreements, derivative financial instruments, and other borrowings.  As of December 31, 2016, investment securities with a carrying value of $61.81 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, 2016.

Page 51

Index

HILLS BANCORPORATION


Item 3.
Quantitative and Qualitative Disclosures about Market Risk

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

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

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

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

The Bank's interest rate risk, as monitored by management, has not changed materially from December 31, 2016.


Page 52

Index

HILLS BANCORPORATION

Item 4.
Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission.  There have been no changes in the Company’s internal controls over financial reporting during the quarter ended September 30, 2017 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

None
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, 2016.
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, 2017:

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
5,543

$
52.50

5,543

505,779

August 1 to August 31
4,123

52.97

4,123

501,656

September 1 to September 30
4,872

53.00

4,872

496,784

Total
14,538

$
52.80

14,538

496,784

 
(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 has authorized the 2005 Stock Repurchase Program through December 31, 2018.  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. 
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 54

Index

Item 6.
Exhibits

3.1
Restated Articles of Incorporation, incorporated by reference to Exhibit 3.1 to the Company's Form 10-Q Filed with the Commission on May 6, 2015.
3.2
Amended and Restated Bylaws, 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 55

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 7, 2017
 
By:  /s/ Dwight O. Seegmiller
 
 
 
Dwight O. Seegmiller, Director, President and Chief Executive Officer
 
 
 
 
Date:
November 7, 2017
 
By:  /s/ Shari DeMaris
 
 
 
Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer


Page 56

Index

HILLS BANCORPORATION
QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED SEPTEMBER 30, 2017
Exhibit
Number
Description
Page Number In The Sequential
Numbering System
September 30, 2017 Form 10-Q
 
 
 
58-59

 
 
 
60



Page 57