HILLS BANCORPORATION - Quarter Report: 2017 March (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 March 31, 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	April 30, 2017

Common Stock, no par value	9,338,187

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HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION



		Page
		Number

Item 1.	Financial Statements

	Consolidated balance sheets, March 31, 2017 (unaudited) and December 31, 2016	4
	Consolidated statements of income (unaudited) for three months ended March 31, 2017 and 2016	5
	Consolidated statements of comprehensive income (unaudited) for three months ended March 31, 2017 and 2016	6
	Consolidated statements of stockholders' equity (unaudited) for three months ended March 31, 2017 and 2016	7
	Consolidated statements of cash flows (unaudited) for three months ended March 31, 2017 and 2016	8
	Notes to consolidated financial statements (condensed)	10

Item 2.	Management Discussion and Analysis of Financial Condition and Results of Operations	37

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	49

Item 4.	Controls and Procedures	50

	Part II
	OTHER INFORMATION

Item 1.	Legal proceedings	51

Item 1A.	Risk factors	51

Item 2.	Unregistered sales of equity securities and use of proceeds	51

Item 3.	Defaults upon senior securities	51

Item 4.	Mine safety disclosures	51

Item 5.	Other information	51

Item 6.	Exhibits	52

	Signatures	53

	Exhibits Index	54

Page 3

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



	March 31, 2017			December 31, 2016
ASSETS	(Unaudited)			December 31, 2016
Cash and cash equivalents	$	151,273		$	38,197
Investment securities available for sale at fair value (amortized cost March 31, 2017 $273,538; December 31, 2016 $269,039)	273,409			267,537
Stock of Federal Home Loan Bank	12,607			12,413
Loans held for sale	1,656			9,806
Loans, net of allowance for loan losses (March 31, 2017 $26,450; December 31, 2016 $26,530)	2,281,541			2,251,445
Property and equipment, net	38,335			37,859
Tax credit real estate investment	10,539			10,563
Accrued interest receivable	10,286			9,121
Deferred income taxes, net	12,056			12,611
Other real estate	218			237
Goodwill	2,500			2,500
Other assets	2,632			3,481
Total Assets	$	2,797,052		$	2,655,770

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities
Noninterest-bearing deposits	$	339,867		$	348,505
Interest-bearing deposits	1,833,465			1,687,807
Total deposits	$	2,173,332		$	2,036,312
Other borrowings	28,086			33,489
Federal Home Loan Bank borrowings	235,000			235,000
Accrued interest payable	940			984
Other liabilities	22,586			19,934
Total Liabilities	$	2,459,944		$	2,325,719

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	43,341		$	40,781

STOCKHOLDERS' EQUITY
Common stock, no par value; authorized 20,000,000 shares; issued March 31, 2017 10,310,582 shares; December 31, 2016 10,227,178 shares	$	—		$	—
Paid in capital	48,676			44,606
Retained earnings	322,371			319,982
Accumulated other comprehensive loss	(2,296		)	(3,359		)
Treasury stock at cost (March 31, 2017 972,297 shares; December 31, 2016 962,951 shares)	(31,643		)	(31,178		)
Total Stockholders' Equity	$	337,108		$	330,051
Less maximum cash obligation related to ESOP shares	43,341			40,781
Total Stockholders' Equity Less Maximum Cash Obligations Related to ESOP Shares	$	293,767		$	289,270
Total Liabilities & Stockholders' Equity	$	2,797,052		$	2,655,770

See Notes to Consolidated Financial Statements.

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HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Amounts In Thousands, Except Per Share Amounts)



	Three Months Ended March 31,
	2017			2016
Interest income:
Loans, including fees	$	23,890		$	22,528
Investment securities:
Taxable	393			356
Nontaxable	833			828
Federal funds sold	64			44
Total interest income	$	25,180		$	23,756
Interest expense:
Deposits	$	2,128		$	1,921
Short-term borrowings	22			30
FHLB borrowings	1,833			2,132
Total interest expense	$	3,983		$	4,083
Net interest income	$	21,197		$	19,673
Provision for loan losses	(814		)	549
Net interest income after provision for loan losses	$	22,011		$	19,124
Noninterest income:
Net gain on sale of loans	$	316		$	289
Trust fees	1,879			1,728
Service charges and fees	2,132			2,055
Net gain on sale of other real estate owned and other repossessed assets	34			34
Other noninterest income	880			767
	$	5,241		$	4,873

Noninterest expenses:
Salaries and employee benefits	$	7,980		$	6,984
Occupancy	1,042			1,001
Furniture and equipment	1,429			1,404
Office supplies and postage	461			401
Advertising and business development	790			786
Outside services	2,008			1,776
FDIC insurance assessment	207			303
Other noninterest expense	494			397
	$	14,411		$	13,052
Income before income taxes	$	12,841		$	10,945
Income taxes	3,967			3,245
Net income	$	8,874		$	7,700

Earnings per share:
Basic	$	0.95		$	0.83
Diluted	$	0.95		$	0.83

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 March 31,
	2017			2016
Net income	$	8,874		$	7,700

Other comprehensive income (loss)
Securities:
Net change in unrealized loss on securities available for sale	$	1,373		$	1,018
Reclassification adjustment for net gains realized in net income	—			—
Income taxes	(526		)	(390		)
Other comprehensive income on securities available for sale	$	847		$	628
Derivatives used in cash flow hedging relationships:
Net change in unrealized loss on derivatives	$	349		$	(1,753	)
Income taxes	(133		)	670
Other comprehensive income (loss) on cash flow hedges	$	216		$	(1,083	)

Other comprehensive income (loss), net of tax	$	1,063		$	(455	)

Comprehensive income	$	9,937		$	7,245

See Notes to Consolidated Financial Statements.

