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HILLS BANCORPORATION - Annual Report: 2018 (Form 10-K)


 
 
 
 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K
 
ý  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2018.
 
Commission File Number 0-12668
HILLS BANCORPORATION
(Exact name of Registrant as specified in its charter)
Iowa
 
42-1208067
(State or Other Jurisdiction of Incorporation or Organization)
 
(IRS Employer Identification No.)
 
131 E. Main Street, PO Box 160, Hills, Iowa 52235
(Address of principal executive offices)

Registrant's telephone number, including area code:  (319) 679-2291
Securities Registered pursuant to Section 12 (b) of the Act:  None
Securities Registered pursuant to Section 12 (g) of the Act:

No par value common stock
Title of Class

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o No þ
 
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ

Indicate by check mark 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.  Yes þ No­­­ o

Indicate by checkmark whether the Registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).  Yes þ No­­ o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Registrant S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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 check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o No þ

The aggregate market value of the common stock held by non-affiliates of the registrant as of June 30, 2018, based on the most recent sale price of $58.00 per share, and 7,722,910 shares held was $447,928,780.  Common stock held by non-affiliates excludes 1,650,756 shares held by directors, executive officers, and under the Registrant’s Employee Stock Ownership Plan.

The number of shares outstanding of the Registrant's common stock as of February 28, 2019 is 9,387,412 shares of no par value common stock.

DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement dated March 15, 2019 for the Annual Meeting of the Shareholders of the Registrant to be held April 15, 2019 (the Proxy Statement) are incorporated by reference in Part III of this Form 10-K.
 
 
 
 
 


Table of Contents

HILLS BANCORPORATION
FORM 10-K

TABLE OF CONTENTS
 
 
PART I
 
Item 1.
 
 
 
 
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.
 
 
 
 
PART II
 
Item 5.
Item 6.
Item 7.
Item 7A.
Item 8.
Item 9.
Item 9A.
Item 9B.
 
 
 
 
PART III
 
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
 
 
 
 
PART IV
 
Item 15.




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PART I

References in this report to “we,” “us,” “our,” “Bank,” or the “Company” or similar terms refer to Hills Bancorporation and its subsidiary.

Item 1.
Business

GENERAL

Hills Bancorporation (the "Company") is a holding company principally engaged, through its subsidiary bank, in the business of banking.  The Company was incorporated December 12, 1982 and all operations are conducted within the state of Iowa.  The Company became owner of 100% of the outstanding stock of Hills Bank and Trust Company, Hills, Iowa (“Hills Bank and Trust” or the “Bank”) as of January 23, 1984 when stockholders of Hills Bank and Trust exchanged their shares for shares of the Company.  Effective July 1, 1996, the Company formed a new subsidiary, Hills Bank, which acquired for cash all the outstanding shares of a bank in Lisbon, Iowa.  Subsequently an office of Hills Bank was opened in Mount Vernon, Iowa, a community that is contiguous to Lisbon.  Effective November 17, 2000, Hills Bank was merged into the Bank.  On September 20, 1996, another subsidiary, Hills Bank Kalona, acquired cash and other assets and assumed the deposits of the Kalona, Iowa office of Boatmen's Bank Iowa, N.A.  Effective October 26, 2001, Hills Bank Kalona was merged into the Bank.

Through its internet website (www.hillsbank.com), the Company makes available the Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, all amendments to those reports, and other filings with the Securities and Exchange Commission, as soon as reasonably practicable after they are filed or furnished.

The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers.  The Bank is actively engaged in all areas of commercial banking, including acceptance of demand, savings and time deposits; making commercial, real estate, agricultural and consumer loans; maintaining night and safe deposit facilities; and performing collection, exchange and other banking services tailored for individual customers.  The Bank administers estates, personal trusts, and pension plans and provides farm management, investment advisory and custodial services for individuals, corporations and nonprofit organizations.  In addition, the Bank earns substantial fees from originating mortgages that are sold on the secondary residential real estate market without mortgage servicing rights being retained.

Lending Activities

Real Estate Loans

Real estate loans totaled $2.223 billion and comprised 84.59% of the Bank’s loan portfolio as of December 31, 2018.  The Bank’s real estate loans include construction loans and mortgage loans.

Mortgage Loans.  The Bank offers residential, commercial and agricultural real estate loans.  As of December 31, 2018, mortgage loans totaled $2.037 billion and comprised 77.51% of the Bank’s loan portfolio.

Residential real estate loans totaled $1,064.68 million and were 40.51% of the Bank’s loan portfolio as of December 31, 2018.  These loans include first and junior liens on 1 to 4 family residences.  The Bank originates 1 to 4 family mortgage loans to individuals and businesses within its trade area.  The Bank sells certain mortgage loans to third parties on the secondary market.  For the loans sold on the secondary market, the Bank does not retain any percentage of ownership or servicing rights.  Interest rates for residential real estate mortgages are determined by competitive pricing factors on the secondary market and within the Bank’s trade area.  Collateral for residential real estate mortgages is generally the underlying property.  Generally, repayment of these loans is from monthly principal and interest payments from the borrower’s personal cash flows and liquidity, and collateral values are a function of residential real estate values in the markets that the Bank serves.

Commercial real estate loans totaled $383.31 million and were 14.59% of the Bank’s loan portfolio at December 31, 2018.  The Bank originates loans for commercial properties to individuals and businesses within its trade area.  The primary source of repayment is the cash flow generated by the collateral underlying the loan.  The secondary repayment source would be the liquidation of the collateral.  Generally, terms for commercial real estate loans range from one to five years with an amortization period of 25 years or less.  The Bank offers both fixed and variable rate loans for commercial real estate.


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Multi-family real estate loans totaled $352.43 million and were 13.41% of the Bank’s loan portfolio at December 31, 2018.  Multi-family real estate loans are made to individuals and businesses in the Bank’s trade area.  These loans are primarily secured by properties such as apartment complexes.  The primary source of repayment is the cash flow generated by the collateral underlying the loan.  The secondary repayment source would be the liquidation of the collateral.  Generally, terms for commercial real estate loans range from one to five years with an amortization period of 25 years or less.  Generally, interest rates for multi-family loans are fixed for the loan term.

Mortgage loans secured by farmland totaled $236.45 million and were 9.00% of the Bank’s loan portfolio at December 31, 2018.  Loans for farmland are made to individuals and businesses within the Bank’s trade area.  The primary source of repayment is the cash flow generated by the collateral underlying the loan.  The secondary repayment source would be the liquidation of the collateral.  Terms for real estate loans secured by farmland range from one to ten years with an amortization period of 25 years or less.  Generally, interest rates are fixed for mortgage loans secured by farmland.

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

As of December 31, 2018, construction loans for personal residences totaled $72.28 million and were 2.75% of the Bank’s loan portfolio.  Construction loans for land development and commercial projects totaled $113.81 million and were 4.33% of the Bank’s loan portfolio.  In total, construction loans totaled $186.09 million and were 7.08% of the Bank’s loan portfolio as of December 31, 2018.

Commercial and Financial Loans

The Bank’s commercial and financial loan portfolio totaled $229.50 million and comprised 8.73% of the total loan portfolio at December 31, 2018.  The Bank’s commercial and financial loans include loans to contractors, retailers and other businesses.  The Bank provides a wide range of business loans, including lines of credit for working capital and operational purposes and term loans for the acquisition of equipment.  Although most loans are made on a secured basis, loans may be made on an unsecured basis where warranted by the overall financial condition of the borrower.  Terms of commercial and financial loans generally range from one to five years.  Interest rates for commercial loans can be fixed or variable.

The Bank’s commercial and financial loans are primarily made based on the reported cash flow of the borrower and secondarily on the underlying collateral provided by the borrower.  The collateral support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of personal guarantees, if applicable.  The primary repayment risks of commercial loans are that the cash flows of the borrower may be unpredictable, and the collateral securing these loans may fluctuate in value.

Agricultural Loans

Agricultural loans include loans made to finance agricultural production and other loans to farmers and farming operations.  These loans totaled $92.67 million and constituted 3.53% of the total loan portfolio at December 31, 2018.  Agricultural loans, most of which are secured by crops and machinery, are provided to finance capital improvement and farm operations as well as acquisitions of livestock and machinery.  The ability of the borrower to repay may be affected by many factors outside of the borrower’s control including adverse weather conditions, loss of livestock due to disease or other factors, declines in market prices for agricultural products and the impact of government regulations.  The ultimate repayment of agricultural loans is dependent upon the profitable operation or management of the agricultural entity.  Agricultural loans generally have a term of one year and may have a fixed or variable rate.

Consumer Lending

The Bank offers consumer loans including personal loans and automobile loans.  These consumer loans typically have shorter terms and lower balances.  At December 31, 2018, consumer loans totaled $30.07 million and were 1.14% of the Bank’s total loan portfolio.


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Loans to State and Political Subdivisions

Loans to State and Political Subdivisions include only tax-exempt loans. These loans totaled $52.73 million and comprised 2.01% of the Bank’s total loan portfolio at December 31, 2018.

Deposit Activities

The Bank’s primary funding source for its loan portfolio and other investments consist of the acceptance of demand, savings and time deposits.

Average Daily Balances

The following table shows average balances of assets, liabilities and stockholders’ equity:

AVERAGE BALANCES
(Average Daily Basis)
 
Years Ended December 31,
 
2018
 
2017
 
2016
 
(Amounts In Thousands)
ASSETS
 
 
 
 
 
Noninterest-bearing cash and cash equivalents
$
27,914

 
$
27,409

 
$
26,180

Interest-bearing cash and cash equivalents
105,609

 
37,024

 
31,886

Taxable securities
128,128

 
105,059

 
101,187

Nontaxable securities
180,912

 
168,877

 
162,742

Federal funds sold
46

 
71

 
50

Loans, net
2,487,736

 
2,340,606

 
2,159,985

Property and equipment, net
37,766

 
38,139

 
35,225

Other assets
32,178

 
39,175

 
43,558

 
$
3,000,289

 
$
2,756,360

 
$
2,560,813

LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

 
 

Noninterest-bearing demand deposits
$
364,916

 
$
342,640

 
$
312,406

Interest-bearing demand deposits
644,712

 
548,598

 
499,882

Savings deposits
832,772

 
748,862

 
684,283

Time deposits
537,575

 
451,208

 
438,173

Other borrowings
9

 
28,602

 
51,177

FHLB borrowings
228,066

 
268,411

 
231,443

Noninterest-bearing other liabilities
21,773

 
22,226

 
23,177

Interest-bearing other liabilities

 

 
872

Redeemable common stock held by Employee Stock Ownership Plan
46,089

 
42,045

 
39,172

Stockholders' equity
324,377

 
303,768

 
280,228

 
$
3,000,289

 
$
2,756,360

 
$
2,560,813

 
Other Information

The Bank’s business is not seasonal.  As of December 31, 2018, the Company had no employees and the Bank had 424 full-time and 57 part-time employees.

For additional discussion of the impact of the economy on the financial condition and results of operations of the Company, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.


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MARKET AREA

Johnson County

The Bank’s trade area includes the Johnson County communities of Iowa City, Coralville, Hills and North Liberty, located near Interstate 80 and Interstate 380 in Eastern Iowa.  These communities have a combined population of approximately 119,400.  Johnson County, Iowa has a population of approximately 152,900.  The University of Iowa in Iowa City has approximately 32,900 students and 40,200 full and part-time employees, including 10,000 employees of The University of Iowa Hospitals and Clinics.

Linn County

The Bank operates offices in the Linn County, Iowa communities of Lisbon, Marion, Mount Vernon and Cedar Rapids, Iowa.  Lisbon has a population of approximately 2,200 and Mount Vernon, located two miles from Lisbon, has a population of about 4,600. Both communities are within easy commuting distances to Cedar Rapids and Iowa City, Iowa.  Cedar Rapids has a metropolitan population of approximately 173,800 including approximately 38,800 from adjoining Marion, Iowa and is located approximately 10 miles west of Lisbon, Iowa and 25 miles north of Iowa City on Interstate 380.  The total population of Linn County is approximately 227,000.  The largest employer in the Cedar Rapids area is Collins Aerospace, manufacturer of communications instruments, with approximately 9,000 employees.

Washington County

The Bank has offices located in Kalona, Washington and Wellman, Iowa, which are in Washington County.  Kalona is located approximately 14 miles north of Washington. Wellman is located approximately 5 miles west of Kalona.  Kalona has a population of approximately 2,900, Washington has a population of approximately 7,400 and Wellman has a population of about 1,400.  The population of Washington County is approximately 22,400.  Kalona, Washington and Wellman are primarily agricultural communities, but are located within easy driving distance for employment in Iowa City, Coralville and North Liberty.

COMPETITION

Competition among financial institutions in attracting and retaining deposits and making loans is intense.  Traditionally, the Company’s most direct competition for deposits has come from commercial banks, savings institutions and credit unions doing business in its areas of operation.  Increasingly, the Company has experienced competition for deposits from nonbanking sources, such as securities firms, insurance companies, money market mutual funds and financial services subsidiaries of commercial and manufacturing companies.  Competition for loans comes primarily from other commercial banks, savings institutions, consumer finance companies, credit unions, mortgage banking companies, insurance companies and other institutional lenders.  The Company competes primarily on the basis of products offered, customer service and price.  A number of institutions with which the Company competes enjoy the benefits of fewer regulatory constraints and lower cost structures including favorable income tax treatments.  Some have greater assets and capital than the Company does and, thus, are better able to compete on the basis of price than the Company.  Technological advances, which may diminish the importance of depository institutions and other financial intermediaries in the transfer of funds between parties, could make it more difficult for the Company to compete in the future.


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The Bank is in direct competition for loans and deposits and financial services with a number of other banks and credit unions in Johnson, Linn and Washington County.  A comparison of the number of office locations and deposits in the three counties as of June, 2018 (most recent date of available data from the FDIC and national credit union websites) is as follows:
 
Johnson County
 
Linn County
 
Washington County
 
Offices
 
Deposits
(in millions)
 
Offices
 
Deposits
(in millions)
 
Offices
 
Deposits
(in millions)
Hills Bank and Trust Company
9

 
$
1,772

 
7

 
$
438

 
3

 
$
187

Branches of largest competing national bank
7

 
299

 
8

 
740

 
1

 
22

Largest competing independent bank
7

 
678

 
5

 
971

 
2

 
185

Largest competing credit union (1)
6

 
3,895

 
7

 
950

 
1

 
1

All other bank and credit union offices
23

 
905

 
81

 
3,239

 
8

 
207

Total Market in County
52

 
$
7,549

 
108

 
$
6,338

 
15

 
$
602


(1)
Deposit balance of the largest competing credit union in Johnson County and Linn County includes the credit union’s deposit balance for the entire institution.  County specific deposit balances for the credit union are unavailable.

SUPERVISION AND REGULATION

Financial institutions and their holding companies are extensively regulated under federal and state law. As a result, the growth and earnings performance of the Company can be affected not only by management decisions and general economic conditions but also by the requirements of applicable state and federal statutes and regulations and the policies of various governmental regulatory authorities, including the Iowa Superintendent of Banking (the “Superintendent”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Federal Deposit Insurance Corporation (the “FDIC”), the Internal Revenue Service and state taxing authorities and the Securities and Exchange Commission (the “SEC”).  The effect of applicable statutes, regulations and regulatory policies can be significant and cannot be predicted with a high degree of certainty.

Federal and state laws and regulations generally applicable to financial institutions regulate, among other things, the scope of business, investments, reserves against deposits, capital levels relative to operations, the nature and amount of collateral for loans, the establishment of branches, mergers, consolidations and dividends.  The system of supervision and regulation applicable to the Company and its subsidiary Bank establishes a comprehensive framework for their respective operations and is intended primarily for the protection of the FDIC’s deposit insurance funds and the depositors, rather than the stockholders, of financial institutions.  The enforcement powers available to federal and state banking regulators are substantial and include, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions.

The following is a summary of the material elements of the regulatory framework applicable to the Company and its subsidiary Bank.  It does not describe all of the statutes, regulations and regulatory policies that apply, nor does it restate all of the requirements of the statutes, regulations and regulatory policies that are described.  As such, the following is qualified in its entirety by reference to the applicable statutes, regulations and regulatory policies.  Any change in applicable law, regulations or regulatory policies may have a material effect on the business of the Company and its subsidiary Bank.

Regulation of the Company

General.  The Company, as the sole shareholder of the Bank, is a bank holding company.  As a bank holding company, the Company is registered with, and is subject to regulation by, the Federal Reserve under the Bank Holding Company Act, as amended (the “BHCA”). According to Federal Reserve Board policy, bank/financial holding companies are expected to act as a source of financial strength to each subsidiary bank and to commit resources to support each such subsidiary. This support may be required at times when a bank/financial holding company may not be able to provide support. Under the BHCA, the Company is subject to periodic examination by the Federal Reserve.  The Company is also required to file with the Federal Reserve periodic reports of the Company’s operations and such additional information regarding the Company and its subsidiary as the Federal Reserve may require.


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Investments and Activities.  Under the BHCA, a bank holding company must obtain Federal Reserve approval before: (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after the acquisition, it would own or control more than 5% of the shares of the other bank or bank holding company (unless it already owns or controls the majority of such shares), (ii) acquiring all or substantially all of the assets of another bank or (iii) merging or consolidating with another bank holding company.  Subject to certain conditions (including certain deposit concentration limits established by the BHCA), the Federal Reserve may allow a bank holding company to acquire banks located in any state of the United States without regard to whether the acquisition is prohibited by the law of the state in which the target bank is located.  On approving interstate acquisitions, however, the Federal Reserve is required to give effect to applicable state law limitations on the aggregate amount of deposits that may be held by the acquiring bank holding company and its insured depository institution affiliates in the state in which the target bank is located (provided that those limits do not discriminate against out-of-state depository institutions or their holding companies) and state laws which require that the target bank have been in existence for a minimum period of time (not to exceed five years) before being acquired by an out-of-state bank holding company.

The BHCA also generally prohibits the Company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries.  This general prohibition is subject to a number of exceptions.  The principal exception allows bank holding companies to engage in, and to own shares of companies engaged in, certain businesses found by the Federal Reserve to be “so closely related to banking as to be a proper incident thereto.”  Under current regulations of the Federal Reserve, the Company either directly or through non-bank subsidiaries would be permitted to engage in a variety of banking-related businesses, including the operation of a thrift, sales and consumer finance, equipment leasing, the operation of a computer service bureau (including software development) and mortgage banking and brokerage.  The BHCA generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies.

Federal law also prohibits any person from acquiring “control” of a bank holding company without prior notice to the appropriate federal bank regulator.  “Control” is defined in certain cases as the acquisition of 10% or more of the outstanding shares of a bank or a bank holding company depending on the circumstances surrounding the acquisition.

Regulatory Capital Requirements.  Bank holding companies are required to maintain minimum levels of capital in accordance with bank regulatory agencies' capital guidelines.  If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses. The guidelines include requirements to maintain certain core capital amounts included as Tier 1 capital at minimum levels relative to total assets (the "Tier 1 Leverage Capital Ratio") and at minimum levels relative to "risk-weighted assets" which is calculated by assigning value to assets, and off balance sheet commitments, based on their risk characteristics (the "Total Risk-Based Capital Ratio"), and to maintain total capital at minimum levels relative to risk-weighted assets (the "Total Risk-Based Capital Ratio").

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.  The rule includes a new Common Equity Tier 1 Capital Ratio, an increased Tier 1 Leverage Capital Ratio and an increased Tier 1 Risk-Based Capital Ratio. Bank holding companies are required to include in Common Equity Tier 1 capital the effects of other comprehensive income adjustments, such as gains and losses on securities held to maturity, that are currently excluded from the definition of Tier 1 capital, but were allowed to make a one-time election not to include those effects. The Company and the Bank meet the well-capitalized requirements under the regulatory framework for prompt corrective action and have made the one-time election to exclude the effects of other comprehensive income adjustments on Tier 1 capital.

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 December 31, 2018, the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements, with a Tier 1 Leverage Capital Ratio of 12.68%, with Common Equity Tier 1 Ratio of 15.93%, with Tier 1 Risk-Based Capital Ratio of 15.93% and Total Risk-Based Capital Ratio of 17.18%.


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Dividends.  The ability of the Company to pay dividends to its shareholders is dependent upon the earnings and capital adequacy of its subsidiary Bank, which directly impact the ability of the Bank to pay dividends to the Company.  The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends, which restrictions are discussed more thoroughly below.  The Iowa Business Corporation Act (“IBCA”) allows the Company to make distributions, including cash dividends, to its shareholders unless, after giving effect to such distributions, either (i) the Company would not be able to pay its debts as they become due in the ordinary course of business or (ii) the Company’s total assets would be less than the sum of its total liabilities plus the amount that would be needed to satisfy preferential shareholder rights, if any, that are superior to the rights of those receiving the distribution.  Additionally, the Federal Reserve has issued a policy statement with regard to the payment of cash dividends by bank holding companies.  The policy statement provides that a bank holding company should not pay cash dividends which exceed its net income or which can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing.  The Federal Reserve also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations.  Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.

Federal Securities Regulation.  The Company’s common stock is registered with the SEC under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Consequently, the Company is subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act.

Regulation of the Bank

General. The Bank is an Iowa-chartered bank, the deposit accounts of which are insured by the FDIC.  As an Iowa-chartered, FDIC insured bank, the Bank is subject to the examination, supervision, reporting and enforcement requirements of the Superintendent of Banking of the State of Iowa (the “Superintendent”), as the chartering authority for Iowa banks, and the FDIC, as the Bank’s primary federal regulator.

Deposit Insurance. The deposits of the Bank are insured up to regulatory limits set by the FDIC, and, accordingly in 2018, were subject to deposit insurance assessments based on the Federal Deposit Insurance Reform Act of 2005, as adopted and effective on April 21, 2006.  The FDIC maintains the Deposit Insurance Fund (“DIF”) by assessing depository institutions an insurance premium (assessment).  The amount assessed to each institution is based on the average total assets of the Company less average tangible equity as well as the degree of risk the institution poses to the DIF.  The FDIC assesses higher rates to those institutions that pose greater risks to the insurance fund.

In addition, all institutions with deposits insured by the FDIC are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation (FICO), a mixed-ownership government corporation established in the 1980’s to recapitalize the Federal Savings and Loan Insurance Corporation.  The current annualized assessment rate is 0.14 basis points, or approximately 0.035 basis points per quarter.  These assessments will continue until the FICO bonds mature in 2019.

Capital Requirements.  The Bank is an insured state bank, incorporated under the laws of the state of Iowa.  As such, the Bank is subject to regulation, supervision and periodic examination by the Superintendent.  Among the requirements and restrictions imposed upon state banks by the Superintendent are the requirements to maintain reserves against deposits, restrictions on the nature and amount of loans, and restrictions relating to investments, opening of bank offices and other activities of state banks.  Changes in the capital structure of state banks are also approved by the Superintendent.  State banks must have a Tier 1 risk-based leverage ratio of 6.50% plus a fully-funded loan loss reserve. In certain instances, the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement on the Bank.  In determining the Tier 1 risk-based leverage ratio, the Superintendent uses total equity capital without unrealized securities gains and the allowance for loan losses less any intangible assets.   At December 31, 2018, the Tier 1 risk-based leverage ratio of the Bank was 12.73% and exceeded the ratio required by the Superintendent.

Capital adequacy for banks took on an added dimension with the establishment of a formal system of prompt corrective action under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) which provides the federal banking regulators of the Bank with broad power to take prompt corrective action to resolve the problems of undercapitalized banking institutions.  The extent of the regulators’ powers depends on whether the institution in question is “well-capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized,” in each case as defined by regulation.  Under prompt corrective action, banks that are inadequately capitalized face a variety of mandatory and discretionary supervisory actions.  For example, “undercapitalized banks” must restrict asset growth, obtain prior approval for business expansion, and have an approved plan to restore capital.  “Critically undercapitalized banks” must be placed in receivership or conservatorship within 90 days unless some other action would result in lower long-term costs to the deposit insurance fund.


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The actual amounts of risk-based capital and risk-based capital ratios as of December 31, 2018 and the minimum regulatory requirements for the Company and the Bank 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 December 31, 2018:
 
 
 
 
 
 
 
Company:
 
 
 
 
 
 
 
Total risk-based capital
$
414,772

 
17.18
%
 
8.00
%
 
10.00
%
Tier 1 risk-based capital
384,502

 
15.93

 
6.00

 
8.00

Tier 1 common equity
384,502

 
15.93

 
4.50

 
6.50

Leverage ratio
384,502

 
12.68

 
4.00

 
5.00

Bank:
 

 
 

 
 

 
 

Total risk-based capital
416,198

 
17.25

 
8.00

 
10.00

Tier 1 risk-based capital
385,943

 
16.00

 
6.00

 
8.00

Tier 1 common equity
385,943

 
16.00

 
4.50

 
6.50

Leverage ratio
385,943

 
12.73

 
4.00

 
5.00


Supervisory Assessments.  All Iowa banks are required to pay supervisory assessments to the Superintendent to fund the Superintendent’s examination and supervision operations.  The method of computation of the supervisory assessment is based on the assets of the bank, the expected hours needed to conduct examinations of that size bank and an additional amount if more work is required.

Community Investment and Consumer Protection Laws.  The Community Reinvestment Act requires insured institutions to offer credit products and take other actions that respond to the credit needs of the community.  Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations.  These laws include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act and the Home Mortgage Disclosure Act.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) posed a significant impact on financial regulations.  The Dodd-Frank Act created an independent regulatory body, the Bureau of Consumer Financial Protection (“Bureau”), with authority and responsibility to set rules and regulations for most consumer protection laws applicable to all banks – large and small - adds another regulator to scrutinize and police financial activities.  The Bureau has responsibility for mortgage reform and enforcement, as well as broad new powers over consumer financial activities which could impact what consumer financial services would be available and how they are provided.   The following consumer protection laws are the designated laws that fall under the Bureau’s rulemaking authority:  the Alternative Mortgage Transactions Parity Act of 1928, the Consumer Leasing Act of 1976, the Electronic Fund Transfer Act, the Equal Credit Opportunity Act, the Fair Credit Billing Act, the Fair Credit Reporting Act subject to certain exclusions, the Fair Debt Collection Practices Act, the Home Owners Protection Act, certain privacy provisions of the Gramm-Leach-Bliley Act, the Home Mortgage Disclosure Act (HMDA), the Home Ownership and Equity Protection Act of 1994, the Real Estate Settlement Procedures Act (RESPA), the S.A.F.E. Mortgage Licensing Act of 2008 (SAFE Act), and the Truth in Lending Act.

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Dividends.  The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by the Bank.  The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends. The Iowa Banking Act provides that an Iowa bank may not pay dividends in an amount greater than its undivided profits. The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized.  As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2018.  Notwithstanding the availability of funds for dividends, however, the Superintendent may prohibit the payment of any dividends by the Bank if the Superintendent determines such payment would constitute an unsafe or unsound practice.  To maintain acceptable capital ratios in the Bank, certain of its retained earnings are not available for the payment of dividends.  To maintain a ratio of total risk-based capital to assets of 8%, $192.92 million of the Bank’s Tier 1 capital of $385.94 million as of December 31, 2018, is available for the payment of dividends to the Company. Also, the capital conservation buffer discussed previously could limit the amount of payment of dividends if the Company fails to maintain required capital levels.

Insider Transactions.  The Bank is subject to certain restrictions imposed by federal law on extensions of credit to the Company, on investments in the stock or other securities of the Company and the acceptance of the stock or other securities of the Company as collateral for loans.  Certain limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to directors and officers of the Company and its subsidiary, to principal stockholders of the Company, and to related interests of such directors, officers and principal stockholders.  In addition, federal law and regulations may affect the terms upon which any person becoming a director or officer of the Company or one of its subsidiaries or a principal stockholder of the Company may obtain credit from banks with which the Bank maintains a correspondent relationship.

Safety and Soundness Standards.  The federal banking agencies have adopted guidelines that establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions.  The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.

In general, the safety and soundness guidelines prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals.  If an institution fails to comply with any of the standards set forth in the guidelines, the institution’s primary federal regulator may require the institution to submit a plan for achieving and maintaining compliance.  If an institution fails to submit an acceptable compliance plan, or fails in any material respect to implement a compliance plan that has been accepted by its primary federal regulator, the regulator is required to issue an order directing the institution to cure the deficiency.  Until the deficiency cited in the regulator’s order is cured, the regulator may restrict the institution’s rate of growth, require the institution to increase its capital, restrict the rates the institution pays on deposits or require the institution to take any action the regulator deems appropriate under the circumstances.  Noncompliance with the standards established by the safety and soundness guidelines may also constitute grounds for other enforcement action by the federal banking regulators, including cease and desist orders and civil money penalty assessments.

Branching Authority.  Historically, Iowa’s intrastate branching statutes have been rather restrictive when compared with those of other states.  Effective July 1, 2004, all limitations on bank office locations were repealed, which effectively allowed statewide branching.  Since that date, banks have been allowed to establish an unlimited number of offices in any location in Iowa subject only to regulatory approval.

Under the Riegle-Neal Act, both state and national banks are allowed to establish interstate branch networks through acquisitions of other banks, subject to certain conditions including limitations on the aggregate amount of deposits that may be held by the surviving bank and all of its insured depository institution affiliates.  The establishment of new interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is allowed by the Riegle-Neal Act only if specifically authorized by state law.  Iowa permits interstate bank mergers, subject to certain restrictions, including a prohibition against interstate mergers involving an Iowa bank that has been in existence and continuous operation for fewer than five years.

State Bank Activities.  Under federal law and FDIC regulations, FDIC insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank.  Federal law and FDIC regulations also prohibit FDIC insured state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank or its subsidiary, respectively, unless the Bank meets, and continues to meet, its minimum regulatory capital requirements and the FDIC determines the activity would not pose a significant risk to the deposit insurance fund of which the Bank is a member.  These restrictions have not had, and are not currently expected to have, a material impact on the operations of the Bank.


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Financial Privacy.  In accordance with the Gramm-Leach-Bliley Financial Modernization Act of 1999 (the “GLB Act”), federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to non-affiliated third parties.  These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a non-affiliated third party.  The privacy provisions of the GLB Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.

Anti-Money Laundering Initiatives and the USA Patriot Act.  A major focus of governmental policy on financial institutions has been aimed at combating money laundering and terrorist financing.  The USA PATRIOT Act of 2001 (the “USA Patriot Act”) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States.  The U. S. Treasury Department has issued a number of regulations that apply various requirements of the USA Patriot Act to financial institutions such as the Bank.  These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers.  Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution.

Depositor Preference Statute.  In the "liquidation or other resolution" of an institution by any receiver, U.S. federal legislation provides that deposits and certain claims for administrative expenses and employee compensation against the insured depository institution would be afforded a priority over general unsecured claims against that institution, including federal funds and letters of credit.

Government Monetary Policy. The earnings of the Company are affected primarily by general economic conditions and to a lesser extent by the fiscal and monetary policies of the federal government and its agencies, particularly the Federal Reserve.  Its policies influence, to some degree, the volume of bank loans and deposits, and interest rates charged and paid thereon, and thus have an effect on the earnings of the Company's subsidiary Bank.

Dodd-Frank Wall Street Reform and Consumer Protection Act.  The Dodd-Frank Act was signed into law on July 21, 2010.  The Dodd-Frank Act represents the most sweeping financial services industry reform since the 1930s.  Generally, the Dodd-Frank Act is effective the day after it was signed into law, but different effective dates apply to specific sections of the Dodd-Frank Act.  The Dodd-Frank Act is expected to be fully phased in over twelve years.  Among other things, the Dodd-Frank Act may result in added costs of doing business and regulatory compliance burdens and affect competition among financial services entities.  Uncertainty exists as to the ultimate impact of many provisions of the Dodd-Frank Act, which could have a material adverse impact on the financial services industry as a whole and on the Company’s business, results of operations and financial condition.  Additional information, including a summary of certain provisions of the Dodd-Frank Act, is available on the Federal Deposit Insurance Corporation website at www.fdic.gov/regulations/reform/index.html.

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Item 1A.
Risk Factors

The performance of our Company is subject to various risks.  We consider the risks described below to be the most significant risks we face, but such risks are not the only risk factors that could affect us.  Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition or results of operations.  For a discussion of the impact of risks on our financial condition and results of operations in recent years and on forward looking statements contained in this report, reference is made to Item 7 below.

We may be adversely affected by economic conditions in the local economies in which we conduct our operations, and in the United States in general.

Our primary market includes the Iowa counties of Johnson, Linn and Washington.  Our market has been one of the strongest economic areas in Iowa exhibiting economic growth over the past ten years.  The unemployment rate for the our prime market area is favorable and the rate historically has been lower than the unemployment rates for both the United States and the State of Iowa.  However, unfavorable or uncertain economic and market conditions may adversely affect our business and profitability.  Our business faces various material risks, including credit risk, liquidity risk and the risk that the demand for our products and services will decrease.  Consumer confidence, real estate values, interest rates and investment returns could make the types of loans we originate less profitable and could increase our credit risk and litigation expense.  And, while the presence of the University of Iowa and its affiliated institutions has a significant favorable impact upon the regional economy, it is unclear what impact the State budget and funding models will have on the University of Iowa and the University of Iowa Hospitals and Clinics.

Changes in U.S. trade policies, such as the implementation of tariffs, and other factors beyond the Company’s control may adversely impact our business, financial condition and results of operations.

Throughout 2018, the U.S. government implemented tariffs on certain products from countries or entities such as Mexico, Canada, China and the European Union. These countries have issued or continue to threaten retaliatory tariffs against products from the United States, including agricultural products. The United States and these countries may impose additional tariffs and retaliatory tariffs in the future. Tariffs, retaliatory tariffs or other trade restrictions on products and materials that our customers import or export, including agricultural products such as soybeans, could cause the prices of our customers’ products to increase which could reduce demand for such products, or reduce our customer margins, and adversely impact their revenues, financial results and ability to service debt. This could adversely affect our financial condition and results of operations. In addition, to the extent changes in the political environment have a negative impact on us or on the markets in which we operate, our business, results of operations and financial condition could be materially and adversely impacted in the future.

We may be adversely impacted by recent legislation and potential additional legislation and rulemaking.

The 2008-2009 recession produced a number of new laws that impact financial institutions including the Dodd-Frank Act.  The Dodd-Frank Act established the Consumer Financial Protection Bureau (the “CFPB”) and granted it the broad authority to administer and enforce a new federal regulatory framework of consumer financial regulation.  Any changes to state and federal banking laws and regulations may adversely impact our ability to expand services and to increase the value of our business.  We are subject to extensive state and federal regulation, supervision, and legislation that govern almost all aspects of our operations.  These laws may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds.  In addition, our earnings are affected by the monetary policies of the Board of Governors of the Federal Reserve.  These policies, which include regulating the national supply of bank reserves and bank credit, may have a major effect upon the source and cost of funds and the rates of return earned on loans and investments.  The Federal Reserve influences the size and distribution of bank reserves through its open market operations and changes in cash reserve requirements against member bank deposits.  We cannot predict what effect such act and any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, but such changes could be materially adverse to our financial performance.

Our profitability and liquidity may be adversely affected by deterioration in the credit quality of, or defaults by, third parties who owe us money or other assets.

We are exposed to the risk that third parties that owe us money or other assets will not fulfill their obligations.  These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons.  Our rights against third parties may not be enforceable in all circumstances.  In addition, deterioration in the credit quality of third parties whose securities or obligations we hold could result in losses and/or adversely affect our ability to use those securities or obligations for liquidity purposes. 


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Our financial condition has not been materially impacted by the deterioration in the credit quality of third parties except as related to borrower credit quality. Management believes that the allowance for loan losses is adequate to absorb probable losses on any existing loans that may become uncollectible but cannot predict loan losses with certainty and cannot assure that our allowance for loan losses will prove sufficient to cover actual losses in the future.

Changing interest rates may adversely affect our profits.

Our income and cash flows depend to a great extent on the difference between the interest rates earned by us on interest-earning assets such as loans and investment securities and the interest rates paid by us on interest-bearing liabilities such as deposits and borrowings.  Our net interest margin will be affected by general economic conditions, fiscal and monetary policies of the federal government, and our ability to respond to changes in such rates. Our assets and liabilities are affected differently by a change in interest rates. An increase or decrease in rates, the length of loan terms or the mix of adjustable and fixed rate loans in our portfolio could have a positive or negative effect on our net income, capital and liquidity. We measure interest rate risk under various rate scenarios and using specific criteria and assumptions. A summary of this process is presented under the heading "Quantitative and Qualitative Disclosures about Market Risk" included under Item 7A of Part II of this Form 10-K. Although we believe our current level of interest rate sensitivity is reasonable and effectively managed, significant fluctuations in interest rates may have an adverse effect on our business, financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions may not fully predict or capture the impact of actual interest rate changes on our financial condition and results of operations.

We experience intense competition for loans and deposits.

Competition in banking and financial services business in our market is highly competitive and is currently undergoing significant change.  Our competitors include local commercial banks, local credit unions, online banks, mortgage companies, finance companies and other non-bank financial services providers. Increasingly, competitors are able to provide integrated financial services over a broad geographic area. Increased competition may result in a decrease in the amounts of loans and deposits, reduced spreads between loan rates and deposit rates or loan terms that are less favorable to us. Competition may also accelerate investments in technology or infrastructure. Any of these results could have a material adverse effect on our ability to grow and remain profitable.

If we do not continue to meet or exceed regulatory capital requirements and maintain our “well-capitalized” status, there could be an adverse effect on the manner in which we do business and on the confidence of our customers in us.

Under regulatory capital adequacy guidelines, we must meet guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items.  Failure to meet minimum capital requirements could have a material effect on our financial condition and could subject us to a variety of enforcement actions, as well as certain restrictions on our business.  Failure to maintain the status of “well-capitalized” under the regulatory framework could adversely affect the confidence that our customers have in us, which may lead to a decline in the demand for or a reduction in the prices that we are able to charge for our products and services. Failure to meet the guidelines could also limit our access to liquidity sources.

Our growth may require us to raise additional capital in the future, but that capital may not be available.

We may at some point need to raise additional capital to maintain our “well-capitalized” status.  Any capital we obtain may result in the dilution of the interests of existing holders of our stock.  Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial condition and performance.  Accordingly, we cannot make assurances of our ability to raise additional capital if needed, or if the terms will be acceptable to us.

Our allowance for loan losses may not be adequate to cover actual losses.

Like all financial institutions, we maintain an allowance for loan losses to provide for loan defaults and non-performance.  Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan portfolio, including the size and composition of the loan portfolio, current economic conditions and concentrations within the portfolio.  The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes.  Economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses.  In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management.  In addition, if

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charge-offs in future periods exceed expectations, we will need additional provisions to increase the allowance for loan losses.  Any increases in the allowance for loan losses may result in a decrease in net income and capital, and may have a material adverse effect on our financial condition and results of operations.

In June 2016, the Financial Accounting Standards Board (FASB) issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments," which replaces the current "incurred loss" model for recognizing credit losses with an "expected loss" model referred to as the Current Expected Credit Loss model, or CECL. 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. Moreover, the CECL model may create more volatility in the level of our allowance for loan losses. If we are required to increase our level of allowance for loan losses for any reason, such increase could adversely affect our business, financial condition and results of operations.

The new CECL standard will become effective for us for fiscal years beginning after December 15, 2019 and for interim periods during 2020. 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.

Our loan portfolio has a large concentration of real estate loans, which involve risks specific to real estate value.

Real estate loans, which constitute a large portion of our loan portfolio, include home equity, commercial, construction and residential loans, and such loans are concentrated in the Bank’s trade area.  As of December 31, 2018, 84.59% of our loans had real estate as a primary component of collateral.  The market value of real estate may fluctuate significantly in a short period of time as a result of market conditions in the geographic area in which the real estate is located.  Adverse developments affecting real estate values in our market could increase the credit risk associated with our loan portfolio.  Also, real estate lending typically involves higher loan principal amounts and the repayment of the loans generally is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service.  Economic events or governmental regulations outside of the control of the borrower could adversely impact the future cash flow and market values of the affected properties.

If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, then we may not be able to realize the amount of security that we anticipated at the time of originating the loan, which could cause us to increase our provision for loan losses and adversely affect our operating results and financial condition.

Our real estate loans also include construction loans, including land acquisition and development.  Construction, land acquisition and development lending involves additional risks because funds are advanced based upon estimates of costs and the estimated value of the completed project.  Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio.  As a result, commercial construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor to repay principal and interest.  If our appraisal of the value of the completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project.

Commercial loans make up a significant portion of our loan portfolio.

Our commercial loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower.  Repayment of our commercial loans is often dependent on the cash flows of the borrower, which may be unpredictable.  Most often, this collateral is accounts receivable, inventory, machinery and equipment.  In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.  The other types of collateral securing these loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.


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There may be issues with environmental law compliance if we take possession of real property that secures a loan.

A significant portion of our loan portfolio is secured by real property. We may foreclose on and take title to certain real property. There is a risk that hazardous substances could be found on the property and we may be liable for remediation costs, personal injury and/or property damage. We may incur substantial expenses to comply with environmental laws which may materially reduce the property's value or limit our ability to dispose of the property. The remediation costs and any other financial liabilities associated with the property could have a material adverse effect on our financial condition and results of operations.

Our agricultural loans may involve a greater degree of risk than other loans, and the ability of the borrower to repay may be affected by many factors outside of the borrower’s control.

Payments on agricultural real estate loans are dependent on the profitable operation or management of the farm property securing the loan.  The success of the farm may be affected by many factors outside the control of the borrower, including adverse weather conditions that prevent the planting of a crop or limit crop yields (such as hail, drought and floods), loss of livestock due to disease or other factors, changes in market prices for agricultural products (both domestically and internationally) and the impact of government regulation (including changes in price supports, subsidies and environmental regulation). In addition, many farms are dependent on a limited number of key individuals whose injury or death may significantly affect the successful operation of the farm.  If the cash flow from a farming operation is diminished, the borrower’s ability to repay the loan may be impaired. The primary crops in our market areas are corn and soybeans.  Accordingly, adverse circumstances affecting these crops could have an adverse effect on our agricultural real estate loan portfolio.

We also originate agricultural operating loans.  As with agricultural real estate loans, the repayment of operating loans is dependent on the successful operation or management of the farm property.  Likewise, agricultural operating loans involve a greater degree of risk than lending on residential properties, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as farm equipment or assets such as livestock or crops.  The primary livestock in our market areas is hogs and turkeys.  In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.

We may be required to repurchase mortgage loans or reimburse investors and others as a result of breaches in contractual representations and warranties.

We sell residential mortgage loans to various parties that purchase mortgage loans for investment. The agreements under which we sell mortgage loans contain various representations and warranties regarding the origination and characteristics of the mortgage loans, including ownership of the loan, compliance with loan criteria set forth in the applicable agreement, validity of the lien securing the loan, absence of delinquent taxes or liens against the property securing the loan, and compliance with applicable origination laws. We may be required to repurchase mortgage loans, indemnify the investor, or reimburse the investor for credit losses incurred on loans in the event of a breach of contractual representations or warranties. The agreements under which we sell mortgage loans require us to deliver various documents to the investor, and we may be obligated to repurchase any mortgage loan as to which the required documents are not delivered or are defective.

We depend on the accuracy and completeness of information about customers and counterparties.

In deciding whether to extend credit or enter into other transactions with customers and counterparties, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements and other financial information. We also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors and accountants if made available. If this information is inaccurate, we may be subject to regulatory action, reputational harm or other adverse effects with respect to the operation of our business, our financial condition and our results of operation.

Growth levels in local and national real estate markets may impact our operations and/or financial condition.

Change in growth in the national housing market as evidenced by reports of levels of new and existing home sales, inventories of houses on the market, property values, building permits, and the time houses remain on the market may indicate increased levels of credit risk.  In past history of real estate growth, some lenders made many adjustable-rate mortgage loans, and lowered their credit standards with respect to mortgage loans and home equity loans.  A subsequent slowdown in the national housing market created uncertainty and liquidity issues relating to the value of such mortgage loans, which caused disruption in credit markets.  Management will continue to monitor that the Bank has maintained appropriate lending standards in times of real estate growth and decline.  No assurance can be given that these conditions will not directly or indirectly affect our operations.


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If we are unable to continuously attract deposits and other short-term funding, our financial condition and our business prospects could be adversely affected.

In managing our liquidity, our primary source of short-term funding is customer deposits.  Our ability to continue to attract these deposits, and other short-term funding sources, is subject to variability based upon a number of factors, including the relative interest rates we are prepared to pay for these liabilities and the perception of safety of those deposits or short-term obligations relative to alternative short-term investments.  The availability and cost of credit in short-term markets depends upon market perceptions of our liquidity and creditworthiness.  Our efforts to monitor and manage liquidity risk may not be successful or sufficient to deal with dramatic or unanticipated changes in event-driven reductions in liquidity.  In such events, our cost of funds may increase, thereby reducing our net interest revenue, or we may need to dispose of a portion of our investment portfolio, which, depending on market conditions, could result in our realizing a loss or experiencing other adverse consequences.

Conditions in the financial markets may limit our access to funding to meet our liquidity needs.

Liquidity is essential to our business, as we must maintain sufficient funds to respond to the needs of depositors and borrowers.  An inability to raise funds through deposits, borrowings, the sale or pledging as collateral of loans and other assets could have a substantial adverse effect on our liquidity.  Our access to funding sources in the amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general.  Factors that could adversely affect our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us.  Our ability to borrow could also be impaired by factors that are not specific to us, such as severe disruption of the financial markets or adverse news and expectations about the prospects for the financial services industry as a whole.

As a part of our liquidity management, we use a number of funding sources in addition to core deposit growth and repayments and maturities of loans and investments.  These sources include brokered money markets and certificates of deposit, federal funds purchased, lines of credit and Federal Home Loan Bank advances.  Negative operating results or changes in industry conditions could lead to an inability to replace these additional funding sources at maturity.  Our financial flexibility could be constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates.  Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs.  In this case, our results of operations and financial condition would be adversely affected.

Reduction in the value, or impairment of our investment securities, may impact our earnings and stockholders' equity.

We maintained a balance of $331.10 million, or 10.88% of our assets, in investment securities at December 31, 2018. Changes in market interest rates may affect the value of these investment securities, with increasing interest rates generally resulting in a reduction of value. Although the reduction in value from temporary increases in market rates does not affect our income until the security is sold, it does result in an unrealized loss recorded in other comprehensive income that may reduce our stockholders' equity. Further, we periodically test our investment securities for other-than-temporary impairment in value. In assessing whether the impairment of investment securities is other-than-temporary, we consider the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability to retain our investment in the security for a period of time sufficient to allow for any anticipated recovery in fair value.

Our growth strategy relies heavily on our management team, and the unexpected loss of key managers and/or officers may adversely affect our operations.

Our success is dependent on experienced senior management with a strong local community network.  Our ability to retain the current management team is key to the successful implementation of our growth strategy.  It is equally important that we are able to continue to attract and retain quality and community-focused managers and officers.  The unexpected loss of one of our key managers and/or officers or the inability to attract qualified personnel could have an adverse effect on our operations, financial condition and reputation.

We are subject to risks associated with technological changes and the resources needed to implement the changes.

Our industry is susceptible to significant technological changes as there continue to be a high level of new technology driven products and services introduced.  Technological advancement aids us in providing customer service and increases efficiency.  Our national competitors may have more resources to invest in technological changes.  As a result they may be able to offer products and services that are more technologically advanced and that may put us at a competitive disadvantage.  Our future may depend on our ability to analyze technological changes to determine the best course of action for our business, customers and shareholders.

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We rely heavily on our network security and any system failure or data breach could subject us to increased costs as well as reputational risk.

Our operations are dependent on our ability to process financial transactions in a secure manner.  Failure in or breach of our operational or security systems or infrastructure, or those of our third-party vendors and other service providers, could disrupt our business or the businesses of our customers, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. We must ensure that information is properly protected from a variety of threats such as cyber attacks, error, fraud, sabotage, terrorism, industrial espionage, privacy violation, service interruption, and natural disaster.  These threats arise from numerous sources including human error, fraud on the part of employees or third parties, technological failure, telecommunication outages, and severe weather conditions. Information security risks for financial institutions like us have increased recently in part because of new technologies, the increased use of the internet and telecommunications technologies (including mobile devices and cloud computing) to conduct financial and other business transactions, political activism, and the increased sophistication and activities of organized crime. Although we employ detection and response mechanisms designed to contain and mitigate security incidents, early detection may be thwarted by persistent sophisticated attacks and malware designed to avoid detection.

While we have not been materially impacted by cyber incidents, we have been subject to other intentional cyber incidents from third parties over the last several years, including denial of service attacks which attempt to interrupt service to customers and malicious software attacks on computer systems which attempt to allow unauthorized entrance. We also face risks related to cyber attacks and other security breaches in connection with card transactions that typically involve the transmission of sensitive information regarding our customers through various third parties. Some of these parties have in the past been the target of security breaches and cyber attacks, and because the transactions involve third parties and environments that we do not control or secure, future security breaches or cyber attacks affecting any of these third parties could impact us through no fault of our own, and in some cases we may have exposure and suffer losses for breaches or attacks relating to them. We also rely on numerous other third party service providers to conduct other aspects of our business operations and face similar risks relating to them. While we conduct security assessments on our higher risk third party service providers, we cannot be sure that their information security protocols are sufficient to withstand a cyber attack or other security breach. There can be no assurance that cyber incidents will not occur and they could occur more frequently and on a more significant scale.

We devote significant resources to implement, maintain, monitor and regularly upgrade our systems and networks with measures such as intrusion detection and prevention and firewalls to safeguard critical business applications. The additional cost to the Company of our cyber security monitoring and protection systems and controls includes the cost of hardware and software, third party technology providers, consulting, and legal fees, in addition to the incremental cost of our personnel who focus a substantial portion of their responsibilities on cyber security. In addition, because cyber attacks can change frequently we may be unable to implement effective preventive or proactive measures in time. With the assistance of third-party service providers, we intend to continue to implement security technology and establish procedures to maintain network security, but there is no assurance that these measures will be successful. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities.

Any activity that jeopardizes our network and the security of the information stored thereon may result in significant cost and have a significant adverse effect on our reputation. We maintain insurance coverage that may, subject to policy terms and conditions, cover certain aspects of cyber risks. Such insurance coverage may be insufficient to cover all losses.

Any successful cyber attack or other security breach involving the misappropriation or other unauthorized disclosure of confidential customer information or that compromises our ability to function could severely damage our reputation, erode confidence in the security of our systems, products and services, expose us to the risk of litigation and liability, disrupt our operations and have a material adverse effect on our business. Any successful cyber attack may also subject the Company to regulatory investigations, litigation or enforcement, or require the payment of regulatory fines or penalties or undertaking costly remediation efforts with respect to third parties affected by a cyber security incident, all or any of which could adversely affect the Company’s business, financial condition or results of operations and damage its reputation.

Loss of key third-party vendor relationships or failure of a vendor to protect information of our customers or employees could adversely affect our business or result in losses.

We rely on third-party vendors to provide key components of our business operations such as data processing, recording and monitoring transactions, online and mobile banking interfaces and services, internet connections and network access. While we have performed due diligence procedures in selecting vendors, we do not control their actions. In the event that one or more of our vendors suffers a bankruptcy or otherwise becomes unable to continue to provide products or services, or fails to protect non-

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public personal information of our customers or employees, we may suffer operational impairments, reputational damage and financial losses. Replacing these third-party vendors could create significant delay and expense. Accordingly, use of such third parties creates an inherent risk to our business operations.

The potential for business interruption exists throughout our organization.

Integral to our performance is the continued efficacy of our technical systems, operational infrastructure, relationships with third parties and the array of personnel involved with bank operations. Failure by any or all of these resources subjects us to risks that may vary in size, scale and scope. This includes, but is not limited to, operational or technical failures, ineffectiveness or exposure due to interruption in third-party support, as well as the loss of key individuals or failure on the part of key individuals to perform properly. These risks are heightened during data system changes or conversions. Although management has established policies and procedures to address such failures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

Our risk management framework may not be effective in mitigating risk and loss.

We maintain an enterprise risk management program that is designed to identify, quantify, monitor, report and control the risks that we face. These include credit, liquidity, market, operational, liquidity, reputational, compliance, strategic, information technology and security, and trust risks. While we assess this program on an ongoing basis, there can be no assurance that its approach and framework for risk management and related controls will effectively mitigate risk and limit losses in our business. If conditions or circumstances arise that expose flaws or gaps in the risk management program or if its controls break down, the performance and value of our business could be adversely affected.

Our internal controls may be ineffective.

We regularly review and update our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well-designed and operated, is based in part on certain assumptions and may provide only reasonable, not absolute, assurances that the objectives of the controls are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, financial condition and results of operation.

We are subject to a variety of litigation or other proceedings, which could adversely affect our business.

We are involved from time to time in a variety of litigation or other proceedings arising out of business or operations. We establish reserves for claims when appropriate under accounting principles generally accepted in the United States of America, but costs often may be incurred in connection with a matter before any reserve has been created. In addition, the actual costs associated with resolving a claim may be substantially higher than amounts that we have reserved. Substantial legal claims could have a detrimental impact on our business, results of operations, and financial condition and may cause reputational harm.

New products and services are essential to remain competitive but may subject us to additional risks.

We consistently attempt to offer new products and services to our customers to remain competitive. There can be risks and uncertainties associated with these new products and services especially if they are newer to market products and services. We may spend significant time and resources in development of new products and services to market to customers. Through our development and implementation process we may incur risks associated with delivery timetables, pricing and profitability, compliance with regulations, effect on internal controls and shifting customer preferences. Failure to successfully manage these risks could have a material effect on our financial condition, result of operations, and business.

Our customers may decide to use non-bank competitors for financial transactions, which could result in loss of business.

Advancement in technology and other changes are increasing the ability for customers to complete financial transactions that have traditionally involved banks through non-bank competitors. Elimination of banks as intermediaries of financial transactions could result in the loss of customer deposits as well as fee income to us.

We are subject to risks associated with negative publicity.

Reputational risk arises from the potential that negative publicity regarding our business practices, whether true or not, could cause a decline in our customer base, costly litigation, or revenue reductions.  In addition, our success in maintaining our reputation depends on the ability to adapt to a rapidly changing environment including increasing reliance on social media.

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We may be adversely affected by changes in U.S. tax laws and regulations.

The Tax Cuts and Jobs Act was signed into law in December 2017, reforming the U.S. tax code. The legislation includes lowering the federal corporate income tax rate to 21 percent beginning in 2018 from a maximum rate of 35 percent, modifying the U.S. taxation of income earned outside the U.S. and limiting or eliminating various deductions, tax credits and/or other tax preferences. The legislation could negatively impact our customers because it lowers the existing caps on mortgage interest deductions and limits the state and local tax deductions. These changes could make it more difficult for borrowers to make their loan payments and could also negatively impact the housing market, which could adversely affect our business and loan growth.

Our stock is thinly traded.

The average daily trading volume of our common stock is relatively small compared to many public companies. The desired market characteristics of depth, liquidity, and orderliness require the substantial presence of willing buyers and sellers in the marketplace at any given time. In our case, this presence depends on the individual decisions of a relatively small number of investors and general economic and market conditions over which we have no control. Due to the relatively small trading volume of our common stock, significant sales of our common stock, or the expectation of these sales, could cause the stock price to fall more than would be justified by the inherent worth of the Company. Conversely, attempts to purchase a significant amount of our stock could cause the market price to rise above the reasonable inherent worth of the Company.

The stock market can be volatile, and fluctuations in our operating results and other factors could cause our stock price to decline.

The stock market has experienced, and may continue to experience, fluctuations that significantly impact the market prices of securities issued by many companies. Market fluctuations could adversely affect our stock price. These fluctuations have often been unrelated or disproportionate to the operating performance of particular companies. These broad market fluctuations, as well as general economic, systemic, political and market conditions, such as recessions, loss of investor confidence, or interest rate changes, may negatively affect the market price of our common stock. Moreover, our operating results may fluctuate and vary from period to period due to the risk factors set forth herein. As a result, period-to-period comparisons should not be relied upon as an indication of future performance. Our stock price could fluctuate significantly in response to the impact these risk factors have on our operating results or financial position.

There can be no assurances concerning continuing dividend payments.

Our common stockholders are only entitled to receive the dividends declared by our Board of Directors. Although we have historically paid annual dividends on our common stock, there can be no assurances that we will be able to continue to pay regular annual dividends or that any dividends we do declare will be in any particular amount. The primary source of money to pay our dividends comes from dividends paid to the Company by Hills Bank and Trust. Hills Bank and Trust’s ability to pay dividends to the Company is subject to, among other things, its earnings, financial condition and applicable regulations, which in some instances limit the amount that may be paid as dividends.
Item 1B.
Unresolved Staff Comments

None.

Item 2.
Properties

The Company's office and the main office of the Bank are located at 131 E. Main Street, Hills, Iowa.  This is a brick building containing approximately 45,000 square feet. A portion of the building was built in 1977, a two-story addition was completed in 1984, and a two-story brick addition was completed in February 2001.  With the completion of the 2001 addition, the entire Bank’s operations and administrative functions were consolidated in Hills, Iowa.  The Bank operates its business from its main office and its 18 full service branches in the Iowa counties of Johnson, Linn and Washington.  The Bank owns its main office complex and 14 of its branch offices.  Four of the Bank’s branches are leased.

All of the properties owned by the Bank are free and clear of any mortgages or other encumbrances of any type.  See Note 14 to the Consolidated Financial Statements for minimum future rental commitments for leased properties.


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Item 3.
Legal Proceedings

None.
Item 4.
Mine Safety Disclosures

Not applicable.

PART II

Item 5.
Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

As of January 31, 2019, the Company had 2,481 stockholders.  There is no established trading market for the Company's common stock, and the Company's stock is not actively traded.  Our common stock is not listed on the NASDAQ stock market or any other stock exchange.  While there is no established public trading market for our common stock, our shares are currently quoted in the inter-dealer quotation, or “over-the-counter,” marketplace under the trading symbol “HBIA.”  The principal over-the-counter market is operated by OTC Markets Group, Inc., which provides quotes for the Company on its OTC Pink tier.

The high and low bid information for the Company’s stock for each quarter of the two most recent fiscal years, as reported by OTC Market Groups, Inc., is provided below.  The prices indicated reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

 
2018
2017
 
High
Low
High
Low
1st quarter
$
57.00

$
54.75

$
54.89

$
48.00

2nd quarter
57.50

55.50

54.45

50.50

3rd quarter
59.50

58.00

54.35

52.50

4th quarter
62.99

59.00

54.15

52.60


In addition, based on the Company’s stock transfer records and information informally provided to the Company, stock trading transactions have been as follows:
 
Year
Number of Shares Traded
Number of Transactions
High Selling Price
Low Selling Price
 
2018
157,749

168

$
61.00

$
54.00

(1)
2017
93,095

176

$
54.00

$
48.00

(2)
2016
120,911

191

$
48.00

$
44.50

(3)
 
(1)
2018 transactions included repurchases by the Company of 116,962 shares of stock under the 2005 Stock Repurchase Program.  2018 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $54.00 to $61.00 per share.
(2)
2017 transactions included repurchases by the Company of 46,966 shares of stock under the 2005 Stock Repurchase Program.  2017 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $48.00 to $54.00 per share.
(3)
2016 transactions included repurchases by the Company of 85,362 shares of stock under the 2005 Stock Repurchase Program.  2016 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $44.50 to $48.00 per share.