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



	Paid In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Unearned ESOP Shares		Treasury Stock			Maximum Cash Obligation Related To ESOP Shares			Total
Balance, December 31, 2015	$	43,697		$	294,487		$	(1,195	)	$	—	$	(27,252	)	$	(37,562	)	$	272,175
Issuance of 1,626 shares of common stock	73			—			—			—		—			—			73
Issuance of 1,234 shares of common stock under the employee stock purchase plan	54			—			—			—		—			—			54
Unearned restricted stock compensation	56			—			—			—		—			—			56
Share-based compensation	7			—			—			—		—			—			7
Income tax benefit related to share-based compensation	2			—			—			—		—			—			2
Change related to ESOP shares	—			—			—			—		—			(426		)	(426		)
Net income	—			7,700			—			—		—			—			7,700
Cash dividends ($0.65 per share)	—			(6,060		)	—			—		—			—			(6,060		)
Purchase of 35,252 shares of common stock	—			—			—			—		(1,579		)	—			(1,579		)
Other comprehensive loss	—			—			(455		)	—		—			—			(455		)
Balance, March 31, 2016	$	43,889		$	296,127		$	(1,650	)	$	—	$	(28,831	)	$	(37,988	)	$	271,547

Balance, December 31, 2016	$	44,606		$	319,982		$	(3,359	)	$	—	$	(31,178	)	$	(40,781	)	$	289,270
Issuance of 84,638 shares of common stock	3,966			—			—			—		—			—			3,966
Unearned restricted stock compensation	96			—			—			—		—			—			96
Forfeiture of 1,234 shares of common stock	(48		)	—			—			—		—			—			(48		)
Share-based compensation	12			—			—			—		—			—			12
Income tax benefit related to share-based compensation	44			—			—			—		—			—			44
Change related to ESOP shares	—			—			—			—		—			(2,560		)	(2,560		)
Net income	—			8,874			—			—		—			—			8,874
Cash dividends ($0.70 per share)	—			(6,485		)	—			—		—			—			(6,485		)
Purchase of 9,346 shares of common stock	—			—			—			—		(465		)	—			(465		)
Other comprehensive income	—			—			1,063			—		—			—			1,063
Balance, March 31, 2017	$	48,676		$	322,371		$	(2,296	)	$	—	$	(31,643	)	$	(43,341	)	$	293,767

See Notes to Consolidated Financial Statements.

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



	Three Months Ended March 31,
	2017			2016
Cash Flows from Operating Activities
Net income	$	8,874		$	7,700
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation	757			727
Provision for loan losses	(814		)	549
Share-based compensation	12			7
Forfeiture of common stock	(48		)	—
Compensation expensed through issuance of common stock	85			127
Excess tax benefits from share-based compensation	(44		)	(2		)
Provision for deferred income taxes	(104		)	(481		)
Net gain on sale of other real estate owned and other repossessed assets	(34		)	(34		)
Increase in accrued interest receivable	(1,165		)	(1,348		)
Amortization of premium on investment securities, net	151			148
Decrease in other assets	1,241			739
Increase in accrued interest payable and other liabilities	2,704			1,567
Loans originated for sale	(23,735		)	(32,243		)
Proceeds on sales of loans	32,201			33,515
Net gain on sales of loans	(316		)	(289		)
Net cash and cash equivalents provided by operating activities	$	19,765		$	10,682

Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	8,206		$	11,031
Purchases of investment securities available for sale	(13,049		)	(10,627		)
Loans made to customers, net of collections	(29,401		)	(8,995		)
Proceeds on sale of other real estate owned and other repossessed assets	172			133
Purchases of property and equipment	(1,233		)	(1,619		)
Income from tax credit real estate, net	24			68
Net cash and cash equivalents used in investing activities	$	(35,281	)	$	(10,009	)

Cash Flows from Financing Activities
Net increase in deposits	$	137,020		$	88,879
Net (decrease) increase in other borrowings	(5,403		)	1,330
Net increase in FHLB borrowings	—			15,000
Issuance of common stock, net of costs	3,762			—
Stock options exercised	119			—
Excess tax benefits related to share-based compensation	44			2
Purchase of treasury stock	(465		)	(1,579		)
Dividends paid	(6,485		)	(6,060		)
Net cash and cash equivalents provided by financing activities	$	128,592		$	97,572

(Continued)

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

	Three Months Ended March 31,
	2017		2016
Increase in cash and cash equivalents	$	113,076	$	98,245
Cash and cash equivalents:
Beginning of period	38,197		35,427
End of period	$	151,273	$	133,672

Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	2,172	$	1,929
Interest paid on other obligations	1,855		2,162
Income taxes paid	—		342

Noncash activities:
Increase in maximum cash obligation related to ESOP shares	$	2,560	$	426
Transfers to other real estate owned	95		—
Sale and financing of other real estate owned	214		135

See Notes to Consolidated Financial Statements.

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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 three month period ended March 31, 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 is in the process of evaluating its noninterest income streams and how they might be impacted by the new guidance. The adoption of ASU 2014-09 by the Company is not expected to 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 adoption of ASU 2016-02 by the Company is not expected to have a material impact.

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.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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. We are currently evaluating the impact the CECL model will have on our accounting, but 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 effective.

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 permitting 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.