All transactions under the 2005 Stock Repurchase Program were at a price equal to the most recent quarterly independent appraisal of the shares of the Company's common stock. The most recent independent current quarterly appraisal value of the stock is $62.00 a share. The closing bid for the Company's stock on February 15, 2019 was $60.60 a share as reported by the OTC Markets Group, Inc.

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The following performance graph provides information regarding cumulative, five-year shareholder returns on an indexed basis of the Company's Common Stock compared to the NASDAQ Market Index and the Regional-Southwest Banks Index prepared by MORNINGSTAR of Chicago, IL. The latter index reflects the performance of twenty-five bank holding companies operating principally in the Midwest as selected by MORNINGSTAR. The indexes assume the investment of $100 on December 31, 2013 in Company Common Stock, the NASDAQ Index and the Regional-Southwest Banks Index, with all dividends reinvested.
hbia201412_chart-20057a04.jpg
 
2013
2014
2015
2016
2017
2018
HILLS BANCORPORATION
$
100.00

$
111.69

$
122.31

$
133.86

$
152.79

$
174.99

REGIONAL-SOUTHWEST BANKS
$
100.00

$
96.65

$
94.07

$
142.32

$
150.05

$
136.78

NASDAQ MARKET INDEX
$
100.00

$
114.75

$
122.74

$
133.62

$
173.22

$
168.30


Note regarding the performance graph: Cumulative five-year Shareholder returns on an indexed basis. The indexes assume the investment of $100 in year with all dividends reinvested.


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Table of Contents

The following table sets forth the Company’s equity compensation plan information as of December 31, 2018, all of which relates to stock options issued under stock option plans approved by stockholders of the Company:
Plan Category
Number of securities to
be issued upon exercise of
outstanding options,
warrants and rights (a)
Weighted-average
exercise price of
outstanding options,
warrants and rights (b)
Number of securities
remaining available for
future issuance under equity
compensation plans
[excluding securities reflected
in column (a)] (c)
Equity compensation plans approved by security holders
9,020

$
33.30

38,125

Equity compensation plans not approved by security holders



Total
9,020

$
33.30

38,125

 
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, 2020.  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 following table sets forth information about the Company’s stock purchases pursuant to the 2005 Stock Repurchase Program for the quarter ended December 31, 2018:
Period in 2018
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
October 1 to October 31
11,190

$
59.50

11,190

381,812

November 1 to November 30
1,664

60.70

1,664

380,148

December 1 to December 31
7,027

60.96

7,027

373,121

Total
19,881

$
60.12

19,881

373,121



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Table of Contents

Item 6.
Selected Financial Data

CONSOLIDATED FIVE-YEAR STATISTICAL SUMMARY

The following table sets forth certain of our financial and statistical information for each of the years in the five-year period ended December 31, 2018.  This data should be read in conjunction with the consolidated financial statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document.
 
2018
 
2017
 
2016
 
2015
 
2014
YEAR-END TOTALS (Amounts in Thousands)
 
 
 
 
 
 
 
 
 
Total assets
$
3,042,464

 
$
2,963,360

 
$
2,655,770

 
$
2,493,607

 
$
2,334,318

Investment securities
331,098

 
300,160

 
279,950

 
276,069

 
267,240

Loans held for sale
1,984

 
5,162

 
9,806

 
5,554

 
4,476

Loans, net
2,591,085

 
2,431,165

 
2,251,445

 
2,099,174

 
1,961,369

Deposits
2,421,124

 
2,288,565

 
2,036,312

 
1,890,702

 
1,835,069

Federal Home Loan Bank borrowings
215,000

 
295,000

 
235,000

 
225,000

 
140,000

Redeemable common stock
48,870

 
43,308

 
40,781

 
37,562

 
34,571

Stockholders' equity
334,882

 
311,716

 
289,270

 
272,175

 
255,528

 
 
 
 
 
 
 
 
 
 
EARNINGS (Amounts in Thousands)
 

 
 

 
 

 
 

 
 

Interest income
$
118,797

 
$
105,952

 
$
97,677

 
$
92,167

 
$
86,582

Interest expense
26,323

 
17,972

 
16,087

 
14,967

 
15,037

Provision for loan losses
8,497

 
1,688

 
(1,163
)
 
1,655

 
1,042

Other income
23,818

 
20,818

 
19,995

 
20,802

 
19,356

Other expenses
62,123

 
59,512

 
56,799

 
55,460

 
51,756

Income taxes
8,905

 
19,537

 
14,394

 
12,469

 
11,129

Net income
36,767

 
28,061

 
31,555

 
28,418

 
26,974

Net income before Tax Act (1)
NA
 
32,770

 
NA
 
NA
 
NA
 
 
 
 
 
 
 
 
 
 
PER SHARE
 

 
 

 
 

 
 

 
 

Net income:
 

 
 

 
 

 
 

 
 

Basic
$
3.93

 
$
3.01

 
$
3.40

 
$
3.04

 
$
2.88

Basic before Tax Act (1)
NA
 
3.51

 
NA
 
NA
 
NA
Diluted
3.92

 
3.01

 
3.40

 
3.04

 
2.87

Diluted before Tax Act (1)
NA
 
3.51

 
NA
 
NA
 
NA
Cash dividends
0.750

 
0.700

 
0.650

 
0.625

 
0.575

Book value as of December 31
35.87

 
33.39

 
31.22

 
29.20

 
27.24

Decrease in book value due to:
 
 
 
 
 
 
 
 
 

ESOP obligation
(5.23
)
 
(4.64
)
 
(4.40
)
 
(4.03
)
 
(3.69
)
Accumulated other comprehensive income
(0.35
)
 
(0.26
)
 
(0.36
)
 
(0.13
)
 
(0.05
)
 
 
 
 
 
 
 
 
 
 
SELECTED RATIOS
 
 
 
 
 
 
 
 
 

Return on average assets
1.23
%
 
1.02
%
 
1.23
%
 
1.19
%
 
1.21
%
Return on average assets before Tax Act (1)
NA
 
1.19

 
NA
 
NA
 
NA
Return on average equity
9.92

 
9.24

 
11.26

 
10.79

 
10.83

Return on average equity before Tax Act (1)
NA
 
10.79

 
NA
 
NA
 
NA
Net interest margin
3.25

 
3.43

 
3.43

 
3.50

 
3.49

Average stockholders' equity to average total assets
12.35

 
11.02

 
10.94

 
11.03

 
11.17

Dividend payout ratio
19.05

 
23.11

 
19.20

 
20.60

 
20.09

(1)
Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measures section of this report in Item 7.

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Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operation

The following discussion by management is presented regarding the financial results for the Company for the dates and periods indicated.  The discussion should be read in conjunction with the “Selected Consolidated Five-Year Statistical Summary” and the consolidated financial statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document.

An overview of the year 2018 is presented following the section discussing a special note regarding forward looking statements.

Special Note Regarding Forward Looking Statements

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

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

The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company’s assets.
The effects of financial market disruptions and/or an economic recession, and monetary and other governmental actions designed to address such disruptions and recession.
The financial strength of the counterparties with which the Company or the Company’s customers do business and as to which the Company has investment or financial exposure.
The credit quality and credit agency ratings of the securities in the Company’s investment securities portfolio, a deterioration or downgrade of which could lead to other-than-temporary impairment of the affected securities and the recognition of an impairment loss.
The effects of, and changes in, laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters as well as any laws otherwise affecting the Company.
The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.
The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.
The ability of the Company to obtain new customers and to retain existing customers.
The timely development and acceptance of products and services, including products and services offered through alternative electronic delivery channels.
Technological changes implemented by the Company and by other parties, including third-party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers.
The ability of the Company to develop and maintain secure and reliable technology 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.

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Table of Contents

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.

Non-GAAP Financial Measures

This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the Company's presentation of net income without the effect of the Tax Cut and Jobs Act enacted on December 22, 2017 (the "Tax Act"), and the presentation of earnings per share, return on assets and return on equity with the adjusted net income figure. Management believes these Non-GAAP financial measures provide useful information to both management and investors to analyze and evaluate the Company's financial performance. Limitations associated with non-GAAP financial measures include the risks that persons might disagree as to the appropriateness of items included in these measures. These non-GAAP disclosures should not be considered an alternative to the Company's GAAP results. The following table reconciles the non-GAAP financial measures to GAAP.
 
 
Year Ended December 31, 2017
Reconciliation of net income before effect of Tax Act to net income (GAAP):
 
 
Net Income (GAAP)
 
$
28,061

Tax Act related tax expense
 
4,709

Net Income before Tax Act related expense
 
$
32,770

 
 
 
Reconciliation of earnings per share before effect of Tax Act to earnings per share (GAAP):
 
 
Non-GAAP net income reconciled above
 
$
32,770

Weighted average shares outstanding (basic)
 
9,330,003

Earnings Per Share (basic) before effect of Tax Act
 
$
3.51

 
 
 
Weighted average shares outstanding (diluted)
 
9,334,635

Earnings Per Share (diluted) before effect of Tax Act
 
$
3.51

 
 
 
Reconciliation of return on average assets before effect of Tax Act to return on average assets (GAAP):
 
 
Non-GAAP net income reconciled above
 
$
32,770

Average assets
 
2,756,360

Return on average assets before effect of Tax Act
 
1.19
%
 
 
 
Reconciliation of return on average equity after effect of Tax Act to return on average equity (GAAP):
 
 
Non-GAAP net income reconciled above
 
$
32,770

Average equity
 
303,768

Return on average equity before effect of Tax Act
 
10.79
%



Page 26

Table of Contents

Overview

The Company is a bank holding company engaged, through its wholly-owned subsidiary bank, in the business of commercial banking.  The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa.  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.

The Company’s net income for 2018 was $36.77 million compared to $28.06 million in 2017. Before the effect of the Tax Act, the Company's net income for 2017 would have been $32.77 million. (1) Diluted earnings per share were $3.92 and $3.01 for the years ended December 31, 2018 and 2017, respectively. Before the effect of the Tax Act, diluted earnings per share would have been $3.51 in 2017. (1) Without the effect of the Tax Act, management estimates the Company's net income for 2018 would have been $30.96 million.

The Tax Act resulted in an approximately $4.7 million charge against net income primarily due to the write down of its deferred tax assets as a result of the Tax Act’s reduction in the base corporate tax rate from 35% to 21%. While the Tax Act negatively impacted earnings for the Company's fiscal year ended December 31, 2017, the lower corporate rate is expected to be a significant ongoing benefit to the Company.

The Bank’s net interest income is the largest component of the Bank’s revenue, and is a function of the average earning assets and the net interest margin percentage.  Net interest margin is the ratio of net interest income to average earning assets.  For the years ended December 31, 2018 and 2017, the Bank achieved a net interest margin of 3.25% and 3.43%, respectively. For the year ended December 31, 2018, net interest income on a tax equivalent basis increased by $3.56 million. In 2018, net interest income increased $7.54 million due to growth of $251.20 million in the Bank's average earning assets and decreased $3.98 million due to interest rate changes.

Highlights with respect to items on the Company’s balance sheet as of December 31, 2018 included the following:

Loans, net of allowance for loan losses and unamortized fees and costs, totaling $2.593 billion.
Net loan growth in 2018 of $159.92 million.
Deposit growth of $132.56 million in 2018.  Deposits increased to $2.421 billion and included $132.46 million of brokered deposits.
FHLB Borrowings decreased $80.00 million.
Stockholders’ equity increased $23.17 million to $334.88 million in 2018, with dividends having been paid in 2018 of $7.00 million.
Reference is made to Note 12 of the Company’s consolidated financial statements for a discussion of fair value measurements which relate to methods used by the Company in recording certain assets and liabilities on its consolidated financial statements.

The return on average equity was 9.92% in 2018 compared to 9.24% in 2017.  The returns for the three previous years, 2016, 2015 and 2014, were 11.26%, 10.79% and 10.83%, respectively. Before the effect of the Tax Act, the Company's 2017 return on average equity would have been 10.79%. (1)  The Company remains well-capitalized as of December 31, 2018 with total risk-based capital at 17.18% and Tier 1 risk-based capital at 15.93%.  The minimum regulatory guidelines are 8% and 6% respectively.  The Company paid a dividend per share of $0.750 in 2018, $0.700 in 2017 and $0.650 in the year ended December 31, 2016.

A detailed discussion of the financial position and results of operations follows this overview.








(1) Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measurement section of this report.


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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.

Allowance for Loan Losses

The Company separates its portfolio loans and leases into segments for determining the allowance for loan losses. The Company's portfolio segments includes agricultural, commercial and financial, real estate, loans to individuals and obligations of state and political subdivisions. The Company further separates its portfolio into classes for purposes of monitoring and assessing credit quality based on certain risk characteristics. Classes within the real estate portfolio segment includes 1 to 4 family residential construction, land development and commercial construction, farmland, 1 to 4 family first liens, 1 to 4 family junior liens, multi-family and commercial. For an analysis of the Company's allowance for loan losses by portfolio segment and credit risk rating information by class, see Note 3 to the Company's Consolidated Financial Statements.

Loans that exhibit probable or observed credit weaknesses, as well as loans that have been modified in a troubled debt restructuring ("TDR loans"), are subject to individual review for impairment. When individual loans are reviewed for impairment, the Company determines allowances based on management's estimate of the borrower's ability to repay the loan given the availability of the collateral, other sources of cash flow, as well as evaluation of legal options available. Allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the underlying collateral.

Historical loss rates are applied to loans that are not individually reviewed for impairment. A 20 quarter migration analysis performed by management uses loan level attributes to track the movement of loans through the various credit risk rating categories in order to estimate the percentage of historical loss to apply to each specific credit risk rating in each loan category. The credit risk rating system currently utilized for allowance analysis purposes encompasses six categories.

The Company's allowance for loan loss 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 changes in lending policies and procedures; changes in national and local economic and business conditions; changes in the nature and volume of the loan portfolio; changes in the experience, ability and depth of lending management and staff; changes in the quality of the Bank's loan review system; the existence and effect of concentrations of credit; and the effect of any other identified external factors.

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.  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 for loan losses as of December 31, 2018 and 2017 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.


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Financial Position
Year End Amounts
2018
 
2017
 
2016
 
2015
 
2014
 
(Amounts In Thousands)
 
 
Total assets
$
3,042,464

 
$
2,963,360

 
$
2,655,770

 
$
2,493,607

 
$
2,334,318

Investment securities
331,098

 
300,160

 
279,950

 
276,069

 
267,240

Loans held for sale
1,984

 
5,162

 
9,806

 
5,554

 
4,476

Loans, net
2,591,085

 
2,431,165

 
2,251,445

 
2,099,174

 
1,961,369

Deposits
2,421,124

 
2,288,565

 
2,036,312

 
1,890,702

 
1,835,069

Federal Home Loan Bank borrowings
215,000

 
295,000

 
235,000

 
225,000

 
140,000

Redeemable common stock
48,870

 
43,308

 
40,781

 
37,562

 
34,571

Stockholders' equity
334,882

 
311,716

 
289,270

 
272,175

 
255,528

 
Total assets at December 31, 2018 increased $79.10 million, or 2.67%, from the prior year-end.  Asset growth from 2016 to 2017 was $307.59 million and represented a 11.58% increase.  The largest growth in assets occurred in Net Loans, which increased $159.92 million and $179.72 million for the years ended December 31, 2018 and 2017, respectively.  Loans held for sale to the secondary market decreased $3.18 million and $4.64 for the years ended December 31, 2018 and 2017, respectively.  Loans held for investment represent the largest component of the Bank’s earning assets.  Loans held for investment were $2.629 billion and $2.461 billion at December 31, 2018 and 2017, respectively.

The local economy that generated consistent demand for loans was a significant factor in the trend of increasing net loans in each of the last five years.  The trend of increasing Net Loans may not continue, and as a result, may not be indicative of future performance.

Loans secured by real estate represent the largest increase in loan growth.  These loans increased $154.56 million in 2018 and increased $156.76 million in 2017.  Loans secured by real estate include loans for 1 to 4 family residential properties, multi-family properties, agricultural real estate, commercial real estate and construction and development.

On a net basis, the Company originated $168.57 million and $181.63 million in loans to customers for the years ended December 31, 2018 and 2017, respectively.  Net loan originations decreased 7.19% in 2018 compared to 2017.  The decrease in net loan originations in 2018 as compared to 2017 is reflective of an increasing interest rate environment.  The Company does not engage in significant participation activity and does not purchase participations from outside its established trade area.  The Company’s policy allows for the purchase or sale of participations related to existing customers or to participate in community development activity.  The Company held participations purchased of $14.03, $14.94 and $13.88 million as of December 31, 2018, 2017 and 2016, respectively.  The participations purchased were less than one percent of loans held for investment for each of the three years.

The Company did not experience a material change in the composition of its loans held for investment in 2018 or 2017.  Residential real estate loans, including first and junior liens, were $1,064.68 million, $975.79 million and $892.87 million as of December 31, 2018, 2017 and 2016, respectively.  The dollar total of residential real estate loans increased 9.11% in 2018 and 9.29% in 2017.  Residential real estate loans were 40.51% of the loan portfolio at December 31, 2018, 39.67% at December 31, 2017 and 39.21% at December 31, 2016.  Commercial real estate loans totaled $383.31 million at December 31, 2018, a 6.12% increase over the December 31, 2017 total of $361.20 million.  Commercial real estate loans increased 8.08% in 2017.  Commercial real estate loans totaled $334.20 million at December 31, 2016.  Commercial real estate loans represented 14.59%, 14.69% and 14.67% of the Company’s loan portfolio as of December 31, 2018, 2017 and 2016, respectively.  The Company monitors its commercial real estate level so that it does not have a concentration in that category that exceeds 300% of its capital.  Commercial real estate loan concentration was 181.94% of capital as of December 31, 2018.


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The following table shows the composition of loans (before deducting the allowance for loan losses) as of December 31 for each of the last five years.  The table does not include loans held for sale to the secondary market.
 
 
 
 
 
 
 
 
 
 
 
2018
 
2017
 
2016
 
2015
 
2014
 
 
 
 
 
 
 
 
 
 
Agricultural
$
92,673

 
$
88,580

 
$
92,871

 
$
101,588

 
$
97,645

Commercial and financial
229,501

 
218,632

 
192,995

 
184,199

 
174,738

Real estate:


 
 
 
 
 
 
 
 

Construction, 1 to 4 family residential
72,279

 
69,738

 
57,864

 
51,346

 
45,949

Construction, land development and commercial
113,807

 
109,595

 
121,561

 
83,121

 
77,020

Mortgage, farmland
236,454

 
215,286

 
202,340

 
187,856

 
162,503

Mortgage, 1 to 4 family first liens
912,059

 
831,591

 
767,469

 
727,160

 
672,674

Mortgage, 1 to 4 family junior liens
152,625

 
144,200

 
125,400

 
117,873

 
110,284

Mortgage, multi-family
352,434

 
336,810

 
302,831

 
271,974

 
245,213

Mortgage, commercial
383,314

 
361,196

 
334,198

 
323,409

 
321,601

Loans to individuals
30,072

 
26,417

 
25,157

 
24,019

 
21,342

Obligations of state and political subdivisions
52,725

 
57,626

 
54,462

 
52,371

 
55,729

 
$
2,627,943

 
$
2,459,671

 
$
2,277,148

 
$
2,124,916

 
$
1,984,698

Net unamortized fees and costs
952

 
894

 
827

 
768

 
691

 
$
2,628,895

 
$
2,460,565

 
$
2,277,975

 
$
2,125,684

 
$
1,985,389

Less allowance for loan losses
37,810

 
29,400

 
26,530

 
26,510

 
24,020

 
$
2,591,085

 
$
2,431,165

 
$
2,251,445

 
$
2,099,174

 
$
1,961,369


There were no foreign loans outstanding for any of the years presented.

The following table shows the principal payments due on loans as of December 31, 2018:
 
Amount
Of Loans
 
Amounts Due in One Year
Or Less (1)
 
Amounts Due in One To
Five Years
 
Amounts Due in Over Five
Years
 
(Amounts In Thousands)
Commercial and Agricultural
$
1,480,463

 
$
422,507

 
$
975,208

 
$
82,748

Real Estate (2)
1,064,217

 
115,092

 
732,507

 
216,618

Other
83,263

 
6,346

 
23,662

 
53,255

Totals
$
2,627,943

 
$
543,945

 
$
1,731,377

 
$
352,621

 
 
 
 
 
 
 
 
The types of interest rates applicable to these principal payments are shown below:
 
 
 
 
 
 
 
 
Fixed rate
$
1,454,297

 
$
389,790

 
$
870,189

 
$
194,318

Variable rate
1,173,646

 
154,155

 
861,188

 
158,303

 
$
2,627,943

 
$
543,945

 
$
1,731,377

 
$
352,621

 
(1)
A significant portion of the commercial loans are due in one year or less.  A significant percentage of the loans will be re-evaluated prior to their maturity and are likely to be extended.
(2)
Commercial, multi-family, construction 1 to 4 family residential, construction land development and commercial, and agricultural real estate loans are reflected in the Commercial and Agricultural total.




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The overall economy in the Company’s trade area, Johnson, Linn and Washington Counties, remains in stable condition with levels of unemployment below national and state levels.  The following table shows unemployment as of December 31, 2018, 2017 and 2016 and median income information as of December 31, 2017, 2016 and 2015, as December 31, 2018 information is not available as of the date of this report:

 
Unemployment Rate %
 
Median Income
 
2018
 
2017
 
2016
 
2017
 
2016
 
2015
United States
3.9
%
 
4.1
%
 
4.7
%
 
$
60,336

 
$
57,617

 
$
55,775

State of Iowa
2.5
%
 
2.8
%
 
3.6
%
 
58,570

 
56,247

 
54,736

Johnson County
1.7
%
 
2.0
%
 
2.4
%
 
59,965

 
56,808

 
55,700

Linn County
2.7
%
 
3.2
%
 
3.5
%
 
62,702

 
60,989

 
59,322

Washington County
2.2
%
 
2.4
%
 
2.9
%
 
59,157

 
56,864

 
56,390

 
Competition for quality loans and deposits may continue to be a challenge.  The increased competition for both loans and deposits could result in a lower interest rate margin that could result in lower net interest income if the volume of loans and deposits does not increase to offset any such reduction in the interest margin.

Total deposits increased by $132.56 million in 2018.  Deposits increased by $252.25 million in 2017.  As of June 30, 2018 (latest data available from the FDIC), Johnson County total deposits were $7.549 billion and the Company’s deposits were $1.772 billion, which represent a 23.5% market share.  The Company had nine office locations in Johnson County as of June 30, 2018.  The total banking locations in Johnson County was 52 as of June 30, 2018.  At June 30, 2017, the Company’s deposits were $1.526 billion or a 23.00% market share.  As of June 30, 2018, Linn County total deposits were $6.338 billion and there were 108 total banking locations in the county.  The seven Linn County offices of the Company had deposits of $438.41 million or a 6.9% share of the market.  The Company’s Linn County deposits at June 30, 2017 were $401.73 million and represented a 6.5% market share.  As of June 30, 2018, the Company’s three Washington County offices had deposits of $187.30 million which was 31.1% of the County’s total deposits of $601.98 million.  Washington County had a total of 15 banking locations as of June 30, 2018.  In 2017, the Company’s Washington County deposits were $159.78 million or a 27.4% market share.

The following tables show the amounts of the Company's average deposits and average rates paid on such deposits for the years ended December 31, 2018, 2017 and 2016 and the composition of the certificates of deposit issued in denominations in excess of $100,000 as of December 31, 2018, 2017 and 2016:
 
December 31,
 
2018
 
Rate
 
2017
 
Rate
 
2016
 
Rate
 
(Amounts In Thousands)
Average noninterest-bearing deposits
$
364,916

 

 
$
342,640

 

 
$
312,407

 

Average interest-bearing demand deposits
644,712

 
0.63
%
 
548,598

 
0.21
%
 
499,882

 
0.15
%
Average savings deposits
832,772

 
0.75

 
748,862

 
0.34

 
684,283

 
0.23

Average time deposits
537,575

 
1.72

 
451,208

 
1.34

 
438,173

 
1.24

 
$
2,379,975

 
 

 
$
2,091,308

 
 

 
$
1,934,745

 
 


Time certificates issued in amounts of $100,000 or more with maturity in:
 
2018
 
Rate
 
2017
 
Rate
 
2016
 
Rate
 
(Amounts In Thousands)
3 months or less
$
15,536

 
0.85
%
 
$
18,854

 
0.70
%
 
$
34,810

 
0.83
%
3 through 6 months
15,887

 
0.86

 
26,329

 
0.80

 
28,756

 
0.86

6 through 12 months
98,330

 
1.88

 
71,713

 
1.09

 
48,471

 
0.75

Over 12 months
220,972

 
2.11

 
198,662

 
1.74

 
182,797

 
1.49

 
$
350,725

 
 

 
$
315,558

 
 

 
$
294,834

 
 


Investment securities increased $30.94 million in 2018.  In 2017, investment securities increased by $20.21 million.  The investment portfolio consists of $318.93 million of securities that are stated at fair value, with any unrealized gain or loss, net of income taxes,

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reported as a separate component of stockholders’ equity.  The securities portfolio is used for liquidity and pledging purposes and to provide a rate of return that is acceptable to management.

The following tables show the carrying value of the investment securities held by the Bank, including stock of the Federal Home Loan Bank, as of December 31, 2018, 2017 and 2016 and the maturities and weighted average yields of the investment securities, computed on a tax-equivalent basis using a federal tax rate of 21%, as of December 31, 2018:
 
December 31,
 
2018
 
2017
 
2016
 
(Amounts In Thousands)
Carrying value:
 
 
 
 
 
U.S. Treasury
$
83,155

 
$
54,318

 
$
27,482

Other securities (FHLB, FHLMC and FNMA)
34,871

 
43,959

 
61,660

Stock of the Federal Home Loan Bank
12,172

 
15,005

 
12,413

Obligations of state and political subdivisions
200,900

 
186,878

 
178,395

 
$
331,098

 
$
300,160

 
$
279,950

 
 
December 31, 2018
 
Carrying
Value
 
Weighted
Average
Yield
 
(Amounts In Thousands)
U.S. Treasury
 
 
 
  Within 1 year
$
4,967

 
1.53
%
  From 1 to 5 years
78,188

 
2.27
%
 
$
83,155

 
 
Other securities (FHLB, FHLMC and FNMA), maturities:
 
 
 
Within 1 year
$
19,909

 
1.41
%
From 1 to 5 years
14,962

 
1.23

From 5 to 10 years

 

 
$
34,871

 
 

 
 
 
 
Stock of the Federal Home Loan Bank
$
12,172

 
2.94
%
 
 
 
 
Obligations of state and political subdivisions, maturities:
 

 
 

Within 1 year
$
34,095

 
2.88
%
From 1 to 5 years
87,248

 
2.57

From 5 to 10 years
78,329

 
2.78

Over 10 years
1,228

 
4.49

 
$
200,900

 
 

Total
$
331,098

 
 


As of December 31, 2018, the Company held no investment securities exceeding 10% of stockholders’ equity, other than securities of the U.S. Government agencies and corporations.  The Company does not hold any investments in FNMA preferred stock, any pooled trust preferred stocks or other preferred stock type investments.  See Note 2 to the Company’s Consolidated Financial Statements.


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During 2018, the major funding source for the growth in loans was the $132.56 million increase in deposits.  In 2017, the major source of funding for the growth in loans was the $60.00 million in additional FHLB Borrowings and deposit growth of $252.25 million.  Brokered deposits totaled $132.46 million and $284.41 million as of December 31, 2018 and 2017, respectively.  Brokered deposits decreased as of December 31, 2018 compared to December 31, 2017 due to passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act which allows reciprocal deposits to be treated as core deposits instead of brokered deposits. As of December 31, 2018, $163.41 million of reciprocal deposits are now treated as core deposits under the Act. Total advances from the FHLB were $215.00 million at December 31, 2018 and $295.00 million in 2017.  It is expected that the FHLB funding source and brokered deposits funding will be considered in the future if loan growth continues to exceed core deposit increases and the interest rates on funds borrowed from the FHLB and interest rates on brokered deposits are favorable compared to other funding alternatives.

Stockholders’ equity was $334.88 million at December 31, 2018 compared to $311.72 million at December 31, 2017.  The Company’s capital resources are discussed in detail in the Liquidity and Capital Resources section.  Over the last five years, the Company has realized cumulative earnings of $151.78 million and paid shareholders dividends of $30.82 million, or 20.31% of earnings, while maintaining capital ratios in excess of regulatory requirements.

The following table presents the return on average assets, return on average stockholders' equity, the dividend payout ratio and average stockholders’ equity to average assets ratio for the years ended December 31, 2018, 2017 and 2016:
 
2018
 
2017
 
2016
Return on average assets
1.23
%
 
1.02
%
 
1.23
%
Return on average assets before Tax Act (1)
NA
 
1.19

 
NA
Return on average stockholders' equity
9.92

 
9.24

 
11.26

Return on average equity before Tax Act (1)
NA
 
10.79

 
NA
Dividend payout ratio
19.05

 
23.11

 
19.20

Average stockholders' equity to average assets ratio
12.35

 
11.02

 
10.94

(1)
Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measures section of this report in Item 7.