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.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 2.	Earnings Per Share

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

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



	Three Months Ended March 31,
	2017		2016
Common shares outstanding at the beginning of the period	9,264,227		9,322,054
Weighted average number of net shares issued (redeemed)	61,124		(14,370		)
Weighted average shares outstanding (basic)	9,325,351		9,307,684
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method	6,190		6,130
Weighted average number of shares (diluted)	9,331,541		9,313,814
Net income (In thousands)	$	8,874	$	7,700
Earnings per share:
Basic	$	0.95	$	0.83
Diluted	$	0.95	$	0.83


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 March 31, 2017 and December 31, 2016:



	March 31, 2017			December 31, 2016
	(amounts in thousands)
Net unrealized loss on available-for-sale securities	$	(129	)	$	(1,502	)
Net unrealized loss on derivatives used for cash flow hedges	(3,589		)	(3,938		)
Tax effect	$	1,422		$	2,081
Net-of-tax amount	$	(2,296	)	$	(3,359	)

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 4.	Securities

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



	March 31, 2017				December 31, 2016
	Amount		Percent		Amount		Percent
Securities available for sale
U.S. Treasury	$	32,389	11.85	%	$	27,482	10.27	%
Other securities (FHLB, FHLMC and FNMA)	57,744		21.12		61,660		23.05
State and political subdivisions	183,276		67.03		178,395		66.68
Total securities available for sale	$	273,409	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 March 31, 2017 or December 31, 2016. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of March 31, 2017 and December 31, 2016 (in thousands):



	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Estimated Fair Value
March 31, 2017:
U.S. Treasury	$	32,320	$	80	$	(11	)	$	32,389
Other securities (FHLB, FHLMC and FNMA)	58,029		45		(330		)	57,744
State and political subdivisions	183,189		1,020		(933		)	183,276
Total	$	273,538	$	1,145	$	(1,274	)	$	273,409
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

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at March 31, 2017, were as follows (in thousands):



	Amortized Cost		Fair Value
Due in one year or less	$	54,197	$	54,263
Due after one year through five years	144,824		145,067
Due after five years through ten years	73,442		73,007
Due over ten years	1,075		1,072
Total	$	273,538	$	273,409

As of March 31, 2017 investment securities with a carrying value of $45.51 million were pledged to collateralize repurchase agreements, derivative financial instruments, and other borrowings.

Page 13

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2017 and December 31, 2016 (in thousands):



	Less than 12 months								12 months or more								Total
March 31, 2017 Description of Securities	#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
U.S. Treasury	2	$	4,937	$	(11	)	0.22	%	—	$	—	$	—		—	%	2	$	4,937	$	(11	)	0.22	%

Other securities (FHLB, FHLMC and FNMA)	12	29,741		(330		)	1.11		—	—		—			—		12	29,741		(330		)	1.11

State and political subdivisions	237	57,946		(904		)	1.56		11	1,500		(29		)	1.93		248	59,446		(933		)	1.57

Total temporarily impaired securities	251	$	92,624	$	(1,245	)	1.34	%	11	$	1,500	$	(29	)	1.93	%	262	$	94,124	$	(1,274	)	1.35	%



	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	%

The Company considered the following information in reaching the conclusion that the impairments disclosed in the table above are temporary and not other-than-temporary impairments. None of the unrealized losses in the above table was due to the deterioration in the credit quality of any of the issues that might result in the non-collection of contractual principal and interest. The unrealized losses are due to changes in interest rates. The Company has not recognized any unrealized loss in income because management does not have the intent to sell the securities included in the previous table. Management has concluded that it is more likely than not that the Company will not be required to sell these securities prior to recovery of the amortized cost basis.

Page 14

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 5.	Loans

Classes of loans are as follows:



	March 31, 2017		December 31, 2016
	(Amounts In Thousands)
Agricultural	$	87,934	$	92,871
Commercial and financial	199,702		192,995
Real estate:
Construction, 1 to 4 family residential	63,784		57,864
Construction, land development and commercial	125,144		121,561
Mortgage, farmland	205,334		202,340
Mortgage, 1 to 4 family first liens	780,407		767,469
Mortgage, 1 to 4 family junior liens	127,721		125,400
Mortgage, multi-family	303,653		302,831
Mortgage, commercial	334,067		334,198
Loans to individuals	24,710		25,157
Obligations of state and political subdivisions	54,709		54,462
	$	2,307,165	$	2,277,148
Net unamortized fees and costs	826		827
	$	2,307,991	$	2,277,975
Less allowance for loan losses	26,450		26,530
	$	2,281,541	$	2,251,445

Page 15

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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 months ended March 31, 2017 were as follows:



	Three Months Ended March 31, 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	—			(220		)	—			—		(145		)	—		(188		)	(553		)
Recoveries	38			454			381			—		133			180		101			1,287
Provision	(480		)	(866		)	(177		)	90		507			133		(21		)	(814		)

Ending balance	$	2,505		$	3,899		$	3,094		$	3,507	$	8,172		$	4,358	$	915		$	26,450

Ending balance, individually evaluated for impairment	$	587		$	144		$	72		$	345	$	62		$	15	$	36		$	1,261

Ending balance, collectively evaluated for impairment	$	1,918		$	3,755		$	3,022		$	3,162	$	8,110		$	4,343	$	879		$	25,189

Loans:

Ending balance	$	87,934		$	199,702		$	188,928		$	205,334	$	908,128		$	637,720	$	79,419		$	2,307,165

Ending balance, individually evaluated for impairment	$	11,388		$	1,787		$	671		$	8,502	$	5,521		$	2,034	$	36		$	29,939

Ending balance, collectively evaluated for impairment	$	76,546		$	197,915		$	188,257		$	196,832	$	902,607		$	635,686	$	79,383		$	2,277,226