Net Income Overview

Net income and diluted earnings per share for the last five years are as presented below:
Year
Net Income
 
% (Decrease) Increase
 
Earnings Per
Share - Diluted
 
(In Thousands)
 
 
 
 
2018
$
36,767

 
31.03
 %
 
$
3.92

2017
28,061

 
(11.07
)
 
3.01

2017 (1)
32,770

 
3.85

 
3.51

2016
31,555

 
11.04

 
3.40

2015
28,418

 
5.35

 
3.04

2014
26,974

 
4.02

 
2.87


(1)
Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measurement section of this report.

Net income for 2018 increased by $8.71 million or 31.03% and diluted earnings per share increased by 30.23%. Without the effect of the Tax Act, net income for 2017 would have increased by $1.22 million or 3.85%. In addition, diluted earnings per share would have increased 3.25%.(1) In 2018, net interest income increased $7.54 million due to growth of $251.20 million in the Bank's average earning assets and decreased $3.98 million due to interest rate changes. Noninterest income increased by $3.00 million, the provision for loan losses increased by $6.81 million and total noninterest expenses increased by $2.61 million.


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Annual fluctuations in the Company's net income continue to be driven primarily by three generally recurring important factors. The first important factor is net interest margin. Net interest income of $92.47 million in 2018 was derived from the Company's $2.903 billion of average earning assets and its net interest margin of 3.25%, compared to $2.652 billion of average earning assets and a 3.43% net interest margin in 2017. The importance of net interest margin is illustrated by the fact that a decrease or an increase in the net interest margin of 10 basis points would result in a $2.90 million decrease or increase in income before taxes.  Net interest margin in 2016 was 3.43%. Based on the current interest rate environment, the Company expects continued net interest compression to impact earnings for the foreseeable future.  The Company believes net interest margin in dollars will be contingent on the growth of the Company’s earnings assets. Net interest income was also impacted by the increase in interest expense of $8.35 million compared to 2017, primarily driven by interest rate increases which accounted for $7.99 million of the change.

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 $2.631 billion at the end of 2018.  The Company’s allowance for loan losses was $37.81 million at December 31, 2018.  The allowance in 2018 increased in comparison to 2017 due to an increased provision for loan losses of $6.81 million resulting from a combination of the composition of loan growth, historical loss rates, changes in the composition of loans among the credit risk ratings in 2018 and management's evaluation of qualitative factors given the current and expected deterioration in national and local economic conditions.  The loan loss provision, which is the amount necessary to adjust the allowance to the level considered appropriate by management, totaled an expense of $8.50 million for 2018, an expense of $1.69 million for 2017 and a reduction of expense of $1.16 million for 2016.  The Company may experience some credit quality deterioration in 2019.  Provision expense is expected to be dependent on the Company’s loan growth through the end of 2019. See Note 3 to the Company's Consolidated Financial Statements. A detailed discussion is included in the Provision for Loan Losses section below.

The third significant factor affecting the Company’s net income is income tax expense. Federal and state income tax expenses were $8.91 million and $19.54 million for the years ended December 31, 2018 and 2017, respectively. Income taxes as a percentage of income before taxes were 19.50% in 2018 and 41.05% in 2017. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cut and Jobs Act (the “Tax Act”). The Tax Act established new tax laws that reduced the U.S. federal corporate income tax rate from 35% to 21% in 2018. Without the effect of the Tax Act, management estimates the Company's net income for 2018 would have been $30.96 million.

Net income for 2017 was $28.06 million, or diluted earnings per share of $3.01.  For 2017, diluted earnings per share decreased by $0.39 per share compared to 2016.  Net interest income increased $6.39 million for the year ended December 31, 2017 compared to 2016.  This increase in net interest income was due to an increase in average earning assets of $195.79 million in 2017.  Noninterest income increased 4.12% in 2017 to $20.82 million.  Noninterest expense increased from $56.80 million in 2016 to $59.51 million in 2017, or 4.78%.


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Net Interest Income

Net interest income is the excess of the interest and fees received on interest-earning assets over the interest paid on the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin.  The volume of average earning assets has continued to grow each year, primarily due to net loan growth.  The net interest margin was 3.25% in 2018, 3.43% in 2017, 3.43% in 2016, 3.50% in 2015, and 3.49% in 2014.  The measure is shown on a tax-equivalent basis using a rate of 21% for 2018 and 35% for 2017 and 2016 to make the interest earned on taxable and nontaxable assets more comparable.  Interest income and expense for 2018, 2017 and 2016 are indicated on the following table: 
 
Years Ended December 31,
 
2018
 
2017
 
2016
 
(Amounts In Thousands)
Income:
 
 
 
 
 
Loans (1)
$
111,172

 
$
101,564

 
$
93,744

Taxable securities
2,759

 
1,709

 
1,471

Nontaxable securities (1)
4,717

 
4,972

 
4,938

Interest-bearing cash and cash equivalents
1,939

 
433

 
163

Total interest income
$
120,587

 
$
108,678

 
$
100,316

Expense:
 

 
 

 
 

Interest-bearing demand deposits
4,056

 
1,172

 
740

Savings deposits
6,208

 
2,532

 
1,577

Time deposits
9,267

 
6,038

 
5,440

Other borrowings

 
184

 
158

FHLB borrowings
6,792

 
8,046

 
8,172

Interest-bearing other liabilities

 

 

Total interest expense
$
26,323

 
$
17,972

 
$
16,087

Net interest income
$
94,264

 
$
90,706

 
$
84,229

 
(1)  Presented on a tax equivalent basis using a rate of 21% for 2018 and 35% for 2017 and 2016.

Net interest income on a tax-equivalent basis changed in 2018 as follows:
 
Change In
 
Change In
 
Increase (Decrease)
 
Average
Balance
 
Average
Rate
 
Volume
Changes
 
Rate
Changes
 
Net
Change
 
(Amounts In Thousands)
Interest income:
 
 
 
 
 
 
 
 
 
Loans, net
$
147,130

 
0.13
 %
 
$
6,369

 
$
3,239

 
$
9,608

Taxable securities
23,069

 
0.50

 
374

 
676

 
1,050

Nontaxable securities
12,035

 
(0.33
)
 
354

 
(609
)
 
(255
)
Interest-bearing cash and cash equivalents
68,585

 
0.67

 
801

 
705

 
1,506

Federal funds sold
(25
)
 
0.99

 

 

 

 
$
250,794

 
 

 
$
7,898

 
$
4,011

 
$
11,909

Interest expense:
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
$
96,114

 
0.42
 %
 
$
(205
)
 
$
(2,679
)
 
$
(2,884
)
Savings deposits
83,910

 
0.41

 
(389
)
 
(3,288
)
 
(3,677
)
Time deposits
86,367

 
0.38

 
(1,156
)
 
(2,072
)
 
(3,228
)
Other borrowings
(28,593
)
 
2.07

 
184

 

 
184

FHLB borrowings
(40,345
)
 
(0.02
)
 
1,209

 
45

 
1,254

Interest-bearing other liabilities

 

 

 

 

 
$
197,453

 
 

 
$
(357
)
 
$
(7,994
)
 
$
(8,351
)
Change in net interest income
 

 
 

 
$
7,541

 
$
(3,983
)
 
$
3,558


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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 at tax equivalent amounts.

Net interest income on a tax equivalent basis changes for 2017 were as follows:
 
Change In Average Balance
 
Change In Average Rate
 
Increase (Decrease)
 
 
 
Volume
Changes
 
Rate
Changes
 
Net
Change
 
(Amounts In Thousands)
Interest income:
 
 
 
 
 
 
 
 
 
Loans, net
$
180,621

 
0.01
 %
 
$
7,550

 
$
270

 
$
7,820

Taxable securities
3,872

 
0.17

 
93

 
145

 
238

Nontaxable securities
6,135

 
(0.09
)
 
186

 
(152
)
 
34

Interest-bearing cash and cash equivalents
5,138

 
0.66

 
26

 
244

 
270

Federal funds sold
21

 
0.28

 

 

 

 
$
195,787

 
 

 
$
7,855

 
$
507

 
$
8,362

Interest expense:
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
$
48,716

 
0.06
 %
 
$
(70
)
 
$
(362
)
 
$
(432
)
Savings deposits
64,579

 
0.11

 
(141
)
 
(813
)
 
(954
)
Time deposits
13,035

 
0.10

 
(147
)
 
(452
)
 
(599
)
Other borrowings
(22,575
)
 
0.33

 
50

 
(76
)
 
(26
)
FHLB borrowings
36,968

 
(0.51
)
 
(1,279
)
 
1,405

 
126

Interest-bearing other liabilities
(872
)
 

 

 

 

 
$
139,851

 
 

 
$
(1,587
)
 
$
(298
)
 
$
(1,885
)
Change in net interest income
 

 
 

 
$
6,268

 
$
209

 
$
6,477



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A summary of the net interest spread and margin is as follows:
 
Years Ended December 31,
 
2018
 
2017
 
2016
Average yields:
 
 
 
 
 
Loans (1)
4.45
%
 
4.30
%
 
4.24
%
Loans (tax equivalent basis) (1)
4.47

 
4.34

 
4.33

Taxable securities
2.13

 
1.63

 
1.45

Nontaxable securities
1.96

 
1.91

 
1.97

Nontaxable securities (tax equivalent basis)
2.61

 
2.94

 
3.03

Interest-bearing cash and cash equivalents
1.84

 
1.17

 
0.51

Federal funds sold
1.75

 
0.76

 
0.48

Average rates paid:
 

 
 

 
 

Interest-bearing demand deposits
0.63

 
0.21

 
0.15

Savings deposits
0.75

 
0.34

 
0.23

Time deposits
1.72

 
1.34

 
1.24

Short-term borrowings
2.71

 
0.64

 
0.31

FHLB borrowings
2.94

 
2.96

 
3.47

Yield on average interest-earning assets
4.15

 
4.10

 
4.07

Rate on average interest-bearing liabilities
1.17

 
0.87

 
0.84

Net interest spread (2)
2.99

 
3.23

 
3.23

Net interest margin (3)
3.25

 
3.43

 
3.43

 
(1)
Non-accruing loans have been included in the average loan balances for purposes of this computation.
(2)
Net interest spread is the difference between the yield on average interest-earning assets and the yield on average interest-paying liabilities stated on a tax equivalent basis using a federal rate of 21% for 2018 and 35% for 2017 and 2016.  The net interest spread decreased 24 basis points in 2018 compared to 2017 and 2016.
(3)
Net interest margin is net interest income, on a tax equivalent basis, divided by average interest-earning assets.  The net interest margin decreased 18 basis points in 2018.  The net interest margin did not change in 2017 compared to 2016. 

In December 2018, the Federal Open Market Committee increased the target rate to 2.50%.  Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally correlate to the Federal Reserve Board federal funds rate.  In pricing of loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates.  As of December 31, 2018, the average rate indexes for the one, three and five year indexes were 2.63%, 2.46% and 2.51%, respectively.  The one year index increased 43.72% from December 31, 2017, the three year index increased 22.39% and the five year index increased 11.56%. 

Provision for Loan Losses

Management has determined that the allowance for loan losses was appropriate at December 31, 2018, 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 and well-documented 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 peers. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.


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The allowance for loan losses totaled $37.81 million at December 31, 2018 compared to $29.40 million at December 31, 2017.  The increase in 2018 is the result of increased loan volume and management's evaluation of qualitative factors.  Specifically for 2018, there was an increase of $7.73 million due to the composition of new loans added and qualitative factor increases in 2018.  There was an increase of $0.68 million in the amount allocated to the allowance due to a change in the composition and allocation of loan balances within the credit quality ratings.  The percentage of the allowance to outstanding loans was 1.44% and 1.20% at December 31, 2018 and 2017, respectively.  The percentage increase was due to a combination of loan growth composition, historical loss rates and changes in the composition of loans among the credit risk ratings.  The provision for loan losses totaled an expense of $8.50 million in 2018, an expense of $1.69 million in 2017 and a reduction of expense of $1.16 million for 2016.  Loan charge-offs net of recoveries were $0.88 million in 2018. Loan recoveries net of charge-offs were $1.18 million in 2017 and 2016.

The provision for loan losses is the amount necessary to adjust the allowance for loan losses to the level considered appropriate by management.  The adequacy of the allowance for loans and any related 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 significant factors, including the size and growth of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact of the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more and the trends in problem and watch loans.  In addition, management considers the credit quality of the loans based on management’s review of special mention and substandard loans, including loans with historical higher credit risks.  Quantitative factors include the Company’s historical loss experience, which is 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 TDR loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.

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 nonaccrual 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 payment 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 we determine that a loan amount, or portion thereof, is uncollectible, the loan’s credit risk rating is immediately downgraded and the uncollectible amount is charged-off.  The Bank’s credit and legal departments undertake a thorough and ongoing analysis to determine if additional impairment and/or charge-offs are appropriate and to begin a workout plan for the loan to minimize realized loss.

In certain circumstances, the Bank may modify the terms of a loan to maximize the collection of amounts due.  In most cases, the modification is either a reduction in interest rate, conversion to interest only payments, deferral of payments or extension of the maturity date.  Generally, the borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term, so concessionary modification is granted to the borrower that otherwise would 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.  The Bank’s TDR loans occur on a case-by-case basis in connection with ongoing loan collection processes.

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 that can be identified as uncollectible.  In general, this is the amount that the carrying value of the loan exceeds the related appraised value less estimated selling costs.  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 additional charge-off or loss allocations based on the applicable facts and circumstances.  In instances where there is an estimated decline in value, a loss allocation 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 loss allocation 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.


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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.

The Bank regularly reviews loans in the portfolio and assesses whether the loans are impaired in accordance with ASC 310-10-35, Accounting by Creditors for Impairment of a Loan.  If the loans are impaired, the Bank determines if a specific allowance is appropriate.  In addition, the Bank'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 Bank allocates a percentage, as determined by management, for a required allowance needed.  The determination concerning 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 TDR 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 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 related to an impaired loan when loan balances exceed net present value of cash flows or collateral.  Impaired loans decreased by $3.50 million from December 31, 2017 to December 31, 2018.  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 Bank expects to be unable to collect in full according to the contractual terms of the original loan agreement.  The decrease in impaired loans is primarily due to a decrease in specific reserve loans of $4.70 million from December 31, 2017 to December 31, 2018.

Special mention loan balances were $53.60 million at December 31, 2018 and $43.37 million at December 31, 2017.  These asset quality changes increased the provision by $0.20 million based upon the relative mix of special mention loans by category.  The $10.23 million increase in special mention loans is related to management’s evaluation of its loan portfolio.  The total increase of $10.23 million is comprised of approximately $5.84 million in commercial loans, $4.28 million in construction land development and commercial, $16.07 million for multi-family real estate mortgages, and $0.03 million in individual loans. The increase is offset by a decrease in the special mention classification of $6.25 million in agricultural operating loans, $0.08 million in construction 1 to 4 family residential, $4.25 million in real estate farmland, $1.63 million in 1 to 4 family residential mortgages, $0.70 million in 1 to 4 family junior mortgages, and $3.08 million for commercial real estate mortgages.

Substandard loan balances were $54.40 million at December 31, 2018 and $52.34 million at December 31, 2017.  These asset quality changes increased the provision by $0.48 million at December 31, 2018 due to the mix of the reserve required for certain substandard loans.  The increase of $2.06 million in substandard loans at December 31, 2018 includes $0.16 million in agricultural operating loans, $0.14 million in commercial loans, $0.40 million in construction 1 to 4 family residential, $0.40 million in construction land development, $0.78 million in real estate farmland, and $4.38 million in commercial real estate mortgages. The increase is offset by a decrease in the substandard classification of $3.51 million of 1 to 4 family residential mortgages, $0.39 million in 1 to 4 family junior mortgages, $0.23 million in multi-family real estate mortgages, and $0.07 million in loans to individuals. A description of the Bank's credit quality indicators are discussed in Note 3 to the Company's Consolidated Financial Statements.

The Company evaluates the following loans to determine impairment:  1) all nonaccrual and TDR loans, 2) all non-consumer and non 1 to 4 family residential loans with prior charge-offs, 3) all non-consumer and non 1 to 4 family loan relationships classified as substandard and 4) loans with indications of or suspected deteriorating credit quality.


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The following table summarizes the Company's impaired loans and non-performing assets as of December 31 for each of the years presented:
 
2018
 
2017
 
2016
 
2015
 
2014
 
(Amounts In Thousands)
Nonaccrual loans (1)
$
10,829

 
$
9,096

 
$
9,938

 
$
7,415

 
$
6,081

Accruing loans past due 90 days or more (2)
370

 
971

 
635

 
467

 
348

Specific reserve loans
8,247

 
12,950

 
17,683

 
100

 

Troubled debt restructurings ("TDR loans")(1) (3)
8,539

 
8,470

 
5,408

 
8,279

 
14,340

Total impaired loans
$
27,985

 
$
31,487

 
$
33,664

 
$
16,261

 
$
20,769

Other real estate

 

 
237

 
439

 
1,213

Non-performing assets (includes impaired loans and other real estate)
$
27,985

 
$
31,487

 
$
33,901

 
$
16,700

 
$
21,982

Loans held for investment
$2,627,943
 
$2,459,671
 
$2,277,148
 
$2,124,916
 
$1,984,698
Ratio of allowance for loan losses to loans held for investment
1.44
%
 
1.20
%
 
1.17
%
 
1.25
%
 
1.21
%
Ratio of allowance for loan losses to impaired loans
135.11

 
93.37

 
78.81

 
163.03

 
115.65

Ratio of impaired loans to total loans held for investment
1.06

 
1.28

 
1.48

 
0.77

 
1.05

Ratio of non-performing assets to total assets
0.92

 
1.06

 
1.28

 
0.67

 
0.94


(1)
The gross interest income that would have been recorded if the loans had been current in accordance with their original terms and had been outstanding throughout the period or since origination if held for part of the period was $0.79 million in 2018 and $0.90 million in 2017. The amount of interest income on the loans that was included in income was $0.40 million in 2018 and $0.44 million in 2017.
(2)
The accruing loans past due 90 days or more are still believed to be adequately collateralized.  Loans are placed on nonaccrual status when management believes the collection of future principal and interest is not reasonably assured.
(3)
Total TDR loans were $13.38, $12.09, $9.64, $10.59, and $16.48 million as of December 31, 2018, 2017, 2016, 2015, and 2014, respectively.  Included in the total nonaccrual loans were $4.84, $3.62, $4.23, $2.31, and $2.14 million of TDR loans as of December 31, 2018, 2017, 2016, 2015, and 2014, respectively.

The ratio of allowance for loan losses to impaired loans increased to 135.11% as of December 31, 2018 compared to 93.37% as of December 31, 2017.  The increase in 2018 is the result of an increase in the allowance for loan losses.  The ratio of impaired loans to total gross loans was 1.06% and 1.28% at December 31, 2018 and 2017, respectively.  The decrease in the 2018 ratio is primarily due to the decrease in specific reserve loans.

Other factors that are considered in determining the credit quality of the Company’s loan portfolio are the vacancy rates for both residential and commercial space, current equity the borrower has in the property and overall financial strength of the customer including cash flow to continue to fund loan payments.  The Company also considers the state of the total economy including unemployment levels.  In most instances, the borrowers have used in their rental projections of income at least a 10% vacancy rate.  As of December 31, 2018, the unemployment levels in Johnson County and Linn County were 1.7% and 2.7%, respectively, compared to 2.0% and 3.2% in December of 2017.  These levels compare favorably to the State of Iowa at 2.5% and the national unemployment level at 3.9% in December 2018 compared to 2.8% and 4.1%, respectively in December 2017.

The residential rental vacancy rates in 2017 and 2018 in Johnson and Linn County were estimated between 5.0% and 7.0%. The State of Iowa vacancy rate is 7.0% and the national rate is 6.6% with the Midwest rate at 7.1%.  These vacancy rates one year ago were 6.2%, 6.9% and 7.6%, respectively.  The Company continues to consider those vacancy rates among other factors in its current evaluation of the real estate portion of its loan portfolio.   Favorable vacancy rates may not continue in 2019, and vacancy rates may rise and affect the overall quality of the loan portfolio.

See Note 3 to the Company's Consolidated Financial Statements for additional disclosures on loans.


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Table of Contents

SUMMARY OF LOAN LOSS EXPERIENCE

The allowance for loan losses balance is also affected by the charge-offs and recoveries for the periods presented.  For the years ended December 31, 2018, 2017 and 2016, recoveries were $2.23 million, $3.29 million and $3.81 million, respectively; charge-offs were $2.32 million, $2.10 million and $2.63 million in 2018, 2017 and 2016, respectively.
 
Overall credit quality may deteriorate in 2019.  Such deterioration could cause increases in impaired loans, allowance for loan losses provision expense and net charge-offs.  Management will monitor changing market conditions as a part of its allowance for loan loss methodology.  The following table summarizes the Bank's loan loss experience for the years ended December 31 for each of the years presented:
 
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)
2018
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,294

 
$
4,837

 
$
2,989

 
$
3,669

 
$
8,668

 
$
5,700

 
$
1,243

 
$
29,400

Charge-offs
(95
)
 
(585
)
 

 

 
(830
)
 
(251
)
 
(561
)
 
(2,322
)
Recoveries
119

 
1,057

 
148

 
30

 
612

 
107

 
162

 
2,235

Provision
471

 
517

 
155

 
273

 
4,066

 
2,609

 
406

 
8,497

Ending balance
$
2,789

 
$
5,826

 
$
3,292

 
$
3,972

 
$
12,516

 
$
8,165

 
$
1,250

 
$
37,810

 
 
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)
2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,947

 
$
4,531

 
$
2,890

 
$
3,417

 
$
7,677

 
$
4,045

 
$
1,023

 
$
26,530

Charge-offs
(167
)
 
(583
)
 
(114
)
 
(3
)
 
(553
)
 
(130
)
 
(554
)
 
(2,104
)
Recoveries
146

 
1,183

 
662

 

 
661

 
376

 
258

 
3,286

Provision
(632
)
 
(294
)
 
(449
)
 
255

 
883

 
1,409

 
516

 
1,688

Ending balance
$
2,294

 
$
4,837

 
$
2,989

 
$
3,669

 
$
8,668

 
$
5,700

 
$
1,243

 
$
29,400


 
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)
2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
3,082

 
$
4,517

 
$
2,280

 
$
3,342

 
$
8,172

 
$
4,223

 
$
894

 
$
26,510

Charge-offs
(226
)
 
(315
)
 
(34
)
 
(116
)
 
(1,181
)
 
(66
)
 
(693
)
 
(2,631
)
Recoveries
181

 
1,169

 
849

 

 
1,043

 
385

 
187

 
3,814

Provision
(90
)
 
(840
)
 
(205
)
 
191

 
(357
)
 
(497
)
 
635

 
(1,163
)
Ending balance
$
2,947

 
$
4,531

 
$
2,890

 
$
3,417

 
$
7,677

 
$
4,045

 
$
1,023

 
$
26,530



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Table of Contents

 
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)
2015
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,515

 
$
4,231

 
$
2,241

 
$
2,672

 
$
7,419

 
$
4,195

 
$
747

 
$
24,020

Charge-offs
(325
)
 
(526
)
 
(285
)
 

 
(1,108
)
 
(723
)
 
(438
)
 
(3,405
)
Recoveries
123

 
1,370

 
501

 
6

 
762

 
1,310

 
168

 
4,240

Provision
769

 
(558
)
 
(177
)
 
664

 
1,099

 
(559
)
 
417

 
1,655

Ending balance
$
3,082

 
$
4,517

 
$
2,280

 
$
3,342

 
$
8,172

 
$
4,223

 
$
894

 
$
26,510


 
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)
2014
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,852

 
$
4,733

 
$
2,918

 
$
2,557

 
$
7,064

 
$
4,787

 
$
639

 
$
25,550

Charge-offs
(174
)
 
(3,388
)
 
(250
)
 

 
(1,195
)
 
(217
)
 
(325
)
 
(5,549
)
Recoveries
66

 
1,128

 
390

 

 
870

 
377

 
146

 
2,977

Provision
(229
)
 
1,758

 
(817
)
 
115

 
680

 
(752
)
 
287

 
1,042

Ending balance
$
2,515

 
$
4,231

 
$
2,241

 
$
2,672

 
$
7,419

 
$
4,195

 
$
747

 
$
24,020


The ratio of net charge-offs to average net loans outstanding during the years ended December 31, 2018, 2017, 2016, 2015, and 2014 was 0.00%, (0.05)%, (0.05)%, (0.04)%, and 0.14%, respectively.


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ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

The following table presents the allowance for loan losses by type of loans, the percentage of the allocation for each category to the total allowance and the percentage of all loans in each category to total loans as of December 31, 2018, 2017, 2016, 2015, and 2014:
 
2018
 
2017
 
Amount
 
% of Total Allowance
 
% of Loans
to Total Loans
 
Amount
 
% of Total Allowance
 
% of Loans
to Total Loans
 
(In Thousands)
 
 
 
 
 
(In Thousands)
 
 
 
 
Agricultural
$
2,789

 
7.38
%
 
3.53
%
 
$
2,294

 
7.80
%
 
3.60
%
Commercial and financial
5,826

 
15.41
%
 
8.73

 
4,837

 
16.45
%
 
8.89

Real estate:
 

 


 
 

 
 

 
 
 
 

Construction, 1 to 4 family residential
1,297

 
3.43
%
 
2.75

 
1,193

 
4.06
%
 
2.84

Construction, land development and commercial
1,995

 
5.28
%
 
4.33

 
1,796

 
6.11
%
 
4.46

Mortgage, farmland
3,972

 
10.51
%
 
9.00

 
3,669

 
12.48
%
 
8.75

Mortgage, 1 to 4 family first liens
10,750

 
28.43
%
 
34.71

 
7,369

 
25.07
%
 
33.81

Mortgage, 1 to 4 family junior liens
1,766

 
4.67
%
 
5.81

 
1,299

 
4.42
%
 
5.86

Mortgage, multi-family
4,083

 
10.80
%
 
13.41

 
2,791

 
9.49
%
 
13.69

Mortgage, commercial
4,082

 
10.80
%
 
14.58

 
2,909

 
9.89
%
 
14.69

Loans to individuals
723

 
1.91
%
 
1.14

 
782

 
2.66
%
 
1.07

Obligations of state and political subdivisions
527

 
1.38

 
2.01

 
461

 
1.57

 
2.34

 
$
37,810

 
100.00
%
 
100.00
%
 
$
29,400

 
100.00
%
 
100.00
%

 
2016
 
2015
Agricultural
$
2,947

 
11.11
%
 
4.08
%
 
$
3,082

 
11.63
%
 
4.78
%
Commercial and financial
4,531

 
17.08

 
8.48

 
4,517

 
17.04

 
8.67

Real estate:
 

 
 
 
 

 
 

 
 
 
 

Construction, 1 to 4 family residential
1,023

 
3.86

 
2.54

 
866

 
3.27

 
2.42

Construction, land development and commercial
1,867

 
7.04

 
5.34

 
1,414

 
5.33

 
3.91

Mortgage, farmland
3,417

 
12.88

 
8.89

 
3,342

 
12.61

 
8.84

Mortgage, 1 to 4 family first liens
6,560

 
24.72

 
33.70

 
6,931

 
26.14

 
34.22

Mortgage, 1 to 4 family junior liens
1,117

 
4.21

 
5.51

 
1,241

 
4.68

 
5.55

Mortgage, multi-family
1,669

 
6.29

 
13.30

 
1,713

 
6.46

 
12.80

Mortgage, commercial
2,376

 
8.95

 
14.67

 
2,510

 
9.47

 
15.22

Loans to individuals
642

 
2.42

 
1.10

 
501

 
1.89

 
1.13

Obligations of state and political subdivisions
381

 
1.44

 
2.39

 
393

 
1.48

 
2.46

 
$
26,530

 
100.00
%
 
100.00
%
 
$
26,510

 
100.00
%
 
100.00
%


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Table of Contents

 
2014
 
Amount
 
% of Total Allowance
 
% of Loans
to Total Loans
 
(In Thousands)
 
 
 
 
Agricultural
$
2,515

 
10.47
%
 
4.92
%
Commercial and financial
4,231

 
17.61

 
8.80

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
810

 
3.37

 
2.32

Construction, land development and commercial
1,431

 
5.96

 
3.88

Mortgage, farmland
2,672

 
11.12

 
8.19

Mortgage, 1 to 4 family first liens
6,268

 
26.11

 
33.88

Mortgage, 1 to 4 family junior liens
1,151

 
4.79

 
5.56

Mortgage, multi-family
1,490

 
6.20

 
12.36

Mortgage, commercial
2,705

 
11.26

 
16.20

Loans to individuals
299

 
1.24

 
1.08

Obligations of state and political subdivisions
448

 
1.87

 
2.81

 
$
24,020

 
100.00
%
 
100.00
%

The Company believes that the allowance for loan losses is at a level commensurate with the overall risk exposure of the loan portfolio.  However, if economic conditions deteriorate, certain borrowers may experience difficulty and the level of impaired loans, charge-offs and delinquencies could rise and require increases in the provision for loan losses.   The Company will continue to monitor the adequacy of the allowance on a quarterly basis and will consider 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.

Noninterest Income

The following table sets forth the various categories of noninterest income for the year ended December 31, 2018, 2017 and 2016.
 
Year Ended December 31,
 
$ Change
 
% Change
 
2018
 
2017
 
2016
 
2018/2017

 
2017/2016

 
2018/2017

 
2017/2016

 
(Amounts in thousands)
 
 

 
 

 
 

 
 

Net gain on sale of loans
$
1,517

 
$
1,547

 
$
2,043

 
$
(30
)
 
$
(496
)
 
(1.94
)%
 
(24.28
)%
Trust fees
10,007

 
8,043

 
7,033

 
1,964

 
1,010

 
24.42

 
14.36

Service charges and fees
9,614

 
8,850

 
8,750

 
764

 
100

 
8.63

 
1.14

Other noninterest income
2,680

 
2,378

 
2,169

 
302

 
209

 
12.70

 
9.64

 
$
23,818

 
$
20,818

 
$
19,995

 
$
3,000

 
$
823

 
14.41
 %
 
4.12
 %

The noninterest income of the Company was $23.82 million in 2018 compared to $20.82 million in 2017.  The increase of $3.00 million in 2018 was the result of a combination of factors discussed below.  In 2017, the total noninterest income increased $0.82 million from 2016.

Trust fees increased $1.96 million to $10.01 million in 2018.  Trust fees increased $1.01 million in 2017.  As of December 31, 2018, the Bank’s Trust Department had $1.618 billion in assets under management compared to $1.649 billion and $1.392 billion at December 31, 2017 and 2016, respectively.  Trust fees are based on total assets under management and increased primarily due to new trust relationships though the stock market decline in late 2018 led to a decline in total assets under management as of December 31, 2018.  The trust assets that are the most volatile are those that are held in common stocks, which amount to approximately 62.00% of assets under management.  In 2018, the Dow Jones Industrial Average decreased 5.63%.  The market value of the Dow Jones Industrial Average increased 25.08% in 2017 and increased 13.42% in 2016.

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Service charges and fees increased $0.76 million in 2018 from increased debit and credit card interchange income. Service charges and fees increased $0.10 million in 2017.

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the year ended December 31, 2018, 2017 and 2016.
 
Year Ended December 31,
 
$ Change
 
% Change
 
2018
 
2017
 
2016
 
2018/2017

 
2017/2016

 
2018/2017

 
2017/2016

 
(Amounts in thousands)
 
 

 
 

 
 

 
 

Salaries and employee benefits
$
34,981

 
$
33,197

 
$
30,778

 
$
1,784

 
$
2,419

 
5.37
 %
 
7.86
 %
Occupancy
4,374

 
4,189

 
3,962

 
185

 
227

 
4.42

 
5.73

Furniture and equipment
5,741

 
5,580

 
5,368

 
161

 
212

 
2.89

 
3.95

Office supplies and postage
1,778

 
1,961

 
1,797

 
(183
)
 
164

 
(9.33
)
 
9.13

Advertising and business development
2,513

 
2,764

 
3,403

 
(251
)
 
(639
)
 
(9.08
)
 
(18.78
)
Outside services
10,076

 
8,303

 
7,584

 
1,773

 
719

 
21.35

 
9.48

FDIC insurance assessment
856

 
845

 
1,022

 
11

 
(177
)
 
1.30

 
(17.32
)
Other noninterest expense
1,804

 
2,673

 
2,885

 
(869
)
 
(212
)
 
(32.51
)
 
(7.35
)
 
$
62,123

 
$
59,512

 
$
56,799

 
$
2,611

 
$
2,713

 
4.39
 %
 
4.78
 %

Total noninterest expenses were $62.12 and $59.51 million for the years ended December 31, 2018 and 2017, respectively.  The increase is $2.61 million or 4.39% in 2018 and an increase of $2.71 million or 4.78% in 2017.

Salaries and employee benefits increased $1.78 million in 2018. The increase is the result of annual salary increases and hiring additional employees.

Outside services increased $1.77 million in 2018 due to outsourcing services previously managed by the Company.

Total noninterest expenses were $56.80 million for the year ended December 31, 2016.  The increase in expenses in 2017 was $2.71 million.  This included an increase of $2.42 million in salaries and benefits, which was the direct result of salary adjustments and restricted stock awards increases due to the increase in the appraised value of the Company stock. 

Income Taxes

Income tax expense was $8.91, $19.54 and $14.39 million for the years ended December 31, 2018, 2017 and 2016, respectively.  Income taxes as a percentage of income before income taxes were 19.50% in 2018, 41.05% in 2017 and 31.33% in 2016.  The amount of tax credits were $1.29, $1.43 and $1.43 million for 2018, 2017, and 2016, respectively.

On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cut and Jobs Act (the “Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code that affected 2017, including, but not limited to, accelerated depreciation that allowed for full expensing of qualified property. The Tax Act also established new tax laws that affected 2018 and thereafter, including a reduction in the U.S. federal corporate income tax rate from 35% to 21%. As a result of the reduction of the federal corporate income tax rate, we revalued our net deferred tax asset, excluding after tax credits, as of December 22, 2017. Based on this revaluation, we recorded a net tax expense of $4.71 million to reduce our net deferred tax asset balance, which was recorded as additional income tax expense for the year ended December 31, 2017. Our effective tax rate increased by 30.99% to 41.05% primarily as a result of the revaluation of our net deferred tax asset. While the Tax Act negatively impacted earnings for the Company's fiscal year ended December 31, 2017, the lower corporate rate is expected to be a significant ongoing benefit to the Company. For the year ended December 31, 2018, net income was $5.81 million higher than it would have been under the tax laws in effect before the Tax Act.

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Effects of Inflation

The consolidated financial statements and the accompanying notes have been prepared in accordance with accounting principles generally accepted in the United States of America.  These principles require the measurement of financial position and operating results in terms of historical dollar amounts without considering the changes in the relative purchasing power of money over time due to inflation.  The impact of inflation is reflected in the increased cost of the Company’s operations.  Nearly all of the assets and liabilities of the Company are monetary in nature.  As a result, interest rates have a more significant impact in the Company’s performance than do the effects of general levels of inflation.  Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services.  Liquidity and interest rate adjustments are features of the Company’s asset/liability management, which are important to the maintenance of acceptable performance levels.  Item 7A of this Form 10-K contains a more thorough discussion of interest rate risk.  The Company attempts to maintain a balance between monetary assets and monetary liabilities to offset the potential effects of changing interest rates.

Liquidity and Capital Resources

The objective of liquidity management is to ensure the availability of sufficient cash flows to fund operations, to meet depositor withdrawals, to provide for our customers' credit needs and to meet maturing obligations and existing commitments. The Company's principal source of funds is deposits. Other sources include loan principal repayments, proceeds from the maturity and sale of investment securities, federal funds purchased, advances from the FHLB, advances on bank lines of credit, brokered deposit relationships and funds provided by operations. Liquidity management is conducted on both a daily and a long-term basis. Investments in liquid assets are adjusted based on expected loan demand, projected loan and investment securities maturities and payments, expected deposit flows and the objectives set by the Company's asset-liability management, liquidity and contingency funding policies.

As of December 31, 2018, the Company had additional borrowing capacity available from the FHLB of $695.00 million. In addition, the Company had $455.94 million in borrowing capacity available through secured and unsecured lines of credit with correspondent banks. The Company had no amounts outstanding under those federal funds lines as of December 31, 2018.

On an unconsolidated basis, the Company had cash balances of $3.74 million as of December 31, 2018.  In 2018, the Company received dividends of $11.50 million from its subsidiary Bank and used those funds to pay dividends to its stockholders of $7.00 million and to fund purchases of treasury stock under the 2005 Stock Repurchase Program.  The total purchase of treasury stock under the 2005 Stock Repurchase Program totaled $6.78 and $2.44 million for the years ended December 31, 2018 and 2017, respectively.

As of December 31, 2018 and 2017, stockholders' equity, before deducting for the maximum cash obligation related to the ESOP, was $383.75 million and $355.02 million, respectively.  This measure of stockholders’ equity as a percent of total assets was 12.61% at December 31, 2018 and 11.98% at December 31, 2017.  As of December 31, 2018, total equity, after deducting the maximum cash value related to the ESOP, was 11.01% of assets compared to 10.52% of assets at the prior year end.

The Company and the Bank are subject to the Federal Deposit Insurance Corporation Improvement Act of 1991, and the Bank is subject to Prompt Corrective Action Rules as determined and enforced by the Federal Reserve.  These regulations establish minimum capital requirements that member banks must maintain.

The Bank is classified as "well-capitalized" by FDIC capital guidelines.  For more information regarding regulatory capital requirements, see the section under Part I, Item 1 to this 10-K captioned “Supervision and Regulation.”


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Table of Contents

On a consolidated basis, 2018 cash flows from operations provided $47.74 million and net increases in deposits provided $132.56 million.  These cash flows were invested in Net Loans of $168.57 million and $90.30 million in purchases of investment securities.  In addition, $2.21 million was used to purchase property and equipment and leasehold improvements.

The Bank has a contingency funding plan to address liquidity issues in times of crisis.  The primary source of funding will be the Bank’s customer deposit base.  The Bank has established alternative sources of funding available to increase liquidity.  The availability of the funding sources is tested on an annual basis.  The Bank performs quarterly stress testing to determine if the Bank has an appropriate amount of funding sources to address potential liquidity needs. At December 31, 2018, the Bank had total outstanding loan commitments and unused portions of lines of credit totaling $384.97 million (see Note 14 to the Company's Consolidated Financial Statements).  Management believes that its liquidity levels are sufficient at this time, but the Bank may increase its liquidity by limiting the growth of its assets, by selling more loans in the secondary market or selling portions of loans to other banks through participation agreements.  Another liquidity source includes obtaining additional funds from the Federal Home Loan Bank (FHLB).  As of December 31, 2018, the Bank can obtain an additional $695.00 million from the FHLB based on the current real estate mortgage loans held.  In addition, the Bank has arranged $445.94 million of credit lines at three banks.  The borrowings under these credit lines would be secured by the Bank’s investment securities.  Other liquidity sources include a $10.00 million line of credit with the Federal Reserve Bank of Chicago and various sources of brokered deposits.

The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates of federal funds purchased and securities sold under agreements to repurchase during 2018, 2017 and 2016:
 
2018
 
2017
 
2016
 
(Amounts In Thousands)
Outstanding balance as of December 31
$

 
$

 
$
33,489

Weighted average interest rate at year end
%
 
0.73
%
 
0.33
%
Maximum month-end balance

 
44,588

 
96,224

Average month-end balance

 
25,360

 
47,899

Weighted average interest rate for the year
2.71
%
 
0.64
%
 
0.31
%
 
The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates of Federal Home Loan Bank borrowings during 2018, 2017 and 2016:
 
2018
 
2017
 
2016
 
(Amounts In Thousands)
Outstanding balance as of December 31
$
215,000

 
$
295,000

 
$
235,000

Weighted average interest rate at year end
2.94
%
 
2.82
%
 
3.15
%
Maximum month-end balance
280,000

 
345,000

 
260,000

Average month-end balance
228,066

 
268,411

 
231,443

Weighted average interest rate for the year
2.94
%
 
2.96
%
 
3.47
%

The Bank has off-balance sheet commitments to fund additional borrowings of customers as well as derivative financial instruments, consisting of interest rate swaps as disclosed in Note 16 to the Company's Consolidated Financial Statements.  Contractual commitments to fund loans are met from the proceeds of federal funds sold or investment securities and additional borrowings.  Many of the contractual commitments to extend credit will not be funded because they represent the credit limits on credit cards and home equity lines of credits.


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As disclosed in Note 14 to the Company's Consolidated Financial Statements, the Company has certain obligations and commitments to make future payments under contracts. The following table summarizes significant contractual obligations and other commitments as of December 31, 2018:

 
Payments Due By Period
 
(Amounts In Thousands)
 
Total
 
Less Than
One Year
 
One -
Three Years
 
Three -
Five Years
 
More Than
Five Years
Contractual obligations:
 
 
 
 
 
 
 
 
 
Long-term debt obligations
$
215,000

 
$

 
$
25,000

 
$
25,000

 
$
165,000

Operating lease obligations
2,005

 
464

 
838

 
623

 
80

Total contractual obligations:
$
217,005

 
$
464

 
$
25,838

 
$
25,623

 
$
165,080

Other commitments:
 

 
 

 
 

 
 

 
 

Lines of credit
$
375,940

 
$
255,442

 
$
99,175

 
$
17,522

 
$
3,801

Standby letters of credit
9,033

 
9,033

 

 

 

Total other commitments
$
384,973

 
$
264,475

 
$
99,175

 
$
17,522

 
$
3,801

 
The Company and the Bank have no additional material commitments or plans that will materially affect liquidity or capital resources.  Property and equipment may be acquired in cash purchases, or they may be financed if favorable terms are available.

Item 7A.
Quantitative and Qualitative Disclosures About Market Risk

The Company's primary market risk exposure is to changes in interest rates.  Interest rate risk is the risk to current or anticipated earnings or capital arising from movements in interest rates.  Interest rate risk arises from repricing risk, basis risk, yield curve risk and options risk.  Repricing risk is the difference between the timing of rate changes and the timing of cash flows.  Basis risk is the difference from changing rate relationships among different yield curve affecting Bank activities.  Yield curve risk is the difference from changing rate relationships across the spectrum of maturities.  Option risk is the difference resulting from interest-related options imbedded in Bank products.  The Bank’s primary source of interest rate risk exposure arises from repricing risk.  To measure this risk the Bank uses a static gap measurement system that identifies the repricing gaps across the full maturity spectrum of the Bank’s assets and liabilities and an earnings simulation approach.  The gap schedule is known as the interest rate sensitivity report.  The report reflects the repricing characteristics of the Bank’s assets and liabilities.  The report details the calculation of the gap ratio.  This ratio indicated the amount 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.


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Table of Contents

The Bank uses derivative financial instruments, when needed, to manage the impact of changes in interest rates on future interest income or interest expense.  The Bank is exposed to credit-related losses in the event of nonperformance by the counterparties to these derivative instruments, but believe the risk of the these losses has been minimized by entering into the contracts with large, stable financial institutions.  The estimated fair market value of these derivative instruments are presented in Note 16 to the Consolidated Financial Statements.

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 table set forth below includes the portion of the balances in interest-bearing checking, savings and money market accounts that management has estimated to mature within one year. The classifications are used because the Bank’s historical data indicates that these have been very stable deposits without much interest rate fluctuation.  Historically, these accounts would not need to be adjusted upward as quickly in a period of rate increases so the interest risk exposure would be less than the re-pricing schedule indicates. The FHLB borrowings are classified based on either their due date or if they are callable on their most likely call date based on the interest rate.
 
Repricing
 
 
 
 
 
 
 
 
 
 
 
 
 
Maturities
 
Days
 
More Than
 
 
 
Immediately
 
2-30
 
31-90
 
91-180
 
181-365
 
One Year
 
Total
 
(Amounts in Thousands)
Earning assets:
 
 
 

 
 

 
 

 
 

 
 
 
 
Excess Cash
$
8,237

 
$

 
$

 
$

 
$

 
$

 
$
8,237

Federal funds sold

 

 

 

 

 

 

Investment securities

 
2,501

 
7,753

 
34,392

 
14,472

 
271,980

 
331,098

Loans
10,637

 
207,808

 
53,147

 
75,716

 
214,295

 
2,069,276

 
2,630,879

Total earning assets
18,874

 
210,309

 
60,900

 
110,108

 
228,767

 
2,341,256

 
2,970,214

Sources of funds:
 

 
 

 
 

 
 

 
 

 
 

 
 

Interest-bearing checking and savings accounts
186,017

 

 

 

 

 
1,281,585

 
1,467,602

Certificates of deposit

 
10,517

 
14,904

 
35,718

 
167,952

 
352,279

 
581,370

FHLB borrowings

 

 

 

 

 
215,000

 
215,000

Federal funds and repurchase agreements

 

 

 

 

 

 

 
186,017

 
10,517

 
14,904

 
35,718

 
167,952

 
1,848,864

 
2,263,972

Other sources, primarily noninterest-bearing

 

 

 

 

 
372,152

 
372,152

Total sources
186,017

 
10,517

 
14,904

 
35,718

 
167,952

 
2,221,016

 
2,636,124

Interest
 

 
 

 
 

 
 

 
 

 
 

 
 

Rate Gap
$
(167,143
)
 
$
199,792

 
$
45,996

 
$
74,390

 
$
60,815

 
$
120,240

 
$
334,090

Cumulative Interest
 

 
 

 
 

 
 

 
 

 
 

 
 

Rate Gap at December 31, 2018
$
(167,143
)
 
$
32,649

 
$
78,645

 
$
153,035

 
$
213,850

 
$
334,090

 
 

Gap Ratio
0.10

 
20.00

 
4.09

 
3.08

 
1.36

 
1.05

 
 

Cumulative Gap Ratio
0.10

 
1.17

 
1.37

 
1.62

 
1.52

 
1.13

 
 



Page 49

Table of Contents

Based on the data following, net interest income should decline with instantaneous increases in interest rates while net interest income should increase with instantaneous declines in interest rates.  Generally, during periods of increasing interest rates, the Company's interest rate sensitive liabilities would re-price faster than its interest rate sensitive assets causing a decline in the Company's interest rate spread and margin.  This would tend to reduce net interest income because the resulting increase in the Company’s cost of funds would not be immediately offset by an increase in its yield on earning assets. In times of decreasing interest rates, fixed rate assets could increase in value and the lag in re-pricing of interest rate sensitive assets could be expected to have a positive effect on the Company's net interest income.

The following table, which presents principal cash flows and related weighted average interest rates by expected maturity dates, provides information about the Company's loans, investment securities and deposits that are sensitive to changes in interest rates.
 
2018
 
2019
 
2020
 
2021
 
2022
 
Thereafter
 
Total
 
Fair Value
 
(Amounts In Thousands)
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans, fixed:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance
$
389,790

 
$
145,417

 
$
198,304

 
$
279,419

 
$
247,049

 
$
194,318

 
$
1,454,297

 
$
1,265,101

Average interest rate
5.06
%
 
4.39
%
 
4.34
%
 
4.35
%
 
4.82
%
 
4.10
%
 
4.59
%
 
 

Loans, variable:
 

 
 

 
 

 
 

 
 

 
 
 
 

 
 

Balance
$
154,155

 
$
136,786

 
$
199,330

 
$
280,553

 
$
244,519

 
$
158,303

 
$
1,173,646

 
$
1,308,858

Average interest rate
5.36
%
 
4.17
%
 
4.09
%
 
4.11
%
 
4.36
%
 
4.22
%
 
4.35
%
 
 

Investments (1):
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Balance
$
71,142

 
$
49,906

 
$
45,957

 
$
47,597

 
$
36,939

 
$
79,557

 
$
331,098

 
$
331,098

Average interest rate
2.38
%
 
2.11
%
 
2.10
%
 
2.47
%
 
2.71
%
 
2.81
%
 
2.45
%
 
 

Liabilities:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Liquid deposits (2):
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Balance
$

 
$

 
$

 
$

 
$

 
$

 
$
1,462,663

 
$
1,467,806

Average interest rate
%
 
%
 
%
 
%
 
%
 
%
 
0.82
%
 
 

Deposits, certificates:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Balance
$
229,091

 
$
223,254

 
$
44,610

 
$
35,002

 
$
49,413

 
$

 
$
581,370

 
$
587,788

Average interest rate
1.72
%
 
1.94
%
 
1.81
%
 
2.72
%
 
3.22
%
 
%
 
2.00
%
 
 


(1)
Includes all available-for-sale investments, federal funds and Federal Home Loan Bank stock.
(2)
Includes NOW and other demand, savings and money market funds.
Item 8.
Consolidated Financial Statements and Supplementary Data

The consolidated financial statements and supplementary data are included on pages 51 through 106.


Page 50

bkdletterheada01.jpg


Report of Independent Registered Public Accounting Firm


To the Shareholders, Board of Directors and Audit Committee
Hills Bancorporation
Hills, Iowa

Opinion on the Financial Statements

We have audited the accompanying consolidated balance sheets of Hills Bancorporation (the "Company") as of December 31, 2018 and 2017, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2018, and the related notes (collectively referred to as the "financial statements"). In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2018, in conformity with accounting principles generally accepted in the United States of America.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2018, based on Internal Control-Integrated Framework (2013) and our report dated March 5, 2019, expressed an unqualified opinion.
Basis for Opinion

These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits.

We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

BKD, LLP
bkdsignaturea04.jpg
We have served as the Company’s auditor since 2012.

Springfield, Missouri
March 5, 2019



Page 51

bkdletterheada01.jpg

Report of Independent Registered Public Accounting Firm
To the Shareholders, Board of Directors and Audit Committee
Hills Bancorporation
Hills, Iowa

Opinion on the Internal Control over Financial Reporting

We have audited Hills Bancorporation's (the "Company") internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) ("PCAOB"), the consolidated financial statements of the Company and our report dated March 5, 2019, expressed an unqualified opinion.

Basis for Opinion

The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.

We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.

Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

Definitions and Limitations of Internal Control over Financial Reporting

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of reliable financial statements in accordance with accounting principles generally accepted in the United States of America. Because management's assessment and our audit also were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), our examination of Hills Bancorporation's internal control over financial reporting included controls over the preparation of financial statements in accordance with accounting principles generally accepted in the United States of America and with the instructions to the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C). A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention, or timely detection and correction of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Page 52

bkdletterheada01.jpg


Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.

BKD, LLP
bkdsignaturea04.jpg
Springfield, Missouri
March 5, 2019

Page 53

Table of Contents

HILLS BANCORPORATION

CONSOLIDATED BALANCE SHEETS
December 31, 2018 and 2017
(Amounts In Thousands, Except Shares) 
ASSETS
2018
 
2017
Cash and cash equivalents
$
43,305

 
$
154,353

Investment securities available for sale at fair value (amortized cost 2018 $321,660; 2017 $286,296) (Notes 1, 2 and 12)
318,926

 
285,155

Stock of Federal Home Loan Bank
12,172

 
15,005

Loans held for sale
1,984

 
5,162

Loans, net of allowance for loan losses (2018 $37,810; 2017 $29,400) (Notes 1, 3, and 11)
2,591,085

 
2,431,165

Property and equipment, net (Note 4)
37,051

 
37,857

Tax credit real estate
9,193

 
10,076

Accrued interest receivable
11,784

 
10,772

Deferred income taxes, net (Note 9)
10,869

 
8,806

Goodwill
2,500

 
2,500

Other assets
3,595

 
2,509

Total Assets
$
3,042,464

 
$
2,963,360

LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

Liabilities
 

 
 

Noninterest-bearing deposits
$
372,152

 
$
363,817

Interest-bearing deposits (Note 5)
2,048,972

 
1,924,748

Total deposits
2,421,124

 
2,288,565

Federal Home Loan Bank borrowings (Note 6)
215,000

 
295,000

Accrued interest payable
1,812

 
1,290

Other liabilities
20,776

 
23,481

Total Liabilities
2,658,712

 
2,608,336

Commitments and Contingencies (Notes 8 and 14)


 


Redeemable Common Stock Held By Employee Stock
 

 
 

Ownership Plan (ESOP) (Note 8)
48,870

 
43,308

Stockholders' Equity (Note 10)
 

 
 

Common stock, no par value; authorized 20,000,000 shares; issued 2018 10,325,191 shares; 2017 10,320,315 shares

 

Paid in capital
52,122

 
48,930

Retained earnings
371,848

 
341,558

Accumulated other comprehensive loss (Note 7)
(3,250
)
 
(2,446
)
Treasury stock at cost (2018 988,750 shares; 2017 985,161 shares)
(36,968
)
 
(33,018
)
Total Stockholders' Equity
383,752

 
355,024

Less maximum cash obligation related to ESOP shares (Note 8)
48,870

 
43,308

Total Stockholders' Equity Less Maximum Cash Obligations Related To ESOP Shares
334,882

 
311,716

Total Liabilities & Stockholders' Equity
$
3,042,464

 
$
2,963,360

 
See Notes to Consolidated Financial Statements.


Page 54

Table of Contents

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2018, 2017 and 2016
(Amounts In Thousands, Except Per Share Amounts)
 
2018
 
2017
 
2016
Interest income:
 
 
 
 
 
Loans, including fees
$
110,588

 
$
100,579

 
$
92,833

Investment securities:
 

 
 

 
 

Taxable
2,759

 
1,709

 
1,471

Nontaxable
3,511

 
3,231

 
3,210

Federal funds sold
1,939

 
433

 
163

Total interest income
118,797

 
105,952

 
97,677

Interest expense:
 

 
 

 
 

Deposits
19,531

 
9,742

 
7,757

Other borrowings

 
184

 
158

FHLB borrowings
6,792

 
8,046

 
8,172

Total interest expense
26,323

 
17,972

 
16,087

Net interest income
92,474

 
87,980

 
81,590

Provision for loan losses (Note 3)
8,497

 
1,688

 
(1,163
)
Net interest income after provision for loan losses
83,977

 
86,292

 
82,753

Noninterest income:
 

 
 

 
 

Net gain on sale of loans
1,517

 
1,547

 
2,043

Trust fees
10,007

 
8,043

 
7,033

Service charges and fees
9,614

 
8,850

 
8,750

Other noninterest income
2,680

 
2,378

 
2,169

 
23,818

 
20,818

 
19,995

Noninterest expenses:
 

 
 

 
 

Salaries and employee benefits
34,981

 
33,197

 
30,778

Occupancy
4,374

 
4,189

 
3,962

Furniture and equipment
5,741

 
5,580

 
5,368

Office supplies and postage
1,778

 
1,961

 
1,797

Advertising and business development
2,513

 
2,764

 
3,403

Outside services
10,076

 
8,303

 
7,584

FDIC insurance assessment
856

 
845

 
1,022

Other noninterest expenses
1,804

 
2,673

 
2,885

 
62,123

 
59,512

 
56,799

Income before income taxes
45,672

 
47,598

 
45,949

Income taxes (Note 9)
8,905

 
19,537

 
14,394

Net income
$
36,767

 
$
28,061

 
$
31,555

Earnings per share:
 

 
 

 
 

Basic
$
3.93

 
$
3.01

 
$
3.40

Diluted
3.92

 
3.01

 
3.40


See Notes to Consolidated Financial Statements.


Page 55

Table of Contents

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2018, 2017 and 2016
(Amounts In Thousands)
 
2018
 
2017
 
2016
Net income
$
36,767

 
$
28,061

 
$
31,555

Other comprehensive income (loss)
 

 
 

 
 

Securities:
 

 
 

 
 

Net change in unrealized (loss) gain on securities available for sale
(1,593
)
 
361

 
(3,746
)
Income taxes
397

 
(139
)
 
1,433

Other comprehensive (loss) income on securities available for sale
(1,196
)
 
222

 
(2,313
)
Derivatives used in cash flow hedging relationships:
 

 
 

 
 

Net change in unrealized gain on derivatives
1,223

 
1,119

 
242

Income taxes
(305
)
 
(428
)
 
(93
)
Other comprehensive income on cash flow hedges
918

 
691

 
149

Other comprehensive (loss) income, net of tax
(278
)
 
913

 
(2,164
)
Comprehensive income
$
36,489

 
$
28,974

 
$
29,391

 
See Notes to Consolidated Financial Statements.


Page 56

Table of Contents

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Years Ended December 31, 2018, 2017 and 2016
(Amounts In Thousands, Except Share Data)
 
Paid In
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Treasury
Stock
 
Maximum
Cash
Obligation
Related
To ESOP
Shares
 
Total
Balance, December 31, 2015
$
43,697

 
$
294,487

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

Issuance of 23,163 shares of common stock
1,078

 

 

 

 

 
1,078

Issuance of 5,636 shares of common stock under the employee stock purchase plan
254

 

 

 

 

 
254

Unearned restricted stock compensation
(470
)
 

 

 

 

 
(470
)
Forfeiture of 1,264 shares of common stock
(52
)
 

 

 

 

 
(52
)
Share-based compensation
29

 

 

 

 

 
29

Income tax benefit related to share-based compensation
70

 

 

 

 

 
70

Change related to ESOP shares

 

 

 

 
(3,219
)
 
(3,219
)
Net income

 
31,555

 

 

 

 
31,555

Cash dividends ($0.65 per share)

 
(6,060
)
 

 

 

 
(6,060
)
Purchase of 85,362 shares of common stock

 

 

 
(3,926
)
 

 
(3,926
)
Other comprehensive loss

 

 
(2,164
)
 

 

 
(2,164
)
Balance, December 31, 2016
$
44,606

 
$
319,982

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

Issuance of 114,935 shares of common stock
4,851

 

 

 
595

 

 
5,446

Issuance of 6,892 shares of common stock under the employee stock purchase plan
325

 

 

 

 

 
325

Unearned restricted stock compensation
(707
)
 

 

 

 

 
(707
)
Forfeiture of 3,934 shares of common stock
(156
)
 

 

 

 

 
(156
)
Share-based compensation
11

 

 

 

 

 
11

Change related to ESOP shares

 

 

 

 
(2,527
)
 
(2,527
)
Net income

 
28,061

 

 

 

 
28,061

Cash dividends ($0.70 per share)

 
(6,485
)
 

 

 

 
(6,485
)
Purchase of 46,966 shares of common stock

 

 

 
(2,435
)
 

 
(2,435
)
Other comprehensive income

 

 
913

 

 

 
913

Balance, December 31, 2017
$
48,930

 
$
341,558

 
$
(2,446
)
 
$
(33,018
)
 
$
(43,308
)
 
$
311,716

Issuance of 113,373 shares of common stock
3,386

 

 

 
2,834

 

 
6,220

Issuance of 8,172 shares of common stock under the employee stock purchase plan
421

 

 

 

 

 
421

Unearned restricted stock compensation
(463
)
 

 

 

 

 
(463
)
Forfeiture of 3,296 shares of common stock
(152
)
 

 

 

 

 
(152
)
Change related to ESOP shares

 

 

 

 
(5,562
)
 
(5,562
)
Net income

 
36,767

 

 

 

 
36,767

Cash dividends ($0.75 per share)

 
(7,003
)
 

 

 

 
(7,003
)
Reclassification of stranded tax effects due to the Tax Cuts and Jobs Act
 
 
526

 
(526
)
 
 
 
 
 

Purchase of 116,962 shares of common stock

 

 

 
(6,784
)
 

 
(6,784
)
Other comprehensive (loss)

 

 
(278
)
 

 

 
(278
)
Balance, December 31, 2018
$
52,122

 
$
371,848

 
$
(3,250
)
 
$
(36,968
)
 
$
(48,870
)
 
$
334,882

See Notes to Consolidated Financial Statements.