Page 16

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Changes in the allowance for loan losses for the three months ended March 31, 2016 were as follows:



	Three Months Ended March 31, 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	—			(55		)	—		(10		)	(344		)	(66		)	(169		)	(644		)
Recoveries	142			253			52		—			213			11			44			715
Provision	(270		)	(404		)	427		612			(5		)	22			167			549

Ending balance	$	2,954		$	4,311		$	2,759	$	3,944		$	8,036		$	4,190		$	936		$	27,130

Ending balance, individually evaluated for impairment	$	868		$	268		$	32	$	670		$	310		$	88		$	22		$	2,258

Ending balance, collectively evaluated for impairment	$	2,086		$	4,043		$	2,727	$	3,274		$	7,726		$	4,102		$	914		$	24,872

Loans:

Ending balance	$	90,620		$	173,736		$	163,900	$	189,882		$	844,039		$	600,680		$	74,582		$	2,137,439

Ending balance, individually evaluated for impairment	$	12,647		$	2,406		$	1,450	$	8,098		$	5,594		$	3,649		$	22		$	33,866

Ending balance, collectively evaluated for impairment	$	77,973		$	171,330		$	162,450	$	181,784		$	838,445		$	597,031		$	74,560		$	2,103,573

Page 17

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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 March 31, 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
March 31, 2017
Grade:
Excellent	$	3,256	$	9,520	$	—	$	635
Good	14,292		38,506		5,753		22,777
Satisfactory	37,290		115,447		45,876		51,858
Monitor	15,562		25,704		9,256		45,207
Special Mention	4,372		6,328		1,311		4,215
Substandard	13,162		4,197		1,588		452
Total	$	87,934	$	199,702	$	63,784	$	125,144



	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
March 31, 2017
Grade:
Excellent	$	2,829	$	1,183	$	130	$	5,882
Good	49,476		15,354		3,342		72,006
Satisfactory	104,287		659,704		115,372		182,985
Monitor	36,334		68,035		4,891		38,867
Special Mention	3,136		12,523		1,506		3,611
Substandard	9,272		23,608		2,480		302
Total	$	205,334	$	780,407	$	127,721	$	303,653



	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
March 31, 2017
Grade:
Excellent	$	15,424	$	—	$	—	$	38,859
Good	89,922		97		34,395		345,920
Satisfactory	186,099		23,903		17,160		1,539,981
Monitor	34,981		340		3,154		282,331
Special Mention	3,925		193		—		41,120
Substandard	3,716		177		—		58,954
Total	$	334,067	$	24,710	$	54,709	$	2,307,165

Page 18

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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

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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

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Past due loans as of March 31, 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)
March 31, 2017
Agricultural	$	293	$	—	$	81	$	374	$	87,560	$	87,934	$	—
Commercial and financial	1,350		547		120		2,017		197,685		199,702		—
Real estate:
Construction, 1 to 4 family residential	1,411		—		—		1,411		62,373		63,784		—
Construction, land development and commercial	679		—		60		739		124,405		125,144		60
Mortgage, farmland	586		—		—		586		204,748		205,334		—
Mortgage, 1 to 4 family first liens	3,761		694		1,680		6,135		774,272		780,407		221
Mortgage, 1 to 4 family junior liens	132		21		136		289		127,432		127,721		—
Mortgage, multi-family	4,354		—		40		4,394		299,259		303,653		—
Mortgage, commercial	694		16		163		873		333,194		334,067		—
Loans to individuals	97		9		—		106		24,604		24,710		—
Obligations of state and political subdivisions	—		—		—		—		54,709		54,709		—
	$	13,357	$	1,287	$	2,280	$	16,924	$	2,290,241	$	2,307,165	$	281

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

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



	March 31, 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	$	1,528	$	—	$	7,212	$	1,741	$	—	$	91
Commercial and financial	1,278		—		509		1,354		—		1,057
Real estate:
Construction, 1 to 4 family residential	—		—		265		—		—		265
Construction, land development and commercial	—		60		346		85		—		118
Mortgage, farmland	1,410		—		1,662		1,205		—		1,389
Mortgage, 1 to 4 family first liens	3,921		221		1,362		4,097		192		1,375
Mortgage, 1 to 4 family junior liens	149		—		26		136		443		26
Mortgage, multi-family	239		—		—		243		—		—
Mortgage, commercial	719		—		1,075		1,077		—		1,087
	$	9,244	$	281	$	12,457	$	9,938	$	635	$	5,408


(1)	There were $4.17 million and $4.23 million of TDR loans included within nonaccrual loans as of March 31, 2017 and December 31, 2016, respectively.

Loans 90 days or more past due that are still accruing interest decreased $0.35 million from December 31, 2016 to March 31, 2017 due to a decrease in the number of loans past due greater than 90 days. As of March 31, 2017 there were 3 accruing loans past due 90 days or more. The average accruing loans past due as of March 31, 2017 are $0.09 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

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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



	March 31, 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	7	$	8,596	$	143	4	$	1,460	$	167
Commercial and financial	11	1,426		551		14	2,053		117
Real estate:
Construction, 1 to 4 family residential	3	265		119		3	265		1,225
Construction, land development and commercial	2	346		6		1	118		107
Mortgage, farmland	8	3,073		—		7	2,594		—
Mortgage, 1 to 4 family first liens	12	1,454		—		12	1,471		—
Mortgage, 1 to 4 family junior liens	1	26		16		1	26		65
Mortgage, multi-family	—	—		—		—	—		—
Mortgage, commercial	8	1,440		—		10	1,650		—
Loans to individuals	—	—		—		—	—		—
	52	$	16,626	$	835	52	$	9,637	$	1,681

The following is a summary of TDR loans that were modified during the three months ended March 31, 2017:



	Three Months Ended March 31, 2017
	Number of contracts	Pre-modification recorded investment		Post-modification recorded investment
		(Amounts In Thousands)
Agricultural	3	$	8,783	$	8,783
Commercial and financial	—	—		—
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	—	—		—
Mortgage, 1 to 4 family junior liens	—	—		—
Mortgage, multi-family	—	—		—
Mortgage, commercial	—	—		—
	6	$	9,612	$	9,612

Page 23

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The Company had commitments to lend $0.84 million in additional borrowings to restructured loan customers as of March 31, 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 March 31, 2017 and year ended December 31, 2016.