Page 57

Table of Contents

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2018, 2017 and 2016
(Amounts In Thousands)
 
2018
 
2017
 
2016
Cash Flows from Operating Activities
 
 
 
 
 
Net income
$
36,767

 
$
28,061

 
$
31,555

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

 
 

 
 

Depreciation
3,012

 
2,856

 
2,745

Provision for loan losses
8,497

 
1,688

 
(1,163
)
Share-based compensation

 
11

 
29

Compensation expensed through issuance of common stock
1,466

 
1,446

 
1,078

Excess tax benefits related to share-based compensation

 

 
(70
)
Forfeiture of common stock
(152
)
 
(156
)
 
(52
)
Provision for deferred income taxes
(1,971
)
 
3,238

 
424

Net gain on sale of other real estate owned and other repossessed assets
(18
)
 
(60
)
 
(385
)
Increase in accrued interest receivable
(1,012
)
 
(1,651
)
 
(449
)
Amortization of premium on investment securities, net
480

 
586

 
595

(Increase) decrease in other assets
(1,086
)
 
972

 
104

(Decrease) increase in accrued interest and other liabilities
(1,423
)
 
4,263

 
(1,279
)
Loans originated for sale
(136,746
)
 
(150,264
)
 
(208,952
)
Proceeds on sales of loans
141,441

 
156,455

 
206,743

Net gain on sales of loans
(1,517
)
 
(1,547
)
 
(2,043
)
Net cash and cash equivalents provided by operating activities
47,738

 
45,898

 
28,880

Cash Flows from Investing Activities
 

 
 

 
 

Proceeds from maturities of investment securities available for sale
57,284

 
65,339

 
54,323

Purchases of investment securities available for sale
(90,295
)
 
(85,772
)
 
(62,546
)
Loans made to customers, net of collections
(168,567
)
 
(181,631
)
 
(147,248
)
Proceeds on sale of other real estate owned and other repossessed assets
168

 
520

 
182

Purchases of property and equipment
(2,206
)
 
(2,854
)
 
(7,082
)
Expense from tax credit real estate, net
883

 
487

 
875

Net cash and cash equivalents used in investing activities
(202,733
)
 
(203,911
)
 
(161,496
)
 
(Continued)

Page 58

Table of Contents

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 2018, 2017 and 2016
(Amounts In Thousands)
 
2018
 
2017
 
2016
Cash Flows from Financing Activities
 
 
 
 
 
Net increase in deposits
132,559

 
252,253

 
145,610

Net decrease in short-term borrowings

 
(33,489
)
 
(10,562
)
Net (decrease) increase in FHLB borrowings
(80,000
)
 
60,000

 
10,000

Borrowings from FRB
1

 
820

 
1

Payments on FRB borrowings
(1
)
 
(820
)
 
(1
)
Issuance of common stock, net of costs
4,713

 
3,762

 

Stock options exercised
41

 
238

 

Excess tax benefits related to share-based compensation

 

 
70

Purchase of treasury stock
(6,784
)
 
(2,435
)
 
(3,926
)
Proceeds from the issuance of common stock through the employee stock purchase plan
421

 
325

 
254

Dividends paid
(7,003
)
 
(6,485
)
 
(6,060
)
Net cash and cash equivalents provided by financing activities
43,947

 
274,169

 
135,386

 
 
 
 
 
 
(Decrease) increase in cash and cash equivalents
(111,048
)
 
116,156

 
2,770

 
 
 
 
 
 
Cash and cash equivalents:
 

 
 

 
 

Beginning of year
154,353

 
38,197

 
35,427

End of year
$
43,305

 
$
154,353

 
$
38,197

 
 
 
 
 
 
Supplemental Disclosures
 

 
 

 
 

Cash payments for:
 

 
 

 
 

Interest paid to depositors
$
19,009

 
$
9,436

 
$
7,619

Interest paid on other obligations
6,792

 
8,230

 
8,330

Income taxes paid
9,924

 
14,488

 
14,113

Noncash financing activities:
 

 
 

 
 

Increase in maximum cash obligation related to ESOP shares
$
5,562

 
$
2,527

 
$
3,219

Transfers to other real estate owned
150

 
223

 
405

Sale and financing of other real estate owned
96

 
433

 
720

 
See Notes to Consolidated Financial Statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.
Nature of Activities and Significant Accounting Policies

Nature of activities:  Hills Bancorporation (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 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.

The Bank competes with other financial institutions and non-financial institutions providing similar financial products.  Although the loan activity of the Bank is diversified with commercial and agricultural loans, real estate loans, automobile, installment and other consumer loans, the Bank's credit is concentrated in real estate loans.  All of the Company’s operations are considered to be one reportable operating segment.

Accounting estimates:  The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

Certain significant estimates:  The allowance for loan losses, fair values of securities and other financial instruments, and share-based compensation expense involve certain significant estimates made by management.  These estimates are reviewed by management routinely and it is reasonably possible that circumstances that exist at December 31, 2018 may change in the near-term and the effect could be material to the consolidated financial statements.

Principles of consolidation:  The consolidated financial statements include the accounts of the Company and its subsidiary.  All significant intercompany balances and transactions have been eliminated in consolidation.

Revenue recognition: Accounting Standards Codification ("ASC") 606, Revenue from Contracts with Customers ("ASC 606"), establishes principles for reporting information about the nature, amount, timing and uncertainty of revenue and cash flows arising from the Company’s contracts to provide goods or services to customers. The core principle requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it expects to be entitled to receive in exchange for those goods or services recognized as performance obligations are satisfied.
The majority of the Company’s revenue-generating transactions are not subject to ASC 606, including revenue generated from financial instruments, such as loans, letters of credit and investment securities as these activities are not subject to the requirements of ASC 606. Interest income on loans and investment securities is recognized on the accrual method in accordance with written contracts. Loan origination fees of mortgage loans originated for sale are recognized when the loans are sold.
Descriptions of the Company’s revenue-generating activities that are within the scope of ASC 606 are the following: Service charges and fees on deposit accounts represent general service fees for monthly account maintenance and activity- or transaction-based fees and consist of transaction-based revenue which includes interchange income, time-based revenue (service period), item-based revenue or some other individual attribute-based revenue. Revenue is recognized when the Company’s performance obligation is completed which is generally monthly for account maintenance services or when a transaction has been completed (such as a wire transfer). Payment for such performance obligations are generally received at the time the performance obligations are satisfied. Trust income represents monthly fees due from wealth management customers as consideration for managing the customers' assets. Wealth management and trust services include custody of assets, investment management, fees for trust services and similar fiduciary activities. Revenue is recognized when our performance obligation is completed each month, which is generally the time that payment is received.
A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity's obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. As of December 31, 2018, the Company did not have any significant contract balances.
In connection with the adoption of ASC 606, an entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered. The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission). The Company utilizes the practical expedient which allows entities

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to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less. Upon adoption of ASC 606, the Company did not capitalize any contract acquisition costs.
Cash and cash equivalents:  The Company considers all investments with original maturities of three months or less to be cash equivalents.  At December 31, 2018 and 2017, cash equivalents consisted primarily of deposits with other banks.

Investment securities:  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 December 31, 2018 or 2017.

Stock of the Federal Home Loan Bank is carried at cost.  The Company has evaluated the stock and determined there is no impairment.

Premiums on debt securities are amortized to the earliest call date and discounts on debt securities are accreted over the period to maturity of those securities. The method of amortization results in a constant effective yield on those securities (the interest method).  Realized gains and losses on investment securities are included in income, determined on the basis of the cost of the specific securities sold.

Declines in the fair value of investment securities available for sale (with certain exceptions for debt securities noted below) that are deemed to be other-than-temporary are charged to earnings as a realized loss, and a new cost basis for the securities is established.  In evaluating other-than-temporary impairment, the Company considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term.  Declines in the fair value of debt securities below amortized cost are deemed to be other-than-temporary in circumstances where: (1) the Company has the intent to sell a security; (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis; or (3) the Company does not expect to recover the entire amortized cost basis of the security.  If the Company intends to sell a security or if it is more likely than not that the Company will be required to sell the security before recovery, an other-than-temporary impairment write-down is recognized in earnings equal to the difference between the security’s amortized cost basis and its fair value.  If the Company does not intend to sell the security or it is not more likely than not that the Company will be required to sell the security before recovery, the other-than-temporary impairment write-down is separated into an amount representing credit loss, which is recognized in earnings, and an amount related to all other factors, which is recognized in other comprehensive income.  Realized securities gains or losses on securities sales (using specific identification method) and declines in value judged to be other-than-temporary are included in investment securities gains (losses), net, in the consolidated statements of income.

Loans:  Loans are stated at the amount of unpaid principal, reduced by the allowance for loan losses.  Interest income is accrued on the unpaid balances as earned.

Loans held for sale are stated at the lower of aggregate cost or estimated fair value.  Loans are sold on a non-recourse basis with servicing released and gains and losses are recognized based on the difference between sales proceeds and the carrying value of the loan.  The Company has had very few experiences of repurchasing loans previously sold into the secondary market.  A specific reserve was not considered necessary based on the Company’s historical experience with repurchase activity.

The allowance for loan losses is established through a provision for loan losses charged to expense.  Loans are charged against the allowance when management believes the collectability of principal is unlikely.  The allowance for loan losses is maintained at a level considered adequate to provide for probable losses that can be reasonably anticipated.  The allowance is increased by provisions charged to expense and is reduced by net charge-offs.  The Bank makes continuous reviews of the loan portfolio and considers current economic conditions, historical loss experience, review of specific problem loans and other factors in determining the adequacy of the allowance.  Management classifies loans within the following categories: excellent, good, satisfactory, monitor, special mention and substandard.

The policy for charging off loans is consistent throughout all loan categories.  A loan is charged off based on criteria that includes but is not limited to:  delinquency status, financial condition of the entire customer credit line and underlying collateral coverage, economic or external conditions that might impact full repayment of the loan, legal issues, overdrafts, and the customer’s willingness to work with the Company.

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Loans are considered impaired when, based on current information and events, it is probable the Bank will not be able to collect all amounts due.  An impaired loan includes any loan that has been placed on nonaccrual status, loans greater than 90 days past due and still accruing and TDR loans.  They also include loans, based on current information and events, that it is likely the Bank will be unable to collect all amounts due according to the contractual terms of the original loan agreement.  The portion of the allowance for loan losses applicable to impaired loans has been computed based on the present value of the estimated future cash flows of interest and principal discounted at the loans effective interest rate or on the fair value of the collateral for collateral dependent loans.  The entire change in present value of expected cash flows of impaired loans or of collateral value is reported as provision expense in the same manner in which impairment initially was recognized or as a reduction in the amount of provision expense that otherwise would be reported.  Interest income on nonaccrual loans is recognized once principal has been recovered.
The accrual of interest income on loans is discontinued when, in the opinion of management, there is reasonable doubt as to the borrower's ability to meet payments of interest or principal when they become due, which is generally when a loan is 90 days or more past due.  When a loan is placed on nonaccrual status, all previously accrued and unpaid interest is reversed.  Loans are returned to an accrual status when all of the principal and interest amounts contractually due are brought current and repayment of the remaining contractual principal and interest is expected.   A loan may also return to accrual status if additional collateral is received from the borrower and, in the opinion of management, the financial position of the borrower indicates that there is no longer any reasonable doubt as to the collection of the amount contractually due.  Payment received on nonaccrual loans are applied first to principal.  Once principal is recovered, any remaining payments received are applied to interest income.  As of December 31, 2018, none of the Company’s nonaccrual loans were earning interest on a cash basis.

Nonrefundable loan fees and origination costs are deferred and recognized as a yield adjustment over the life of the related loan.

Troubled debt restructurings (“TDR loans”):  A loan is classified as a troubled debt restructuring when a borrower is experiencing financial difficulties that leads to a restructuring of the loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider.  These concessions may include rate reductions, principal forgiveness, extension of maturity date and other actions intended to minimize potential losses to the Company.  A loan that is modified at a market rate of interest is no longer classified as troubled debt restructuring in the quarter following the modification if the borrower is no longer experiencing financial difficulties.  Performance prior to the restructuring is considered when assessing whether the borrower can meet the new terms.  At the time of restructuring, loans included in a troubled debt restructuring may be considered nonaccrual loans.  TDR loans are returned to accrual status under the same criteria noted under loans above.

Transfers of financial assets:  Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered.  Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.

Credit related financial instruments:  In the ordinary course of business, the Company has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit and standby letters of credit.  Such financial instruments are recorded when they are funded.

Tax credit real estate:  Tax credit real estate represents two multi-family rental properties, three assisted living rental properties, a multi-tenant rental property for persons with disabilities, and a multi-family senior living rental property, all which are affordable housing projects as of December 31, 2018.  The Bank has a 99% or greater limited partnership interest in each limited partnership.  The investment in each was completed after the projects had been developed by the general partner.  The Company evaluates the recoverability of the carrying value on a regular basis.  If the recoverability was determined to be in doubt, a valuation allowance would be established by way of a charge to expense.  Depreciation expense is provided on a straight-line basis over the estimated useful life of the assets.  Expenditures for normal repairs and maintenance are charged to expense as incurred.

In 2016, the Company adopted ASU 2015-02 and the investments in tax credit real estate are recorded for the years ended December 31, 2018, 2017 and 2016 using the equity method of accounting. The operations of the properties are not expected to contribute significantly to the Company’s income before income taxes.  However, the properties do contribute in the form of income tax credits, which lowers the Company’s effective tax rate.  Once established, the credits on each property last for ten years and are passed through from the limited partnerships to the Bank and reduces the consolidated federal tax liability of the Company.

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Property and equipment:  Property and equipment is stated at cost less accumulated depreciation.  Depreciation is computed using primarily declining-balance methods over the estimated useful lives of 7-40 years for buildings and improvements and 3-10 years for furniture and equipment.

Deferred income taxes:  Deferred income taxes are provided under the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and net operating loss, and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences.  Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases.  Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some or all of the deferred tax assets will not be realized.  Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.   The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained.  Recognized income tax positions are measured at the largest amount that is greater than 50% likely of being realized.  Changes in recognition or measurement are reflected in the period in which the change in judgment occurs.  Interest and penalties on unrecognized tax benefits are classified as other noninterest expense.  As of December 31, 2018, the Company had no material unrecognized tax benefits.

Goodwill:  Goodwill represents the excess of cost over the fair value of the net assets acquired, and is not subject to amortization, but requires, at a minimum, annual impairment tests for intangibles that are determined to have an indefinite life.

Other real estate:   Other real estate represents property acquired through foreclosures and settlements of loans.  Property acquired is carried at the lower of the principal amount of the loan outstanding at the time of acquisition, plus any acquisition costs, or the estimated fair value of the property, less disposal costs.  The Bank will obtain updated appraisals to determine the estimated fair value of the property based on the type of collateral securing the loan and the date of the latest appraisal.  Subsequent write downs estimated on the basis of later valuations are charged to net loss on sale of other real estate owned and other repossessed assets.  Net operating expenses incurred in maintaining such properties are charged to other non-interest expense. Net capital expenditures incurred are capitalized to the property. In 2017, the Company revised its reporting to include other real estate with other assets.

Derivative financial instruments:  The Bank uses interest rate swaps as part of its interest rate risk management.  Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 815 establishes accounting and reporting standards for derivative instruments and hedging activities.  The Bank records all interest rate swaps on the balance sheet at fair value.  Derivatives used to hedge the exposure to variability in expected future cash flows are considered cash flow hedges.  To qualify for hedge accounting, the Bank must comply with the detailed rules and documentation requirements at the inception of the hedge, and hedge effectiveness is assessed at inception and periodically throughout the life of the hedging relationship.

For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivatives is initially reported in other comprehensive income and subsequently reclassified to interest income or expense when the hedged transaction affects earnings, while the ineffective portion of changes in fair value of the derivative, if any, is recognized immediately in other noninterest income or expense.  The Bank assesses the effectiveness of each hedging relationship by comparing the cumulative changes in cash flows of the derivative hedging instruments with the cumulative changes in cash flows of the designated hedged item or transaction.  No component of the change in the fair value of the hedging instrument is excluded from the assessment of hedge effectiveness.

The Bank does not use derivatives for trading or speculative purposes.

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. 


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table presents calculations of earnings per share:
 
Year Ended December 31,
 
2018
 
2017
 
2016
 
(Amounts In Thousands, except share and per share data)
Computation of weighted average number of basic and diluted shares:
 
 
 
 
 
Common shares outstanding at the beginning of the year
9,335,154

 
9,264,227

 
9,322,054

Weighted average number of net shares issued (redeemed)
31,160

 
65,776

 
(34,965
)
Weighted average shares outstanding (basic)
9,366,314

 
9,330,003

 
9,287,089

Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method
4,027

 
4,632

 
6,445

Weighted average number of shares (diluted)
9,370,341

 
9,334,635

 
9,293,534

Net income
$
36,767

 
$
28,061

 
$
31,555

Earnings per share:
 

 
 

 
 

Basic
$
3.93

 
$
3.01

 
$
3.40

Diluted
$
3.92

 
$
3.01

 
$
3.40


Stock awards and options:   Compensation expense for stock issued through the stock award plan is accounted for using the fair value method prescribed by FASB ASC 718, “Share-Based Payment” (“ASC 718”).  Under this method, compensation expense is measured and recognized for all stock-based awards made to employees and directors based on the fair value of each award as of the date of the grant.

Common stock held by ESOP:  The Company's maximum cash obligation related to these shares is classified outside stockholders' equity because the shares are not readily traded and could be put to the Company for cash.

Treasury Stock:  Treasury stock is accounted for by the cost method, whereby shares of common stock reacquired are recorded at their purchase price.

Trust Department Assets:  Property held for customers in fiduciary or agency capacities is not included in the accompanying consolidated balance sheets, as such items are not assets of the Company.

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 goods 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. ASU 2014-09 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. The Company has evaluated all of its noninterest income streams and contracts to determine potential impact. The adoption of ASU 2014-09 by the Company did not have a material impact on the recognition of revenue though did require additional disclosures on our material noninterest income streams discussed in revenue recognition above.

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 Company adopted ASU 2016-01 for the period ending March 31, 2018. There was no material impact on the financial statements, however, it required the use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes and eliminated the requirement to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. The revised disclosures are in Note 12 Fair Value Measurements.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In February 2016, the FASB issued ASU No. 2016-02 (Topic 842), Leases. The ASU provides guidance requiring lessees to recognize right-of-use (ROU) assets and lease liabilities for all leases other than those that meet the definition of short-term leases. For short-term leases, lessees may elect an accounting policy by class of underlying asset under which these assets and liabilities are not recognized and lease payments are generally recognized over the lease term on a straight-line basis. Under this new ASU, lessees will recognize right-of use assets and lease liabilities for most leases currently accounted for as operating leases under generally accepted accounting principles. For public companies, ASU 2016-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company adopted the ASU on January 1, 2019 and used the effective date as the date of initial application. Consequently, financial information will not be updated and the disclosures required under the new standard will not be provided for dates and periods before January 1, 2019. The new standard provides a number of optional practical expedients in transition. We elected the 'package of practical expedients', which permits us not to reassess under the new standard our prior conclusions about lease identification, lease classification and initial direct costs. We did not elect the use-of-hindsight or the practical expedient pertaining to land easements; the latter not being applicable to us. The most significant impact upon adoption relates to the recognition of new ROU assets and lease liabilities on our balance sheet for our equipment and real estate operating leases. Upon adoption, we recognized additional operating liabilities of $3.58 million, with corresponding ROU assets of the same amount based on the present value of the remaining minimum rental payments under current leasing standards for existing operating leases.

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 Company adopted ASU 2016-04 for the period ending March 31, 2018. There was no material impact on the financial statements.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments (CECL). The ASU changes the way entities recognize impairment of financial assets by requiring immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the "incurred loss" model required under current GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance. For public companies, ASU 2016-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019, early adoption is permitted for the fiscal year beginning after December 15, 2018. The Company has implemented a software solution to assist in the analysis of historical loan data to determine the CECL model that will be implemented. The Company anticipates running parallel calculations of the "incurred loss" and CECL models for the quarter ending March 31, 2019. We expect to recognize a one-time cumulative-effect adjustment to our allowance for loan losses as of the beginning of the first reporting period in which the new standard is adopted. The amount of the one-time cumulative-effect adjustment has not yet been determined.

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

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the company should describe the status of its process to implement the new standards and the significant implementation matters yet to be addressed.

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

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

In February 2018, the FASB issued ASU No. 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220), Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This ASU allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. ASU 2018-02 is effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. The Company adopted ASU 2018-02 for the period ending March 31, 2018 and elected the specific identification method accounting policy. There was a $0.53 million reclassification recorded in stockholders' equity.

In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718), Improvements to Nonemployee Share-Based Payment Accounting. The amendments in this ASU expand the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. ASU 2018-07 is effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within that fiscal year. The adoption of ASU 2018-07 by the Company is not expected to have a material impact.

In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820), Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. The amendments in this ASU modify the disclosure requirements on fair value measurements in Topic 820, Fair Value Measurement, including removal of the requirement to disclose the valuation processes for Level 3 fair value measurements and the additional requirement to disclose the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 is effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The amendments on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements, and the narrative description of measurement uncertainty should be applied prospectively for only the most recent interim or annual period presented in the initial fiscal year of adoption. All other amendments should be applied retrospectively to all periods presented upon their effective date. Early adoption is permitted upon issuance of this ASU. An entity is permitted to early adopt any removed or modified disclosures upon issuance of this ASU and delay adoption of the additional disclosures until their effective date. The adoption of ASU 2018-13 by the Company is not expected to have a material impact.

In August 2018, the FASB issued ASU No. 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40), Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangements That Is a Service Contract. The amendments in this ASU align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). ASU 2018-15 is effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption of the amendments in this ASU is permitted, including adoption in any interim period, for all entities. The amendments in this ASU should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. The Company is in the process of evaluating the impact of this ASU on the financial statements.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In October 2018, the FASB issued ASU No. 2018-16, Derivatives and Hedging (Topic 815), Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes. The amendments in this ASU permit use of the OIS rate based on SOFR as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815 in addition to the interest rates on direct Treasury obligations of the U.S. government, the London Interbank Offered Rate (LIBOR) swap rate, the Overnight Index Swap (OIS) Rate based on the Fed Funds Effective Rate and the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate. The amendments in this ASU are required to be adopted concurrently with the amendments in ASU 2017-12. For public companies, this would be for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018. The adoption of ASU 2018-16 by the Company is not expected to have a material impact.

Note 2.
Investment Securities

The carrying values of investment securities at December 31, 2018 and December 31, 2017 are summarized in the following table (Amounts in Thousands):
 
December 31, 2018
 
December 31, 2017
 
Amount
 
Percent
 
Amount
 
Percent
Securities available for sale
 
 
 
 
 
 
 
U.S. Treasury
$
83,155

 
26.07
%
 
$
54,318

 
19.05
%
Other securities (FHLB, FHLMC and FNMA)
34,871

 
10.93
%
 
43,959

 
15.42
%
State and political subdivisions
200,900

 
63.00
%
 
186,878

 
65.53
%
Total securities available for sale
$
318,926

 
100.00
%
 
$
285,155

 
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.  The Company had no securities designated as trading or held to maturity in its portfolio at December 31, 2018 or 2017.  The carrying amount of available-for-sale securities and their approximate fair values were as follows (Amounts in Thousands):
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
(Losses)
 
Estimated
Fair
Value
December 31, 2018:
 
 
 
 
 
 
 
U.S. Treasury
$
83,839

 
$
124

 
$
(808
)
 
$
83,155

Other securities (FHLB, FHLMC and FNMA)
35,371

 

 
(500
)
 
34,871

State and political subdivisions
202,450

 
278

 
(1,828
)
 
200,900

Total
$
321,660

 
$
402

 
$
(3,136
)
 
$
318,926

December 31, 2017:
 

 
 

 
 

 
 

U.S. Treasury
$
54,696

 
$

 
$
(378
)
 
$
54,318

Other securities (FHLB, FHLMC and FNMA)
44,470

 
1

 
(512
)
 
43,959

State and political subdivisions
187,130

 
722

 
(974
)
 
186,878

Total
$
286,296

 
$
723

 
$
(1,864
)
 
$
285,155


The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at December 31, 2018, were as follows (Amounts in Thousands):

Page 67

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
Amortized
Cost
 
Fair
Value
Due in one year or less
$
59,118

 
$
58,971

Due after one year through five years
182,133

 
180,663

Due after five years through ten years
79,188

 
78,064

Due over ten years
1,221

 
1,228

Total
$
321,660

 
$
318,926


As of December 31, 2018, investment securities with a carrying value of $9.78 million were pledged to collateralize derivative financial instruments and other borrowings.