Page 24

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Information regarding impaired loans as of and for the three months ended March 31, 2017 is as follows:



	March 31, 2017						Three Months Ended March 31, 2017
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	1,528	$	1,748	$	—	$	1,524	$	—
Commercial and financial	1,531		2,163		—		1,555		5
Real estate:
Construction, 1 to 4 family residential	117		151		—		117		1
Construction, land development and commercial	117		167		—		118		1
Mortgage, farmland	2,753		3,062		—		2,636		16
Mortgage, 1 to 4 family first liens	4,682		5,796		—		4,726		13
Mortgage, 1 to 4 family junior liens	149		645		—		151		—
Mortgage, multi-family	239		361		—		241		—
Mortgage, commercial	1,700		2,283		—		1,722		11
Loans to individuals	—		18		—		—		—
	$	12,816	$	16,394	$	—	$	12,790	$	47

With an allowance recorded:
Agricultural	$	9,860	$	9,860	$	587	$	9,967	$	111
Commercial and financial	256		275		144		272		1
Real estate:
Construction, 1 to 4 family residential	289		289		32		290		3
Construction, land development and commercial	148		148		40		148		2
Mortgage, farmland	5,749		5,749		345		5,751		61
Mortgage, 1 to 4 family first liens	664		703		59		684		4
Mortgage, 1 to 4 family junior liens	26		26		3		26		1
Mortgage, multi-family	—		—		—		—		—
Mortgage, commercial	95		97		15		97		1
Loans to individuals	36		36		36		33		1
	$	17,123	$	17,183	$	1,261	$	17,268	$	185

Total:
Agricultural	$	11,388	$	11,608	$	587	$	11,491	$	111
Commercial and financial	1,787		2,438		144		1,827		6
Real estate:
Construction, 1 to 4 family residential	406		440		32		407		4
Construction, land development and commercial	265		315		40		266		3
Mortgage, farmland	8,502		8,811		345		8,387		77
Mortgage, 1 to 4 family first liens	5,346		6,499		59		5,410		17
Mortgage, 1 to 4 family junior liens	175		671		3		177		1
Mortgage, multi-family	239		361		—		241		—
Mortgage, commercial	1,795		2,380		15		1,819		12
Loans to individuals	36		54		36		33		1
	$	29,939	$	33,577	$	1,261	$	30,058	$	232

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 decreased $3.73 million from December 31, 2016 to March 31, 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 1.30% of loans held for investment as of March 31, 2017 and 1.48% as of December 31, 2016. The decrease in impaired loans is due mainly to a decrease in nonaccrual loans of $0.70 million, a decrease of $9.45 million in relationships with a specific allowance for losses, and is offset by an increase in TDR loans of $7.05 million from December 31, 2016 to March 31, 2017.

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 March 31, 2017 are as follows:



	March 31, 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	$	151,273	$	151,273	$	151,273	$	—	$	—
Investment securities	286,016		286,016		—		286,016		—
Loans held for sale	1,656		1,656		—		1,656		—
Loans
Agricultural	85,429		85,394		—		—		85,394
Commercial and financial	195,803		195,651		—		—		195,651
Real estate:
Construction, 1 to 4 family residential	62,689		62,706		—		—		62,706
Construction, land development and commercial	123,145		123,029		—		—		123,029
Mortgage, farmland	201,827		201,988		—		—		201,988
Mortgage, 1 to 4 family first liens	773,417		767,495		—		—		767,495
Mortgage, 1 to 4 family junior liens	126,539		131,430		—		—		131,430
Mortgage, multi-family	301,827		298,276		—		—		298,276
Mortgage, commercial	331,535		328,530		—		—		328,530
Loans to individuals	24,205		24,188		—		—		24,188
Obligations of state and political subdivisions	54,299		53,115		—		—		53,115
Accrued interest receivable	10,286		10,286		—		10,286		—
Total financial instrument assets	$	2,729,946	$	2,721,033	$	151,273	$	297,958	$	2,271,802
Financial instrument liabilities
Deposits
Noninterest-bearing deposits	$	339,867	$	339,867	$	—	$	339,867	$	—
Interest-bearing deposits	1,833,465		1,837,543		—		1,837,543		—
Other borrowings	28,086		28,086		—		28,086		—
Federal Home Loan Bank borrowings	235,000		228,318		—		228,318		—
Interest rate swaps	3,589		3,589		—		3,589		—
Accrued interest payable	940		940		—		940		—
Total financial instrument liabilities	$	2,440,947	$	2,438,343	$	—	$	2,438,343	$	—

	Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	432,943	$	—	$	—	$	—	$	—
Letters of credit	8,885		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	441,828	$	—	$	—	$	—	$	—


(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 three months ended March 31, 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:



	March 31, 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	$	—	$	32,389		$	—	$	32,389
State and political subdivisions	—		57,744			—		57,744
Other securities (FHLB, FHLMC and FNMA)	—		183,276			—		183,276
Derivative Financial Instruments
Interest rate swaps	$	—	(3,589		)	$	—	(3,589		)
Total	$	—	$	269,820		$	—	$	269,820



	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 three months ended March 31, 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.