The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2018 and 2017 (Amounts in Thousands):
 
Less than 12 months
 
12 months or more
 
Total
2018
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Description
#

 
Fair Value
 
Unrealized Loss
 
%
 
#

 
Fair Value
 
Unrealized Loss
 
%
 
#

 
Fair Value
 
Unrealized Loss
 
%
of Securities
 

 
 
 
 
 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
 
 
U.S. Treasury
6

 
$
14,644

 
$
(49
)
 
0.33
%
 
19

 
$
46,443

 
$
(759
)
 
1.63
%
 
25

 
$
61,087

 
$
(808
)
 
1.32
%
Other securities (FHLB, FHLMC and FNMA)

 

 

 
%
 
14

 
34,871

 
(500
)
 
1.43
%
 
14

 
34,871

 
(500
)
 
1.43
%
State and political subdivisions
113

 
31,022

 
(162
)
 
0.52
%
 
325

 
77,921

 
(1,666
)
 
2.14
%
 
438

 
108,943

 
(1,828
)
 
1.68
%
Total temporarily impaired securities
119

 
$
45,666

 
$
(211
)
 
0.46
%
 
358

 
$
159,235

 
$
(2,925
)
 
1.84
%
 
477

 
$
204,901

 
$
(3,136
)
 
1.53
%
 
Less than 12 months
 
12 months or more
 
Total
2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Description
#

 
Fair Value
 
Unrealized Loss
 
%
 
#

 
Fair Value
 
Unrealized Loss
 
%
 
#

 
Fair Value
 
Unrealized Loss
 
%
of Securities
 

 
 
 
 
 
 
 
 

 
 
 
 
 
 
 
 

 
 
 
 
 
 
U.S. Treasury
22

 
$
54,318

 
$
(378
)
 
0.70
%
 

 
$

 
$

 
%
 
22

 
$
54,318

 
$
(378
)
 
0.70
%
Other securities (FHLB, FHLMC and FNMA)
9

 
21,411

 
(83
)
 
0.39
%
 
9

 
22,547

 
(429
)
 
1.90
%
 
18

 
43,958

 
(512
)
 
1.16
%
State and political subdivisions
241

 
58,803

 
(573
)
 
0.97
%
 
65

 
14,944

 
(401
)
 
2.68
%
 
306

 
73,747

 
(974
)
 
1.32
%
Total temporarily impaired securities
272

 
$
134,532

 
$
(1,034
)
 
0.77
%
 
74

 
$
37,491

 
$
(830
)
 
2.21
%
 
346

 
$
172,023

 
$
(1,864
)
 
1.08
%

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 credit quality 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 68

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 3.
Loans

Classes of loans are as follows:
 
December 31,
 
2018
 
2017
 
(Amounts In Thousands)
Agricultural
$
92,673

 
$
88,580

Commercial and financial
229,501

 
218,632

Real estate:


 
 
Construction, 1 to 4 family residential
72,279

 
69,738

Construction, land development and commercial
113,807

 
109,595

Mortgage, farmland
236,454

 
215,286

Mortgage, 1 to 4 family first liens
912,059

 
831,591

Mortgage, 1 to 4 family junior liens
152,625

 
144,200

Mortgage, multi-family
352,434

 
336,810

Mortgage, commercial
383,314

 
361,196

Loans to individuals
30,072

 
26,417

Obligations of state and political subdivisions
52,725

 
57,626

 
2,627,943

 
2,459,671

Net unamortized fees and costs
952

 
894

 
2,628,895

 
2,460,565

Less allowance for loan losses
37,810

 
29,400

 
$
2,591,085

 
$
2,431,165


Changes in the allowance for loan losses and the allowance for loan loss balance applicable to impaired loans and the related loan balance of impaired loans for the years ended December 31, 2018, 2017 and 2016 are as follows:
 
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)
2018
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,294


$
4,837


$
2,989


$
3,669


$
8,668


$
5,700


$
1,243


$
29,400

Charge-offs
(95
)

(585
)





(830
)

(251
)

(561
)

(2,322
)
Recoveries
119


1,057


148


30


612


107


162


2,235

Provision
471


517


155


273


4,066


2,609


406


8,497

Ending balance
$
2,789


$
5,826


$
3,292


$
3,972


$
12,516


$
8,165


$
1,250


$
37,810

Ending balance, individually evaluated for impairment
$
479

 
$
1,189

 
$
4

 
$

 
$
72

 
$
306

 
$
64

 
$
2,114

Ending balance, collectively evaluated for impairment
$
2,310

 
$
4,637

 
$
3,288

 
$
3,972

 
$
12,444

 
$
7,859

 
$
1,186

 
$
35,696

Loan balances:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Ending balance
$
92,673

 
$
229,501

 
$
186,086

 
$
236,454

 
$
1,064,684

 
$
735,748

 
$
82,797

 
$
2,627,943

Ending balance, individually evaluated for impairment
$
2,460

 
$
4,162

 
$
1,137

 
$
3,612

 
$
7,012

 
$
9,538

 
$
64

 
$
27,985

Ending balance, collectively evaluated for impairment
$
90,213

 
$
225,339

 
$
184,949

 
$
232,842

 
$
1,057,672

 
$
726,210

 
$
82,733

 
$
2,599,958



Page 69

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
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)
2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,947

 
$
4,531

 
$
2,890

 
$
3,417

 
$
7,677

 
$
4,045

 
$
1,023

 
$
26,530

Charge-offs
(167
)
 
(583
)
 
(114
)
 
(3
)
 
(553
)
 
(130
)
 
(554
)
 
(2,104
)
Recoveries
146

 
1,183

 
662

 

 
661

 
376

 
258

 
3,286

Provision
(632
)
 
(294
)
 
(449
)
 
255

 
883

 
1,409

 
516

 
1,688

Ending balance
$
2,294

 
$
4,837

 
$
2,989

 
$
3,669

 
$
8,668

 
$
5,700

 
$
1,243

 
$
29,400

Ending balance, individually evaluated for impairment
$
133

 
$
1,018

 
$
39

 
$
238

 
$
66

 
$
482

 
$
190

 
$
2,166

Ending balance, collectively evaluated for impairment
$
2,161

 
$
3,819

 
$
2,950

 
$
3,431

 
$
8,602

 
$
5,218

 
$
1,053

 
$
27,234

Loan balances:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Ending balance
$
88,580

 
$
218,632

 
$
179,333

 
$
215,286

 
$
975,791

 
$
698,006

 
$
84,043

 
$
2,459,671

Ending balance, individually evaluated for impairment
$
4,916

 
$
2,768

 
$
957

 
$
7,962

 
$
6,654

 
$
8,040

 
$
190

 
$
31,487

Ending balance, collectively evaluated for impairment
$
83,664

 
$
215,864

 
$
178,376

 
$
207,324

 
$
969,137

 
$
689,966

 
$
83,853

 
$
2,428,184


 
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)
2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
3,082

 
$
4,517

 
$
2,280

 
$
3,342

 
$
8,172

 
$
4,223

 
$
894

 
$
26,510

Charge-offs
(226
)
 
(315
)
 
(34
)
 
(116
)
 
(1,181
)
 
(66
)
 
(693
)
 
(2,631
)
Recoveries
181

 
1,169

 
849

 

 
1,043

 
385

 
187

 
3,814

Provision
(90
)
 
(840
)
 
(205
)
 
191

 
(357
)
 
(497
)
 
635

 
(1,163
)
Ending balance
$
2,947

 
$
4,531

 
$
2,890

 
$
3,417

 
$
7,677

 
$
4,045

 
$
1,023

 
$
26,530

Ending balance, individually evaluated for impairment
$
856

 
$
718

 
$
105

 
$
390

 
$
90

 
$
34

 
$
150

 
$
2,343

Ending balance, collectively evaluated for impairment
$
2,091

 
$
3,813

 
$
2,785

 
$
3,027

 
$
7,587

 
$
4,011

 
$
873

 
$
24,187

Loan balances:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Ending balance
$
92,871

 
$
192,995

 
$
179,425

 
$
202,340

 
$
892,869

 
$
637,029

 
$
79,619

 
$
2,277,148

Ending balance, individually evaluated for impairment
$
11,720

 
$
2,477

 
$
1,136

 
$
8,028

 
$
7,042

 
$
3,111

 
$
150

 
$
33,664

Ending balance, collectively evaluated for impairment
$
81,151

 
$
190,518

 
$
178,289

 
$
194,312

 
$
885,827

 
$
633,918

 
$
79,469

 
$
2,243,484


The Company evaluates the following loans to determine impairment:  1) all nonaccrual and TDR loans, 2) all non consumer and non 1 to 4 family residential loans with prior charge-offs, 3) all non consumer and non 1 to 4 family loan relationships classified as substandard and 4) loans with indications of or suspected deteriorating credit quality.


Page 70

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table presents the credit quality indicators by type of loans in each category as of December 31, 2018:
 
Agricultural
 
Commercial
and Financial
 
Real Estate:
Construction, 1 to 4
family residential
 
Real Estate:
Construction, land
development and commercial
 
(Amounts In Thousands)
2018
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
3,667

 
$
3,322

 
$

 
$
209

Good
15,342

 
51,562

 
13,029

 
16,667

Satisfactory
39,897

 
121,759

 
42,043

 
68,123

Monitor
27,510

 
35,897

 
15,045

 
19,888

Special Mention
647

 
11,418

 
1,767

 
7,635

Substandard
5,610

 
5,543

 
395

 
1,285

Total
$
92,673

 
$
229,501

 
$
72,279

 
$
113,807


 
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
2018
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
5,619

 
$
2,715

 
$
520

 
$
22,058

Good
52,364

 
33,134

 
4,569

 
60,047

Satisfactory
126,706

 
752,473

 
138,533

 
187,641

Monitor
41,486

 
96,187

 
6,242

 
60,398

Special Mention
1,055

 
10,439

 
1,130

 
16,065

Substandard
9,224

 
17,111

 
1,631

 
6,225

Total
$
236,454

 
$
912,059

 
$
152,625

 
$
352,434


 
Real Estate:
Mortgage,
commercial
 
Loans to
individuals
 
Obligations of state
and political
subdivisions
 
Total
2018
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
34,096

 
$

 
$
8,117

 
$
80,323

Good
86,453

 
315

 
15,652

 
349,134

Satisfactory
177,271

 
28,797

 
20,685

 
1,703,928

Monitor
74,990

 
647

 
8,271

 
386,561

Special Mention
3,228

 
217

 

 
53,601

Substandard
7,276

 
96

 

 
54,396

Total
$
383,314

 
$
30,072

 
$
52,725

 
$
2,627,943



Page 71

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table presents the credit quality indicators by type of loans in each category as of December 31, 2017:
 
Agricultural
 
Commercial
and Financial
 
Real Estate:
Construction, 1 to 4
family residential
 
Real Estate:
Construction, land
development and commercial
 
(Amounts In Thousands)
2017
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
2,585

 
$
10,264

 
$

 
$
2,548

Good
15,755

 
51,620

 
4,710

 
27,296

Satisfactory
40,886

 
116,375

 
47,995

 
35,749

Monitor
17,009

 
29,392

 
15,188

 
39,760

Special Mention
6,898

 
5,576

 
1,845

 
3,358

Substandard
5,447

 
5,405

 

 
884

Total
$
88,580

 
$
218,632

 
$
69,738

 
$
109,595


 
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
2017
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
4,751

 
$
2,392

 
$
489

 
$
16,564

Good
54,409

 
30,094

 
4,527

 
75,768

Satisfactory
109,724

 
689,645

 
130,451

 
195,652

Monitor
32,655

 
76,766

 
4,881

 
42,373

Special Mention
5,306

 
12,072

 
1,834

 

Substandard
8,441

 
20,622

 
2,018

 
6,453

Total
$
215,286

 
$
831,591

 
$
144,200

 
$
336,810


 
Real Estate:
Mortgage,
commercial
 
Loans to
individuals
 
Obligations of state
and political
subdivisions
 
Total
2017
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
30,355

 
$
1

 
$
8,794

 
$
78,743

Good
98,434

 
118

 
30,607

 
393,338

Satisfactory
179,417

 
25,445

 
14,693

 
1,586,032

Monitor
43,786

 
500

 
3,532

 
305,842

Special Mention
6,303

 
182

 

 
43,374

Substandard
2,901

 
171

 

 
52,342

Total
$
361,196

 
$
26,417

 
$
57,626

 
$
2,459,671



Page 72

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 73

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Past due loans as of December 31, 2018 and 2017 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)
December 31, 2018
 
 
 
 
 
 
 
 
 
 
 
 
 
Agricultural
$
1,026

 
$

 
$
135

 
$
1,161

 
$
91,512

 
$
92,673

 
$

Commercial and financial
988

 
459

 
225

 
1,672

 
227,829

 
229,501

 

Real estate:


 


 
 

 
 

 
 

 
 
 
 

Construction, 1 to 4 family residential

 

 
212

 
212

 
72,067

 
72,279

 
212

Construction, land development and commercial
233

 
202

 

 
435

 
113,372

 
113,807

 

Mortgage, farmland
193

 
388

 

 
581

 
235,873

 
236,454

 

Mortgage, 1 to 4 family first liens
3,972

 
833

 
3,234

 
8,039

 
904,020

 
912,059

 
158

Mortgage, 1 to 4 family junior liens
199

 
36

 

 
235

 
152,390

 
152,625

 

Mortgage, multi-family

 

 

 

 
352,434

 
352,434

 

Mortgage, commercial
733

 
344

 

 
1,077

 
382,237

 
383,314

 

Loans to individuals
195

 

 
22

 
217

 
29,855

 
30,072

 

Obligations of state and political subdivisions

 

 

 

 
52,725

 
52,725

 

 
$
7,539

 
$
2,262

 
$
3,828

 
$
13,629

 
$
2,614,314

 
$
2,627,943

 
$
370



Page 74

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
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)
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
Agricultural
$
324

 
$

 
$
269

 
$
593

 
$
87,987

 
$
88,580

 
$

Commercial and financial
447

 
20

 
93

 
560

 
218,072

 
218,632

 

Real estate:
 
 
 
 
 

 
 

 
 

 
 
 
 

Construction, 1 to 4 family residential

 

 

 

 
69,738

 
69,738

 

Construction, land development and commercial
246

 

 

 
246

 
109,349

 
109,595

 

Mortgage, farmland
269

 

 

 
269

 
215,017

 
215,286

 

Mortgage, 1 to 4 family first liens
5,143

 
1,750

 
2,939

 
9,832

 
821,759

 
831,591

 
971

Mortgage, 1 to 4 family junior liens
579

 
116

 

 
695

 
143,505

 
144,200

 

Mortgage, multi-family

 

 

 

 
336,810

 
336,810

 

Mortgage, commercial
307

 
178

 
16

 
501

 
360,695

 
361,196

 

Loans to individuals
206

 
55

 
6

 
267

 
26,150

 
26,417

 

Obligations of state and political subdivisions

 

 

 

 
57,626

 
57,626

 

 
$
7,521

 
$
2,119

 
$
3,323

 
$
12,963

 
$
2,446,708

 
$
2,459,671

 
$
971


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

Accruing loans past due 90 days or more decreased $0.60 million from December 31, 2017 to December 31, 2018.  As of December 31, 2018 and 2017, accruing loans past due 90 days or more were 0.01% and 0.04% of total loans, respectively.  The average balance of the accruing loans past due 90 days or more increased in 2018 as compared to 2017.  The average 90 days or more past due accruing loan balance per loan was $0.19 million as of December 31, 2018 compared to $0.12 million as of December 31, 2017.  The loans 90 days or more past due and still accruing are believed to be adequately collateralized.   Loans are placed on nonaccrual status when management believes the collection of future principal and interest is not reasonably assured.


Page 75

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Certain impaired loan information by loan type at December 31, 2018 and 2017 was as follows:
 
December 31, 2018
 
December 31, 2017
 
Nonaccrual
loans (1)
 
Accruing loans
past due 90
days or more
 
TDR
loans
 
Nonaccrual
loans (1)
 
Accruing loans
past due 90
days or more
 
TDR
loans
 
(Amounts In Thousands)
 
(Amounts In Thousands)
Agricultural
$
1,338

 
$

 
$
120

 
$
1,651

 
$

 
$
2,309

Commercial and financial
1,476

 

 
2,686

 
825

 

 
1,943

Real estate:
 

 
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential

 
212

 

 

 

 

Construction, land development and commercial

 

 
328

 

 

 
339

Mortgage, farmland
1,062

 

 
3,301

 
1,391

 

 
1,451

Mortgage, 1 to 4 family first liens
5,799

 
158

 
1,143

 
4,407

 
971

 
1,357

Mortgage, 1 to 4 family junior liens

 

 
24

 
7

 

 
25

Mortgage, multi-family
145

 

 

 
218

 

 

Mortgage, commercial
1,009

 

 
937

 
597

 

 
1,046

Loans to individuals

 

 

 

 

 

 
$
10,829

 
$
370

 
$
8,539

 
$
9,096

 
$
971

 
$
8,470


(1)
There were $4.84 million and $3.62 million of TDR loans included within nonaccrual loans as of December 31, 2018 and 2017, respectively.

The Company may modify the terms of a loan to maximize the collection of amounts due.  In most cases, the modification is 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 financial 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 76

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Below is a summary of information for TDR loans as of December 31, 2018 and 2017:
 
December 31, 2018
 
Number of
contracts
 
Recorded
investment
 
Commitments
outstanding
 
 
 
(Dollar Amounts In Thousands)
Agricultural
5

 
$
1,316

 
$
91

Commercial and financial
13

 
3,867

 
75

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential

 

 

Construction, land development and commercial
2

 
328

 

Mortgage, farmland
8

 
4,291

 

Mortgage, 1 to 4 family first liens
16

 
1,710

 

Mortgage, 1 to 4 family junior liens
1

 
24

 

Mortgage, multi-family

 

 

Mortgage, commercial
9

 
1,839

 

Loans to individuals

 

 

 
54

 
$
13,375

 
$
166

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

 
$
3,628

 
$
321

Commercial and financial
14

 
2,575

 
169

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential

 

 
16

Construction, land development and commercial
2

 
339

 

Mortgage, farmland
7

 
2,761

 

Mortgage, 1 to 4 family first liens
13

 
1,442

 

Mortgage, 1 to 4 family junior liens
1

 
25

 
24

Mortgage, multi-family

 

 

Mortgage, commercial
8

 
1,324

 

Loans to individuals

 

 

 
54

 
$
12,094

 
$
530



Page 77

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

A summary of TDR loans that were modified during the year ended December 31, 2018 and 2017 was as follows:
 
December 31, 2018
 
Number of
Contracts
 
Pre-modification
recorded
investment
 
Post-modification
recorded
investment
 
 
 
( Dollar Amounts In Thousands)
Agricultural
1

 
$
163

 
$
163

Commercial and financial
6

 
2,294

 
2,294

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential

 

 

Construction, land development and commercial
1

 
218

 
218

Mortgage, farmland
2

 
4,944

 
4,944

Mortgage, 1 to 4 family first liens
6

 
627

 
627

Mortgage, 1 to 4 family junior liens

 

 

Mortgage, multi-family

 

 

Mortgage, commercial
2

 
852

 
852

Loans to individuals

 

 

 
18

 
$
9,098

 
$
9,098

 
December 31, 2017
 
Number of
Contracts
 
Pre-modification
recorded
investment
 
Post-modification
recorded
investment
 
 
 
( Dollar Amounts In Thousands)
Agricultural
6

 
$
10,890

 
$
10,890

Commercial and financial
5

 
2,051

 
2,051

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 liens
2

 
311

 
311

Mortgage, 1 to 4 family junior liens

 

 

Mortgage, multi-family
1

 
249

 
249

Mortgage, commercial

 

 

Loans to individuals

 

 

 
17

 
$
14,330

 
$
14,330



The Bank has commitments to lend additional borrowings to TDR loan customers.  These commitments are in the normal course of business and allow the borrowers to build pre-sold homes and commercial property which increase their overall cash flow.  The additional borrowings are not used to facilitate payments on these loans.

There were no TDR loans modified during the year that were in payment default (defined as past due 90 days or more) as of December 31, 2018 or 2017.


Page 78

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Information regarding impaired loans as of and for the year ended December 31, 2018 is as follows:
 
Recorded
Investment
 
Unpaid
Principal
Balance
 
Related
Allowance
 
Average
Recorded
Investment
 
Interest
Income
Recognized
 
(Amounts in Thousands)
2018
 
 
 
 
 
 
 
 
 
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
Agricultural
$
1,395

 
$
1,663

 
$

 
$
1,071

 
$
23

Commercial and financial
1,650

 
2,503

 

 
1,977

 
58

Real estate:


 


 


 


 


Construction, 1 to 4 family residential
111

 
148

 

 
113

 

Construction, land development and commercial
328

 
344

 

 
333

 
18

Mortgage, farmland
3,612

 
4,071

 

 
3,068

 
89

Mortgage, 1 to 4 family first liens
6,089

 
7,819

 

 
6,435

 
36

Mortgage, 1 to 4 family junior liens

 
254

 

 

 

Mortgage, multi-family
145

 
213

 

 
153

 

Mortgage, commercial
1,871

 
2,486

 

 
1,940

 
42

Loans to individuals

 
14

 

 

 

 
$
15,201

 
$
19,515

 
$

 
$
15,090

 
$
266

With an allowance recorded:
 

 
 

 
 

 
 

 
 

Agricultural
$
1,065

 
$
1,229

 
$
479

 
$
980

 
$
7

Commercial and financial
2,512

 
2,512

 
1,189

 
2,793

 
107

Real estate:


 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential
698

 
698

 
4

 
622

 
28

Construction, land development and commercial

 

 

 

 

Mortgage, farmland

 

 

 

 

Mortgage, 1 to 4 family first liens
899

 
974

 
70

 
888

 
25

Mortgage, 1 to 4 family junior liens
24

 
24

 
2

 
25

 
1

Mortgage, multi-family
7,447

 
7,447

 
305

 
7,543

 
346

Mortgage, commercial
75

 
75

 
1

 
77

 
4

Loans to individuals
64

 
64

 
64

 
77

 
9

 
$
12,784

 
$
13,023

 
$
2,114

 
$
13,005

 
$
527

Total:
 

 
 

 
 

 
 

 
 

Agricultural
$
2,460

 
$
2,892

 
$
479

 
$
2,051

 
$
30

Commercial and financial
4,162

 
5,015

 
1,189

 
4,770

 
165

Real estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
809

 
846

 
4

 
735

 
28

Construction, land development and commercial
328

 
344

 

 
333

 
18

Mortgage, farmland
3,612

 
4,071

 

 
3,068

 
89

Mortgage, 1 to 4 family first liens
6,988

 
8,793

 
70

 
7,323

 
61

Mortgage, 1 to 4 family junior liens
24

 
278

 
2

 
25

 
1

Mortgage, multi-family
7,592

 
7,660

 
305

 
7,696

 
346

Mortgage, commercial
1,946

 
2,561

 
1

 
2,017

 
46

Loans to individuals
64

 
78

 
64

 
77

 
9

 
$
27,985

 
$
32,538

 
$
2,114

 
$
28,095

 
$
793



Page 79

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Information regarding impaired loans as of and for the year ended December 31, 2017 is as follows:
 
Recorded
Investment
 
Unpaid
Principal
Balance
 
Related
Allowance
 
Average
Recorded
Investment
 
Interest
Income
Recognized
 
(Amounts in Thousands)
2017
 
 
 
 
 
 
 
 
 
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
Agricultural
$
1,822

 
$
2,193

 
$

 
$
2,044

 
$
19

Commercial and financial
1,725

 
2,487

 

 
2,080

 
51

Real estate:
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential
114

 
150

 

 
116

 
5

Construction, land development and commercial
338

 
371

 

 
344

 
14

Mortgage, farmland
2,523

 
2,902

 

 
2,476

 
56

Mortgage, 1 to 4 family first liens
6,045

 
7,507

 

 
6,286

 
80

Mortgage, 1 to 4 family junior liens
7

 
482

 

 
23

 

Mortgage, multi-family
218

 
355

 

 
231

 

Mortgage, commercial
1,564

 
2,274

 

 
1,706

 
45

Loans to individuals

 
14

 

 

 

 
$
14,356

 
$
18,735

 
$

 
$
15,306

 
$
270

With an allowance recorded:
 

 
 

 
 

 
 

 
 

Agricultural
$
3,094

 
$
3,149

 
$
133

 
$
3,526

 
$
160

Commercial and financial
1,043

 
1,043

 
1,018

 
1,249

 
60

Real estate:
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential

 

 

 

 

Construction, land development and commercial
505

 
505

 
39

 
321

 
14

Mortgage, farmland
5,439

 
5,439

 
238

 
5,596

 
242

Mortgage, 1 to 4 family first liens
577

 
593

 
63

 
585

 
20

Mortgage, 1 to 4 family junior liens
25

 
25

 
3

 
26

 
1

Mortgage, multi-family
6,179

 
6,179

 
480

 
6,247

 
281

Mortgage, commercial
79

 
79

 
2

 
81

 
4

Loans to individuals
190

 
190

 
190

 
179

 
20

 
$
17,131

 
$
17,202

 
$
2,166

 
$
17,810

 
$
802

Total:
 

 
 

 
 

 
 

 
 

Agricultural
$
4,916

 
$
5,342

 
$
133

 
$
5,570

 
$
179

Commercial and financial
2,768

 
3,530

 
1,018

 
3,329

 
111

Real estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
114

 
150

 

 
116

 
5

Construction, land development and commercial
843

 
876

 
39

 
665

 
28

Mortgage, farmland
7,962

 
8,341

 
238

 
8,072

 
298

Mortgage, 1 to 4 family first liens
6,622

 
8,100

 
63

 
6,871

 
100

Mortgage, 1 to 4 family junior liens
32

 
507

 
3

 
49

 
1

Mortgage, multi-family
6,397

 
6,534

 
480

 
6,478

 
281

Mortgage, commercial
1,643

 
2,353

 
2

 
1,787

 
49

Loans to individuals
190

 
204

 
190

 
179

 
20

 
$
31,487

 
$
35,937

 
$
2,166

 
$
33,116

 
$
1,072



Page 80

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Information regarding impaired loans as of and for the year ended December 31, 2016 is as follows:
 
Recorded
Investment
 
Unpaid
Principal
Balance
 
Related
Allowance
 
Average
Recorded
Investment
 
Interest
Income
Recognized
 
(Amounts in Thousands)
2016
 
 
 
 
 
 
 
 
 
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
Agricultural
$
800

 
$
971

 
$

 
$
923

 
$

Commercial and financial
1,540

 
2,175

 

 
1,662

 
18

Real estate:
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential
117

 
151

 

 
131

 
6

Construction, land development and commercial
204

 
290

 

 
207

 
5

Mortgage, farmland
2,594

 
2,887

 

 
2,767

 
67

Mortgage, 1 to 4 family first liens
5,011

 
6,137

 

 
5,265

 
53

Mortgage, 1 to 4 family junior liens
153

 
646

 

 
186

 

Mortgage, multi-family
243

 
362

 

 
288

 

Mortgage, commercial
1,901

 
2,727

 

 
1,996

 
46

Loans to individuals

 
19

 

 

 

 
$
12,563

 
$
16,365

 
$

 
$
13,425

 
$
195

With an allowance recorded:
 

 
 

 
 

 
 

 
 

Agricultural
$
10,920

 
$
10,978

 
$
856

 
$
11,258

 
$
464

Commercial and financial
937

 
955

 
718

 
777

 
27

Real estate:
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential
815

 
815

 
105

 
537

 
27

Construction, land development and commercial

 

 

 

 

Mortgage, farmland
5,434

 
5,434

 
390

 
5,591

 
240

Mortgage, 1 to 4 family first liens
1,266

 
1,374

 
79

 
1,226

 
43

Mortgage, 1 to 4 family junior liens
612

 
667

 
11

 
637

 
27

Mortgage, multi-family

 

 

 

 

Mortgage, commercial
967

 
1,004

 
34

 
986

 
36

Loans to individuals
150

 
150

 
150

 
151

 
16

 
$
21,101

 
$
21,377

 
$
2,343

 
$
21,163

 
$
880

Total:
 

 
 

 
 

 
 

 
 

Agricultural
$
11,720

 
$
11,949

 
$
856

 
$
12,181

 
$
464

Commercial and financial
2,477

 
3,130

 
718

 
2,439

 
45

Real estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
932

 
966

 
105

 
668

 
33

Construction, land development and commercial
204

 
290

 

 
207

 
5

Mortgage, farmland
8,028

 
8,321

 
390

 
8,358

 
307

Mortgage, 1 to 4 family first liens
6,277

 
7,511

 
79

 
6,491

 
96

Mortgage, 1 to 4 family junior liens
765

 
1,313

 
11

 
823

 
27

Mortgage, multi-family
243

 
362

 

 
288

 

Mortgage, commercial
2,868

 
3,731

 
34

 
2,982

 
82

Loans to individuals
150

 
169

 
150

 
151

 
16

 
$
33,664

 
$
37,742

 
$
2,343

 
$
34,588

 
$
1,075



Page 81

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Impaired loans decreased by $3.50 million from December 31, 2017 to December 31, 2018.  Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more, TDR loans and specific reserve loans.  Impaired loans also include loans that, based on management’s evaluation of current information and events, the Bank expects to be unable to collect in full according to the contractual terms of the original loan agreement. Impaired loans were 1.06% and 1.28% of loans held for investment as of December 31, 2018 and 2017, respectively. The decrease in impaired loans is due mainly to a decrease of $4.70 million in specific reserve loans and a decrease of accruing loans past due 90 days or more of $0.60 million, offset by an increase in nonaccrual loans of $1.73 million and an increase in TDR loans of $0.69 million from December 31, 2017 to December 31, 2018.

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 that can be identified as uncollectible.  In general, this is the amount that the carrying value of the loan exceeds the related appraised value.  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 additional charge-off or loss allocations based on the applicable facts and circumstances.  In instances where there is an estimated decline in value, either a loss allocation is 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 loss allocation 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.

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 helping to determine 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.

The Company separates its portfolio loans and leases into segments for determining the allowance for loan losses. The Company's portfolio segments includes agricultural, commercial and financial, real estate, loans to individuals and obligations of state and political subdivisions. The Company further separates its portfolio into classes for purposes of monitoring and assessing credit quality based on certain risk characteristics. Classes with the real estate portfolio segment includes 1 to 4 family residential constructions, land development and commercial construction, farmland, 1 to 4 family first liens, 1 to 4 family junior liens, multi-family and commercial.

Loans that exhibit probable or observed credit weaknesses, as well as loans that have been modified in a TDR, are subject to individual review for impairment. When individual loans are reviewed for impairment, the Company determines allowances based on management's estimate of the borrower's ability to repay the loan given the availability of the collateral, other sources of cash flow, as well as evaluation of legal options available. Allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the underlying collateral.

Historical loss rates are applied to loans that are not individually reviewed for impairment. The 20 quarter migration analysis performed by management uses loan level attributes to track the movement of loans through the various credit risk rating categories in order to estimate the percentage of historical loss to apply to each specific credit risk rating in each loan category. The credit risk rating system currently utilized for allowance analysis purposes encompasses six categories.


Page 82

Table of Contents

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The Company's allowance for loan loss 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 changes in lending policies and procedures; changes in national and local economic and business conditions; changes in the nature and volume of the loan portfolio; changes in the experience, ability and depth of lending management and staff; changes in the quality of the Bank's loan review system; the existence and effect of concentrations of credit; and the effect of any other identified external factors.

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.  As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly.   Although management believes the levels of the allowance for loan losses as of December 31, 2018 and 2017 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.

Note 4.
Property and Equipment

The major classes of property and equipment and the total accumulated depreciation are as follows:

 
December 31,
 
2018
 
2017
 
(Amounts In Thousands)
Land
$
10,899

 
$
10,880

Buildings and improvements
36,815

 
36,686

Furniture and equipment
36,090

 
34,067

 
83,804

 
81,633

Less accumulated depreciation
46,753

 
43,776

Net
$
37,051

 
$
37,857

 
    
Note 5.
Interest - Bearing Deposits

A summary of these deposits is as follows:
 
December 31,
 
2018
 
2017
 
(Amounts In Thousands)
NOW and other demand
$
542,388

 
$
520,647

Savings
925,214

 
907,121

Time, $100,000 and over
350,725

 
315,558

Other time
230,645

 
181,422

 
$
2,048,972

 
$
1,924,748


Brokered deposits totaled $132.46 million and $284.41 million as of December 31, 2018 and 2017, respectively, with an average interest rate of 2.46% and 1.35% as of December 31, 2018 and 2017, respectively. Brokered deposits decreased as of December 31, 2018 compared to December 31, 2017 due to passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act which allows reciprocal deposits to be treated as core deposits instead of brokered deposits. As of December 31, 2018, $163.41 million of reciprocal deposits are now treated as core deposits under the Act. As of December 31, 2018, brokered deposits of $132.46 million are included in savings deposits and $0.00 million are included in time deposits.  At December 31, 2017, brokered deposits of $274.13 million were included in savings deposits and $10.28 million were included in time deposits. Brokered time deposits in increments greater than $100,000 as of December 31, 2018 and 2017 were $0.00 million and $8.57 million, respectively.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Time deposits have a maturity as follows:
 
December 31,
 
2018
 
2017
 
(Amounts In Thousands)
Due in one year or less
$
229,091

 
$
167,471

Due after one year through two years
223,254

 
90,741

Due after two years through three years
44,610

 
194,530

Due after three years through four years
35,002

 
40,140

Due over four years
49,413

 
4,098

 
$
581,370

 
$
496,980



Note 6.
Federal Home Loan Bank Borrowings

As of December 31, 2018 and 2017, the borrowings were as follows:
 
2018
 
2017
(Effective interest rates as of December 31, 2018)
(Amounts In Thousands)
Due 2018, 3.65%

 
20,000

Due 2019, 1.67%

 
15,000

Due 2020, 3.05%
25,000

 
25,000

Due 2021, 2.06% to 2.27%

 
30,000

Due 2022, 2.44%

 
15,000

Due 2023, 3.77%
25,000

 
25,000

Due 2024, 2.38%
15,000

 
15,000

Due 2025, 2.54% to 3.07%
90,000

 
90,000

Due 2026, 2.52% to 2.86%
30,000

 
30,000

Due 2027, 2.76% to 2.95%
30,000

 
30,000

 
$
215,000

 
$
295,000


On January 17, 2018 the Company paid $15.00 million in FHLB Borrowings due in 2019 and $15.00 million due in 2021. On February 6, 2018 the Company paid $15.00 million in FHLB Borrowings due in 2021. On February 28, 2018 the Company paid $15.00 million in FHLB Borrowings due in 2022. There were no prepayment fees incurred with these prepayments. The remaining borrowings with the FHLB may have prepayment fees based on the current FHLB borrowing rate.