	March 31, 2017								Three Months Ended March 31, 2017
	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	$	—	$	—	$	10,714	$	10,714	$	—
Commercial and financial	—		—		1,383		1,383		—
Real Estate:
Construction, 1 to 4 family residential	—		—		224		224		—
Construction, land development and commercial	—		—		197		197		—
Mortgage, farmland	—		—		7,624		7,624		—
Mortgage, 1 to 4 family first liens	—		—		4,968		4,968		42
Mortgage, 1 to 4 family junior liens	—		—		145		145		17
Mortgage, multi-family	—		—		239		239		—
Mortgage, commercial	—		—		1,195		1,195		—
Loans to individuals	—		—		—		—		—
Foreclosed assets (5)	—		—		—		—		—
Total	$	—	$	—	$	26,689	$	26,689	$	59


(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 972,297 shares of its common stock in privately negotiated transactions from August 1, 2005 through March 31, 2017. Of these 972,297 shares, 9,346 shares were purchased during the quarter ended March 31, 2017, at an average price per share of $49.78.

Page 34

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 8.	Commitments and Contingencies

Concentrations of credit risk: The Bank’s loans, commitments to extend credit, unused lines of credit and outstanding letters of credit have been granted to customers within the Bank's market area. Investments in securities issued by state and political subdivisions within the state of Iowa totaled approximately $79.54 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 March 31, 2017 and December 31, 2016 is as follows:



	March 31, 2017		December 31, 2016
	(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	51,362	$	48,785
Credit cards	47,168		45,738
Commercial, real estate and home construction	147,200		113,251
Commercial lines and real estate purchase loans	187,213		180,892
Outstanding letters of credit	8,885		9,024


Note 9.	Income Taxes

Federal income tax expense for the three months ended March 31, 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 March 31, 2017 and December 31, 2016 and therefore no interest or penalties on unrecognized tax benefits has been recorded. As of March 31, 2017, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending March 31, 2018. Income taxes as a percentage of income before taxes were 30.89% for the three months ended March 31, 2017 and 29.65% for the same period in 2016.

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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 $3.59 million of collateral as of March 31, 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 March 31, 2017 and December 31, 2016:



	Notional Amount		Fair Value			Balance Sheet Category	Maturity
	(Amounts in Thousands)
March 31, 2017
Interest rate swap	$	25,000	$	(948	)	Other Liabilities	11/9/2020
Interest rate swap	25,000		(2,641		)	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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The table below identifies the gains and losses recognized on the Bank’s derivative instruments designated as cash flow hedges as of March 31, 2017 and 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)
March 31, 2017
Interest rate swap	$	92		Interest Expense	$	—	Other Income	$	—
Interest rate swap	124			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 March 31, 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 March 31, 2017, the Bank has nineteen full-service locations.

Net income for the three month period ended March 31, 2017 was $8.87 million compared to $7.70 million for the same three months of 2016, an increase of 15.25%. The $1.17 million increase in net income was caused by a number of factors. The principal factors in the increase in net income for the first three months of 2017 are an increase in net interest income of $1.52 million, an increase in noninterest income of $0.37 million, and a decrease in provision for loan losses of $1.36 million. These changes were offset by an increase in income tax expense of $0.72 million and an increase in noninterest expenses of $1.36 million.

The Company achieved a return on average assets of 1.27% and a return on average equity of 11.58% for the twelve months ended March 31, 2017, compared to the twelve months ended March 31, 2016, which were 1.19% and 11.19%, 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 3.45% for the three months ended March 31, 2017 compared to 3.40% for the same three months of 2016. Average earning assets were $2.571 billion year to date in 2017 and $2.406 billion in 2016.

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Highlights noted on the balance sheet as of March 31, 2017 for the Company included the following:


•	Total assets were $2.797 billion, an increase of $141.28 million since December 31, 2016.


•	Cash and cash equivalents were $151.27 million, an increase of $113.08 million since December 31, 2016. Cash and cash equivalents growth included approximately $77.00 million of temporary public funds.


•	Net loans were $2.283 billion, an increase of $21.95 million since December 31, 2016. Loans held for sale decreased $8.15 million since December 31, 2016.


•	Deposits increased $137.02 million since December 31, 2016. Deposit growth included approximately $77.00 million in temporary tax deposits.

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 construction and mortgage 1 to 4 family first and junior liens loans have been primarily responsible for the increase in total loans.

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



	March 31, 2017				December 31, 2016
	Amount		Percent		Amount		Percent
	(Amounts In Thousands)				(Amounts In Thousands)
Agricultural	$	87,934	3.81	%	$	92,871	4.08	%
Commercial and financial	199,702		8.66		192,995		8.47
Real estate:
Construction, 1 to 4 family residential	63,784		2.76		57,864		2.54
Construction, land development and commercial	125,144		5.42		121,561		5.34
Mortgage, farmland	205,334		8.90		202,340		8.89
Mortgage, 1 to 4 family first liens	780,407		33.83		767,469		33.70
Mortgage, 1 to 4 family junior liens	127,721		5.54		125,400		5.51
Mortgage, multi-family	303,653		13.16		302,831		13.30
Mortgage, commercial	334,067		14.48		334,198		14.68
Loans to individuals	24,710		1.07		25,157		1.10
Obligations of state and political subdivisions	54,709		2.37		54,462		2.39
	$	2,307,165	100.00	%	$	2,277,148	100.00	%
Net unamortized fees and costs	826				827
	$	2,307,991			$	2,277,975
Less allowance for loan losses	26,450				26,530
	$	2,281,541			$	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 March 31, 2017 and December 31, 2016:



	March 31, 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	$	2,505	9.47	%	3.81	%	$	2,947	11.11	%	4.08	%
Commercial and financial	3,899		14.74		8.66		4,531		17.08		8.47
Real estate:
Construction, 1 to 4 family residential	1,095		4.14		2.76		1,023		3.86		2.54
Construction, land development and commercial	1,999		7.56		5.42		1,867		7.04		5.34
Mortgage, farmland	3,507		13.26		8.90		3,417		12.88		8.89
Mortgage, 1 to 4 family first liens	6,990		26.43		33.83		6,560		24.72		33.70
Mortgage, 1 to 4 family junior liens	1,182		4.47		5.54		1,117		4.21		5.51
Mortgage, multi-family	1,826		6.90		13.16		1,669		6.29		13.30
Mortgage, commercial	2,532		9.57		14.48		2,376		8.95		14.68
Loans to individuals	505		1.91		1.07		642		2.42		1.10
Obligations of state and political subdivisions	410		1.55		2.37		381		1.44		2.39
	$	26,450	100.00	%	100.00	%	$	26,530	100.00	%	100.00	%

The allowance for loan losses totaled $26.45 million at March 31, 2017 compared to $26.53 million at December 31, 2016. The percentage of the allowance to outstanding loans was 1.15% and 1.17% at March 31, 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 decrease in the allowance in 2017 is the result of change in the composition and allocation of loans within credit quality ratings partially offset by net recoveries.

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 March 31, 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.

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

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Investment securities available for sale held by the Company increased by $5.87 million from December 31, 2016 to March 31, 2017. The fair value of securities available for sale was $0.13 million less than the amortized cost of such securities as of March 31, 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 $137.02 million in the first three months of 2017. Deposit growth included approximately $77.00 million in seasonal real estate tax deposits which generally decrease within the following two months. Repurchase agreements decreased $5.40 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 $121.27 million as of March 31, 2017 with an average rate of 0.71%. Brokered deposits were $112.70 million as of December 31, 2016 with an average interest rate of 0.59%. As of March 31, 2017 and December 31, 2016, brokered deposits were 5.58% and 5.53% of total deposits, respectively.

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 March 31, 2017 totaled $293.77 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 March 31, 2017 and December 31, 2015, 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 March 31, 2017 and December 31, 2015 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 March 31, 2017:
Company:
Total risk-based capital	$	363,354	16.33	%	8.000	%	10.000	%
Tier 1 risk-based capital	336,904		15.14		6.000		8.000
Tier 1 common equity	336,904		15.14		4.500		6.500
Leverage ratio	336,904		12.61		4.000		5.000
Bank:
Total risk-based capital	363,240		16.34		8.000		10.000
Tier 1 risk-based capital	336,790		15.15		6.000		8.000
Tier 1 common equity	336,790		15.15		4.500		6.500
Leverage ratio	336,790		12.62		4.000		5.000

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	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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Discussion of operations for the three months ended March 31, 2017 and 2016

Net Income Overview

Net income increased $1.17 million for the three months ended March 31, 2017 compared to the first three months of 2016. Total net income was $8.87 million in 2017 and $7.70 million in the comparable period in 2016, an increase of 15.25%. The changes in net income in 2017 from the first three months of 2016 were primarily the result of the following:


•	Net interest income increased by $1.52 million, before provision expense. Total interest income increased by $1.42 million as a result of growth in the volume of earning assets.


•	The provision for loan losses decreased by $1.36 million.


•	Noninterest income increased by $0.37 million.


•	Noninterest expenses increased by $1.36 million.


•	Income tax expense increased by $0.72 million.

For the three month period ended March 31, 2017 and March 31, 2016 basic earnings per share was $0.95 and $0.83, respectively. Diluted earnings per share was $0.95 for the three months ended March 31, 2017 compared to $0.83 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 $21.20 million for the first three months of 2017 was derived from the Company’s $2.571 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.45%. Average earning assets in the three months ended March 31, 2016 were $2.406 billion and the tax-equivalent net interest margin was 3.40%. 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 $0.64 million change in income before income taxes in the three month period ended March 31, 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 compression to impact earnings for the foreseeable future. The Company believes growth in net interest income will be contingent on the growth of the Company’s earnings assets.

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $2.283 billion at March 31, 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 a reduction of expense of $0.81 million in 2017 compared to an expense of $0.55 million in 2016. 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 $3.97 million and $3.25 million for the three months ended March 31, 2017 and 2016, respectively. Income taxes as a percentage of income before taxes were 30.89% in 2017 and 29.65% in 2016.

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Discussion of operations for the three months ended March 31, 2017 and 2016

Net Interest Income

Net interest income increased for the three months ended March 31, 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 three months of 2017 was 3.45% compared to 3.40% 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	$	160,827		(0.02	)%	$	1,469		$	(99	)	$	1,370
Taxable securities	2,211			0.11		9			28			37
Nontaxable securities	7,925			(0.12	)	59			(51		)	8
Federal funds sold	(5,241		)	0.37		(7		)	27			20
	$	165,722				$	1,530		$	(95	)	$	1,435

Interest expense:
Interest-bearing demand deposits	$	25,005		0.01	%	$	(7	)	$	(6	)	$	(13	)
Savings deposits	102,555			0.07		(57		)	(130		)	(187		)
Time deposits	(11,241		)	0.06		49			(56		)	(7		)
Other borrowings	(2,616		)	3.38		(22		)	—			(22		)
FHLB borrowings	1,379			(0.49	)	11			288			299
Interest-bearing other liabilities	(14,495		)	0.01		9			(1		)	8
	$	100,587				$	(17	)	$	95		$	78
Change in net interest income						$	1,513		$	—		$	1,513

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	4.08	%	4.07	%
Rate on average interest-bearing liabilities	0.81		0.86
Net interest spread	3.27	%	3.21	%
Effect of noninterest-bearing funds	0.18		0.19
Net interest margin (tax equivalent interest income divided by average interest-earning assets)	3.45	%	3.40	%

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Discussion of operations for the three months ended March 31, 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 two times during the first three months of 2017. The target rate was increased in March, 2017 at 1.00%. 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 March 31, 2017, the rate indexes for the one, three and five year indexes were 1.03%, 1.50% and 1.93%, respectively. The one year index increased 74.58% from 0.59% at March 31, 2016, the three year index increased 72.41% and the five year index increased 59.50%. The three year index was 0.87% and the five year index was 1.21% at March 31, 2016. The targeted federal funds rate was 1.00% and 0.50% at March 31, 2017 and 2016, respectively. The Company anticipates possible increases in short term and long term rates in the indexes for 2017.

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $0.81 million for the three months ended March 31, 2017 compared to an expense of $0.55 million in 2016, an expense decrease of $1.36 million. The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio. The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks. The decrease in expense in 2017 is the net result of an increase in net loans, the effects of loan recoveries in 2017, a change in the composition and allocation of loans within credit quality ratings, improvement in qualitative factor adjustments, and a specific allowance recorded for a $8.08 agricultural and farmland real estate loan relationship.

The allowance for loan losses decreased $0.08 million during the first three months of 2017. In the first three months of 2017, there was a increase of $1.51 million due to increases in average balances and composition of loans outstanding and a $1.59 million decrease in the amount allocated to the allowance due to improvements in credit quality.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the three months ended March 31, 2017 and 2016, recoveries were $1.29 million and $0.72 million, respectively; and charge-offs were $0.55 million in 2017 and $0.64 million in 2016. The allowance for loan losses totaled $26.45 million at March 31, 2017 compared to $26.53 million at December 31, 2016. The allowance represented 1.15% and 1.17% of loans held for investment at March 31, 2017 and December 31, 2016.

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended March 31, 2017 and 2016.



	Three Months Ended March 31,
	2017		2016		$ Change		% Change
	(Amounts in thousands)
Net gain on sale of loans	$	316	$	289	$	27	9.34	%
Trust fees	1,879		1,728		151		8.74
Service charges and fees	2,132		2,055		77		3.75
Net gain on sale of other real estate owned and other repossessed assets	34		34		—		—
Other noninterest income	880		767		113		14.73
	$	5,241	$	4,873	$	368	7.55

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Discussion of operations for the three months ended March 31, 2017 and 2016

Loans originated for sale in the first three months of 2017 totaled $23.74 million compared to $32.24 million in the same period in 2016, a decrease of 26.40%. In the three months ended March 31, 2017 and 2016, the net gain on sale of loans was $0.32 million and $0.29 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 $0.15 million in the three months ended March 31, 2017 compared to March 31, 2016 due to new trust relationships.

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended March 31, 2017 and 2016.



	Three Months Ended March 31,
	2017		2016		$ Change			% Change
	(Amounts in thousands)
Salaries and employee benefits	$	7,980	$	6,984	$	996		14.26	%
Occupancy	1,042		1,001		41			4.10
Furniture and equipment	1,429		1,404		25			1.78
Office supplies and postage	461		401		60			14.96
Advertising and business development	790		786		4			0.51
Outside services	2,008		1,776		232			13.06
FDIC insurance assessment	207		303		(96		)	(31.68	)
Other noninterest expense	494		397		97			24.43
	$	14,411	$	13,052	$	1,359		10.41

In the three months ended March 31, 2017 and 2016, salaries and employee benefits expense increased $1.00 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 three months ended March 31, 2017.

Income Taxes

Federal and state income tax expenses were $3.97 million and $3.25 million for the three months ended March 31, 2017 and 2016, respectively. Income taxes as a percentage of income before taxes were 30.89% in 2017 and 29.65% 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 9.77% of the Company’s total assets at March 31, 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 March 31, 2017, the Company had borrowed $235.00 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 $453.43 million at March 31, 2017.

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As additional sources of liquidity, the Company has the ability to borrow up to $10.00 million from the Federal Reserve Bank of Chicago, and has lines of credit with three banks totaling $227.34 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 March 31, 2017.

As of March 31, 2017, investment securities with a carrying value of $52.54 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.



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.

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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 three months ended March 31, 2017 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

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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 March 31, 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)
January 1 to January 31	3,806	$	48.00	3,806	533,243
February 1 to February 28	1,284	50.99		1,284	531,959
March 1 to March 31	4,256	51.00		4,256	527,703
Total	9,346	$	49.78	9,346	527,703

(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

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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.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



		HILLS BANCORPORATION

Date:	May 3, 2017	By: /s/ Dwight O. Seegmiller
		Dwight O. Seegmiller, Director, President and Chief Executive Officer

Date:	May 3, 2017	By: /s/ Shari DeMaris
		Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer

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QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED MARCH 31, 2017



Exhibit Number	Description	Page Number In The Sequential Numbering System March 31, 2017 Form 10-Q

31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	55-56

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	57

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