To participate in the FHLB advance program, the Company is required to have an investment in FHLB stock.  The Company’s investment in FHLB stock was $12.17 million and $15.01 million at December 31, 2018 and 2017, respectively.  Collateral is provided by the Company’s 1 to 4 family mortgage loans totaling $290.25 million at December 31, 2018 and $398.25 million at December 31, 2017.  The Company also has the ability to borrow against agricultural real estate, commercial real estate and multi-family loans totaling $296.53 million as of December 31, 2018 and $298.85 million as of December 31, 2017 and there was $0 borrowed against this collateral as of December 31, 2018 or 2017.











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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 7.
Accumulated Other Comprehensive Income

The components of accumulated other comprehensive income (AOCI), included in stockholders’ equity, are as follows:
 
December 31,
 
2018
 
2017
 
(amounts in thousands)
Net unrealized loss on available-for-sale securities
$
(2,734
)
 
$
(1,141
)
Net unrealized loss on derivatives used for cash flow hedges
(1,596
)
 
(2,819
)
Tax effect
1,080

 
1,514

Net-of-tax amount
$
(3,250
)
 
$
(2,446
)
 


Note 8.
Employee Benefit Plans

The Company has an Employee Stock Purchase Plan (the “ESPP”).  For each quarterly offering period, eligible employees can elect to contribute from 1% to 15% of his or her compensation.  The purchase price is the lesser of 90% of the fair market value on the first day of the offering period or the last day of the offering period.  The maximum dollar amount any one employee can elect to contribute in a year is $9,000.  During the year ended December 31, 2018, 8,172 shares of stock were purchased by employees of the Bank through the ESPP.  6,892 shares of stock were purchased by employees of the Bank through the ESPP for the year ended December 31, 2017.

The Company has an Employee Stock Ownership Plan (the "ESOP") to which it makes discretionary cash contributions.  The Company's contribution to the ESOP totaled $1.05 million, $1.01 million and $0.92 million for the years ended December 31, 2018, 2017 and 2016, respectively.  The 2018, 2017 and 2016 discretionary contribution rate was 4.5% of qualified salaries.

In the event a terminated plan participant desires to sell his or her shares of the Company stock, or for certain employees who elect to diversify their account balances, the Company may be required to purchase the shares from the participant at their fair value.  To the extent that shares of common stock held by the ESOP are not readily traded, a sponsor must reflect the maximum cash obligation related to those securities outside of stockholders' equity.  The Company obtains a quarterly independent appraisal of the shares of stock.  As of December 31, 2018 and 2017, the shares held by the ESOP, fair value and maximum cash obligation were as follows:
 
2018
 
2017
Shares held by the ESOP
801,147

 
802,003

Fair value per share
$
61.00

 
$
54.00

Maximum cash obligation
$
48,870,000

 
$
43,308,000


The Company has a profit-sharing plan with a 401(k) feature, which provides for discretionary annual contributions in amounts to be determined by the Board of Directors.  The Company made a 4.50% or $1.05 million contribution to the profit sharing plan contribution for the year ended December 31, 2018. The Company made a 4.50% or $1.01 million contribution to the profit sharing plan for the year ended December 31, 2017. The Company made a 4.50% or $0.92 million contribution to the profit sharing plan for the year ended December 31, 2016. The Company made matching contributions under its 401(k) plan of $0.21 million in 2018, $0.20 million in 2017, and $0.18 million in 2016 and each such amount is included in salaries and employee benefits expense.

The Company provides a deferred compensation program for executive officers.  This program allows executive officers to elect to defer a portion of their salaried compensation for payment by the Company at a subsequent date.  The executive officers can defer up to 30% of their base compensation and up to 100% of any bonus into the deferral plan.  Any amount so deferred is credited to the executive officer’s deferred compensation account and converted to units equivalent in value to the fair market value of a share of stock in Hills Bancorporation.  The “stock units” are book entry only and do not represent an actual purchase of stock.  The executive officer’s account is adjusted each year for dividends paid and the change in the market value of Hills Bancorporation stock.  The deferrals and earnings grow tax deferred until withdrawn from the plan.  Earnings credited to the individual’s accounts are recorded as compensation expense when earned.  The deferred compensation liability is recorded in other liabilities and totals

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$5.90 million and $6.34 million at December 31, 2018 and 2017, respectively.  Expense related to the deferred compensation plan was $0.85 million for 2018, $0.81 million for 2017 and $0.51 million for 2016 and is included in salaries and employee benefits expense.

The Company also provides a deferred compensation program for its Board of Directors.  Under the plan, each director may elect to defer up to 50% of such director’s cash compensation from retainers and meeting fees for payment by the Company at a subsequent date.  Any amount so deferred is credited to the director’s deferred compensation account and converted to units equivalent in value to the fair market value of a share of stock in Hills Bancorporation.  The “stock units” are book entry only and do not represent an actual purchase of stock.  The director’s account is adjusted each year for dividends paid and the change in the market value of Hills Bancorporation stock.  The deferred compensation liability for the directors’ plan is recorded in other liabilities and totaled $3.52 million and $2.95 million at December 31, 2018 and 2017, respectively.  Expense related to the directors’ deferred compensation plan was $0.43 million for 2018, $0.37 million for 2017 and $0.22 million for 2016 and is included in other noninterest expense.

The Company has a Stock Option and Incentive Plan for certain key employees and directors whereby shares of common stock have been reserved for awards in the form of stock options or restricted stock awards. Under the plan, the aggregate number of options and shares granted cannot exceed 188,000 shares. A Stock Option Committee may grant options at prices equal to the fair value of the stock at the date of the grant. Options expire 10 years from the date of the grant.  Director options and officers' rights under the plan vest over a five-year period from the date of the grant.

The fair value of each option is estimated as of the date of grant using a Black Scholes option pricing model.  The expected lives of options granted incorporate historical employee exercise behavior.  The risk-free rate for periods that coincide with the expected life of the options is based on the ten year interest rate swap rate as published by the Federal Reserve Bank on the date of issuance.  Expected volatility is based on volatility levels of the Company’s peers’ common stock as the Company’s stock has limited trading activity.  Expected dividend yield was based on historical dividend rates.

There were no stock options granted in 2016, 2017 or 2018. The intrinsic value of options exercised was $0.03 million, $0.24 million and $0.00 million for 2018, 2017 and 2016, respectively.

A summary of the stock options is as follows: 
 
Number of Shares
 
Weighted-
Average
Exercise Price
 
Weighted-Average
Remaining
Contractual Term
(Years)
 
Aggregate
Intrinsic Value
(In Thousands)
Balance, December 31, 2015
19,380

 
$
29.92

 
4.03
 
$
580

Granted

 
 

 
 
 
 

Exercised

 
 

 
 
 
 

Balance, December 31, 2016
19,380

 
$
29.92

 
3.03
 
580

Granted

 
 

 
 
 
 

Exercised
(9,160
)
 
 

 
 
 
 

Balance, December 31, 2017
10,220

 
$
33.44

 
4.45
 
342

Granted

 
 

 
 
 
 

Exercised
(1,200
)
 
 

 
 
 
 

Balance, December 31, 2018
9,020

 
$
33.30

 
3.41
 
$
250





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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Other pertinent information related to the options outstanding at December 31, 2018 is as follows:
Exercise Price
 
Number Outstanding
 
Remaining Contractual Life
 
Number Exercisable
33.00

 
7,220

 
40 months
 
7,220

34.50

 
1,800

 
46 months
 
1,800

 

 
9,020

 
 
 
9,020


As of December 31, 2018, the outstanding options have a weighted-average exercise price of $33.30 per share and a weighted average remaining contractual term of 3.41 years.  As of December 31, 2018, the vested options totaled 9,020 shares with a weighted-average exercise price of $33.30 per share.

As of December 31, 2018, 38,125 shares were available for stock options and awards.  The Compensation and Incentive Stock Committee is also authorized to grant awards of restricted common stock. A summary of the restricted stock option activity for the year ended December 31, 2018 is as follows:

 
 
Number of Shares
 
Weighted Average Grant Date Fair Value
Balance, December 31, 2017
 
59,728

 
 
Granted
 
24,899

 
$58.90
Forfeited
 
3,296

 
$46.19
Balance, December 31, 2018
 
38,125

 
 

The Company authorized the issuance of 24,899 shares in 2018, 27,407 shares in 2017, and 23,163 shares in 2016 to certain employees.  The vesting period for these awards is five years and the Bank amortizes the expense on a straight line basis during the vesting period.  The expense relating to these awards for the years ended December 31, 2018, 2017 and 2016 was $0.85 million, $0.58 million and $0.56 million, respectively. 15,200, 15,200 and 10,400 shares of the restricted common stock shares awarded in December 31, 2018, 2017 and 2016, are subject to forfeiture upon termination of the employee's employment with the Company within eight years of the award.

Note 9.
Income Taxes

Income taxes for the years ended December 31, 2018, 2017 and 2016 are summarized as follows:
 
2018
 
2017
 
2016
 
(Amounts In Thousands)
Current:
 
 
 
 
 
Federal
$
7,783

 
$
13,770

 
$
11,650

State
3,093

 
2,529

 
2,320

Deferred:
 

 
 

 
 

Federal
(1,560
)
 
3,426

 
435

State
(411
)
 
(188
)
 
(11
)
 
$
8,905

 
$
19,537

 
$
14,394



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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Temporary differences between the amounts reported in the consolidated financial statements and the tax basis of assets and liabilities result in deferred taxes.  Deferred tax assets and liabilities at December 31, 2018 and 2017 were as follows:

 
December 31,
 
2018
 
2017
 
(Amounts In Thousands)
Deferred income tax assets:
 
 
 
Allowance for loan losses
$
9,434

 
$
7,335

Deferred compensation
2,211

 
2,202

Unrealized losses on interest rate swaps
398

 
703

Accrued expenses
668

 
688

State net operating loss
795

 
836

Unrealized losses on investment securities
682

 
285

Gross deferred tax assets
$
14,188

 
$
12,049

Valuation allowance
(795
)
 
(836
)
Deferred tax asset, net of valuation allowance
$
13,393

 
$
11,213

Deferred income tax liabilities:
 

 
 

Property and equipment
1,728

 
1,652

Goodwill
407

 
407

Other
389

 
348

Gross deferred tax liabilities
$
2,524

 
$
2,407

Net deferred tax assets
$
10,869

 
$
8,806


The Company has recorded a deferred tax asset for the future tax benefits of Iowa net operating loss carry-forwards.  The net operating loss carry-forwards are generated by the Company largely from its investment in tax credit real estate properties.  The Company is required to file a separate Iowa tax return and cannot be consolidated with the Bank.  The net operating loss carry-forwards will expire, if not utilized, between 2019 and 2037.  The Company has recorded a valuation allowance to reduce the deferred tax asset attributable to the net operating loss carry-forwards.  At December 31, 2018 and 2017, the Company believes it is more likely than not that the Iowa net operating loss carry-forwards will not be realized.  The decrease in net operating loss carry-forward in 2018 compared to 2017 reflects expiring carry-forwards.  A valuation allowance related to the remaining deferred tax assets has not been provided because management believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets. The valuation allowance (decreased) increased by ($41,000) and $57,000 for the years ended December 31, 2018 and 2017, respectively.

On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cut and Jobs Act (the “Tax Act”). The Tax Act made broad and complex changes to the U.S. tax code that affected 2017, including, but not limited to, accelerated depreciation that allows for full expensing of qualified property. The Tax Act also established new tax laws that affects 2018 and after, including a reduction in the U.S. federal corporate income tax rate from 35% to 21%.

On December 22, 2017, the SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”), which provided guidance on accounting for the tax effects of the Tax Act.  SAB 118 provided that a measurement period should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740, Income Taxes.  In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under ASC 740 is complete. 

As a result of the reduction of the federal corporate income tax rate, we revalued our net deferred tax asset, excluding after tax credits, as of December 22, 2017.  Based on this revaluation, we recorded a net tax expense of $4.71 million to reduce the net deferred tax asset balance, which was recorded as additional income tax expense for the year ended December 31, 2017. Our effective tax rate increased by 30.99% to 41.0% primarily as a result of the revaluation of our net deferred tax asset for the year ended December 31, 2017.


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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The net change in the deferred income taxes for the years ended December 31, 2018, 2017 and 2016 is reflected in the consolidated financial statements as follows:
 
Year Ended December 31,
 
2018
 
2017
 
2016
 
(Amounts In Thousands)
Consolidated statements of income
$
1,971

 
$
(3,238
)
 
$
(424
)
Consolidated statements of stockholders' equity
92

 
(567
)
 
1,340

 
$
2,063

 
$
(3,805
)
 
$
916


Income tax expense for the years ended December 31, 2018, 2017 and 2016 are less than the amounts computed by applying the maximum effective federal income tax rate to the income before income taxes because of the following items:
 
2018
 
2017
 
2016
 
Amount
 
% Of
Pretax
Income
 
Amount
 
% Of
Pretax
Income
 
Amount
 
% Of
Pretax
Income
 
(Amounts In Thousands)
Expected tax expense
$
9,591

 
21.0
 %
 
$
16,659

 
35.0
 %
 
$
16,082

 
35.0
 %
Tax-exempt interest
(1,122
)
 
(2.5
)
 
(1,771
)
 
(3.7
)
 
(1,715
)
 
(3.7
)
Interest expense limitation
87

 
0.2

 
103

 
0.2

 
96

 
0.2

State income taxes, net of federal income tax benefit
2,119

 
4.6

 
1,522

 
3.2

 
1,501

 
3.2

Income tax credits
(1,292
)
 
(2.8
)
 
(1,426
)
 
(3.0
)
 
(1,426
)
 
(3.1
)
Deferred tax asset revaluation

 

 
4,710

 
9.9

 

 

Other
(478
)
 
(1.0
)
 
(260
)
 
(0.6
)
 
(144
)
 
(0.3
)
 
$
8,905

 
19.5
 %
 
$
19,537

 
41.0
 %
 
$
14,394

 
31.3
 %

Federal income tax expense for the years ended December 31, 2018, 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 the State of Iowa purposes.  The tax years ended December 31, 2018, 2017, 2016 and 2015, remain subject to examination by the Internal Revenue Service.  For state tax purposes, the tax years ended December 31, 2018, 2017, 2016 and 2015, remain open for examination.  There were no material unrecognized tax benefits at December 31, 2018 and December 31, 2017No interest or penalties on these unrecognized tax benefits has been recorded.  As of December 31, 2018, the Company does not anticipate any significant increase or decrease in unrecognized tax benefits during the twelve month period ending December 31, 2019.

Note 10.
Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and Cash Restrictions

The Company and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial results.  Under capital adequacy guidelines and the regulatory frameworks for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices.  Capital amounts and classifications of the Company and the Bank are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Quantitative measures established by the regulations to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of capital. 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. Management believes that, as of December 31, 2018 and 2017, the Company and the Bank met all capital adequacy requirements to which they are subject.

As of December 31, 2018, the most recent notifications from the Federal Reserve System categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action.  To be categorized as well-capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, Tier 1 common equity and Tier 1 leverage ratios as set forth in the table that follows.  There are no conditions or events since that notification that management believes have changed the Bank's category.

The actual amounts and capital ratios as of December 31, 2018 and 2017, with the minimum regulatory requirements for the Company and Bank 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 December 31, 2018:
 
 
 
 
 
 
 
Company:
 
 
 
 
 
 
 
Total risk-based capital
$
414,772

 
17.18
%
 
8.00
%
 
10.00
%
Tier 1 risk-based capital
384,502

 
15.93

 
6.00

 
8.00

Tier 1 common equity
384,502

 
15.93

 
4.50

 
6.50

Leverage ratio
384,502

 
12.68

 
4.00

 
5.00

Bank:
 

 
 

 
 

 
 

Total risk-based capital
416,198

 
17.25

 
8.00

 
10.00

Tier 1 risk-based capital
385,943

 
16.00

 
6.00

 
8.00

Tier 1 common equity
385,943

 
16.00

 
4.50

 
6.50

Leverage ratio
385,943

 
12.73

 
4.00

 
5.00



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
Actual
 
For Capital Adequacy Purposes
 
To Be Well-Capitalized Under Prompt Corrective Action Provisions
 
Amount
 
Ratio
 
Ratio
 
Ratio
As of December 31, 2017:
 
 
 
 
 
 
 
Company:
 
 
 
 
 
 
 
Total risk-based capital
$
383,766

 
16.66
%
 
8.00
%
 
10.00
%
Tier 1 risk-based capital
354,970

 
15.41

 
6.00

 
8.00

Tier 1 common equity
354,970

 
15.41

 
4.50

 
6.50

Leverage ratio
354,970

 
12.34

 
4.00

 
5.00

Bank:
 

 
 

 
 

 
 

Total risk-based capital
384,181

 
16.69

 
8.00

 
10.00

Tier 1 risk-based capital
355,402

 
15.44

 
6.00

 
8.00

Tier 1 common equity
355,402

 
15.44

 
4.50

 
6.50

Leverage ratio
355,402

 
12.36

 
4.00

 
5.00


The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by the Bank.  The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends.  To maintain acceptable capital ratios in the Bank, certain of its retained earnings are not available for the payment of dividends.  To maintain a ratio of capital to assets of 8.00%, retained earnings of $192.92 million as of December 31, 2018 are available for the payment of dividends to the Company.

The Bank is required to maintain reserve balances in cash or with the Federal Reserve Bank.  Reserve balances totaled $14.68 million and $139.12 million as of December 31, 2018 and 2017, respectively.

Note 11.
Related Party Transactions

Certain directors of the Company and the Bank, companies with which the directors are affiliated, and certain principal officers are customers of, and have banking transactions with, the Bank in the ordinary course of business.  Such indebtedness has been incurred on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons.

The following is an analysis of the changes in the loans to related parties during the years ended December 31, 2018 and 2017:
 
Year Ended December 31,
 
2018
 
2017
 
(Amounts In Thousands)
Balance, beginning
$
42,496

 
$
30,532

Net increase (decrease) due to change in related parties
188

 
(59
)
Advances
28,194

 
28,305

Collections
(19,662
)
 
(16,282
)
Balance, ending
$
51,216

 
$
42,496


Deposits from these related parties totaled $7.13 million and $9.24 million as of December 31, 2018 and 2017, respectively.  Deposits from related parties are accepted subject to the same interest rates and terms as those from nonrelated parties.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 12.
Fair Value Measurements

The carrying value and estimated fair values of the Company’s financial instruments as of December 31, 2018 are as follows:
 
December 31, 2018
 
Carrying
Amount
 
Estimated
Fair Value
 
Readily
Available
Market
Prices(1)
 
Observable
Market
Prices(2)
 
Company
Determined
Market
Prices(3)
 
(Amounts In Thousands)
Financial instrument assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
43,305

 
$
43,305

 
$
43,305

 
$

 
$

Investment securities
331,098

 
331,098

 
83,155

 
247,943

 

Loans held for sale
1,984

 
1,984

 

 
1,984

 

Loans
 

 
 

 
 

 
 

 
 

Agricultural
89,884

 
93,736

 

 

 
93,736

Commercial and financial
223,675

 
227,774

 

 

 
227,774

Real estate:
 

 
 

 
 

 
 

 
 
Construction, 1 to 4 family residential
70,982

 
72,419

 

 

 
72,419

Construction, land development and commercial
111,812

 
112,960

 

 

 
112,960

Mortgage, farmland
232,482

 
235,771

 

 

 
235,771

Mortgage, 1 to 4 family first liens
902,261

 
882,908

 

 

 
882,908

Mortgage, 1 to 4 family junior liens
150,859

 
148,128

 

 

 
148,128

Mortgage, multi-family
348,351

 
342,099

 

 

 
342,099

Mortgage, commercial
379,232

 
376,257

 

 

 
376,257

Loans to individuals
29,349

 
29,962

 

 

 
29,962

Obligations of state and political subdivisions
52,198

 
51,945

 

 

 
51,945

Accrued interest receivable
11,784

 
11,784

 

 
11,784

 

Total financial instrument assets
$
2,979,256

 
$
2,962,130

 
$
126,460

 
$
261,711

 
$
2,573,959

Financial instrument liabilities:
 

 
 

 
 

 
 

 
 

Deposits
 

 
 

 
 

 
 

 
 

Noninterest-bearing deposits
$
372,152

 
$
372,152

 
$

 
$
372,152

 
$

Interest-bearing deposits
2,048,972

 
2,059,336

 

 
2,059,336

 

Federal Home Loan Bank borrowings
215,000

 
207,948

 

 
207,948

 

Interest rate swaps
1,596

 
1,596

 

 
1,596

 

Accrued interest payable
1,812

 
1,812

 

 
1,812

 

Total financial instrument liabilities
$
2,639,532

 
$
2,642,844

 
$

 
$
2,642,844

 
$

 
Face Amount
 
 

 
 

 
 

 
 

Financial instrument with off-balance sheet risk:
 

 
 

 
 

 
 

 
 

Loan commitments
$
375,940

 
$

 
$

 
$

 
$

Letters of credit
9,033

 

 

 

 

Total financial instrument liabilities with off-balance-sheet risk
$
384,973

 
$

 
$

 
$

 
$


(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.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The carrying value and estimated fair values of the Company’s financial instruments as of December 31, 2017 are as follows:
 
December 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
$
154,353

 
$
154,353

 
$
154,353

 
$

 
$

Investment securities
300,160

 
300,160

 
54,318

 
245,842

 

Loans held for sale
5,162

 
5,162

 

 
5,162

 

Loans
 

 
 

 
 

 
 

 
 

Agricultural
86,286

 
86,229

 

 

 
86,229

Commercial and financial
213,795

 
212,244

 

 

 
212,244

Real estate:
 

 
 

 
 

 
 

 
 
Construction, 1 to 4 family residential
68,545

 
69,036

 

 

 
69,036

Construction, land development and commercial
107,799

 
108,651

 

 

 
108,651

Mortgage, farmland
211,617

 
211,947

 

 

 
211,947

Mortgage, 1 to 4 family first liens
824,222

 
818,083

 

 

 
818,083

Mortgage, 1 to 4 family junior liens
142,901

 
142,180

 

 

 
142,180

Mortgage, multi-family
334,019

 
329,344

 

 

 
329,344

Mortgage, commercial
358,287

 
353,796

 

 

 
353,796

Loans to individuals
25,635

 
25,610

 

 

 
25,610

Obligations of state and political subdivisions
57,165

 
55,066

 

 

 
55,066

Accrued interest receivable
10,772

 
10,772

 

 
10,772

 

Total financial instrument assets
$
2,900,718

 
$
2,882,633

 
$
208,671

 
$
261,776

 
$
2,412,186

Financial instrument liabilities:
 

 
 

 
 

 
 

 
 

Deposits
 

 
 

 
 

 
 

 
 

Noninterest-bearing deposits
$
363,817

 
$
363,817

 
$

 
$
363,817

 
$

Interest-bearing deposits
1,924,748

 
1,934,442

 

 
1,934,442

 

Federal Home Loan Bank Borrowings
295,000

 
284,442

 

 
284,442

 

Interest rate swaps
2,819

 
2,819

 

 
2,819

 

Accrued interest payable
1,290

 
1,290

 

 
1,290

 

Total financial instrument liabilities
$
2,587,674

 
$
2,586,810

 
$

 
$
2,586,810

 
$

 
Face Amount
 
 

 
 

 
 

 
 

Financial instrument with off-balance sheet risk:
 

 
 

 
 

 
 

 
 

Loan commitments
$
380,877

 
$

 
$

 
$

 
$

Letters of credit
9,113

 

 

 

 

Total financial instrument liabilities with off-balance-sheet risk
$
389,990

 
$

 
$

 
$

 
$


(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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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.

ASSETS

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.  U.S. Treasury securities are considered Level 1 with the remaining securities considered Level 2.

The pricing for investment securities is obtained from an independent source.  There are no 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 year ended December 31, 2018.   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 and Loans:  ASU 2016-1, Financial Instruments -Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. This update was effective for financial statement periods beginning after December 15, 2017. Therefore, the fair value presented herein may not be comparable to prior periods. Methodologies utilized for this financial statement period are as follows:
•Income Approach: Fair value is determined based on a discounted cash flow analysis. The discounted cash flow analysis was based on the contractual maturity of the loan and market indications of rates, prepayment speeds, defaults and credit risk.
•Asset Approach: Fair value is determined based on the estimated values of the underlying collateral or individual analysis of receipts. This provides a better indication of value than the contractual income streams as these loans are not performing or exhibit strong signs indicative of non-performance.
Fair value has been estimated in accordance with ASC 820, Fair Value Measurements and Disclosures, and is intended to represent the price that would be received in an orderly transaction between market participants as of the measurement date. In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, at least one significant

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

assumption not observable in the market was utilized. These unobservable assumptions reflect estimates that market participants would use in pricing the asset or liability. Inputs to these valuation techniques are subjective in nature, involve uncertainties and require significant judgment and therefore cannot be determined with precision. Accordingly, the fair value estimates presented are not necessarily indicative of the amounts to be realized in a current market exchange. Loans are classified as Level 3.
For the year ended December 31, 2017, fair value was measured using the following methodologies for loans and 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.

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 impaired 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.

A loan is considered to be impaired when it is probable that all of the principal and interest due may not be collected according to its contractual terms. Generally, when a loan is considered impaired, the amount of reserve required under ASC 310, Receivables, is measured based on the fair value of the underlying collateral. The Company makes such measurements on all material loans deemed impaired using the fair value of the collateral for collateral dependent loans. The fair value of collateral used by the Company is determined by obtaining an observable market price or by obtaining an appraised value from an independent, licensed or certified appraiser, using observable market data. This data includes information such as selling price of similar properties and capitalization rates of similar properties sold within the market, expected future cash flows or earnings of the subject property based on current market expectations, and other relevant factors. All appraised values are adjusted for market-related trends based on the Company's experience in sales and other appraisals of similar property types as well as estimated selling costs. Each quarter management reviews all collateral dependent impaired loans on a loan-by-loan basis to determine whether updated appraisals are necessary based on loan performance, collateral type and guarantor support. At times, the Company measures the fair value of collateral dependent impaired loans using appraisals with dates prior to one year from the date of review. These appraisals are discounted by applying current, observable market data about similar property types such as sales contracts, estimations of value by individuals familiar with the market, other appraisals, sales or collateral assessments based on current market activity until updated appraisals are obtained. Depending on the length of time since an appraisal was performed, the data provided through reviews and estimated selling costs, collateral values are typically discounted by 0-35%.

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 costs 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).









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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

LIABILITIES

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).

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:
 
December 31, 2018
 
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
$
83,155

 
$

 
$

 
$
83,155

State and political subdivisions

 
200,900

 

 
200,900

Other securities (FHLB, FHLMC and FNMA)

 
34,871

 

 
34,871

Derivative Financial Instruments
 
 
 
 
 
 
 
Interest rate swaps

 
(1,596
)
 

 
(1,596
)
Total
$
83,155

 
$
234,175

 
$

 
$
317,330


 
December 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
$
54,318

 
$

 
$

 
$
54,318

State and political subdivisions

 
186,878

 

 
186,878

Other securities (FHLB, FHLMC and FNMA)

 
43,959

 

 
43,959

Derivative Financial Instruments
 
 
 
 
 
 
 
Interest rate swaps

 
(2,819
)
 

 
(2,819
)
Total
$
54,318

 
$
228,018

 
$

 
$
282,336


(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 years ended December 31, 2018 and 2017.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


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.  For assets measured at fair value on a nonrecurring basis that were still held on the balance sheet at December 31, 2018 and 2017, the following tables provide the level of valuation assumptions used to determine the adjustment and the carrying value of the related individual assets at year end.
 
December 31, 2018
 
Year Ended December 31, 2018
 
Readily
Available
Market
Prices(1)
 
Observable
Market
Prices(2)
 
Company
Determined
Market
Prices(3)
 
Total at
Fair Value
 
Total
Losses
 
(Amounts in Thousands)
 
 
Loans (4)
 
 
 
 
 
 
 
 
 
Agricultural
$

 
$

 
$
1,160

 
$
1,160

 
$
63

Commercial and financial

 

 
2,882

 
2,882

 
122

Real Estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential

 

 

 

 

Construction, land development and commercial

 

 
703

 
703

 

Mortgage, farmland

 

 
3,848

 
3,848

 

Mortgage, 1 to 4 family first liens

 

 
6,729

 
6,729

 
520

Mortgage, 1 to 4 family junior liens

 

 
22

 
22

 
60

Mortgage, multi-family

 

 
7,286

 
7,286

 

Mortgage, commercial

 

 
1,458

 
1,458

 
349

Loans to individuals

 

 

 

 

Foreclosed assets (5)

 

 

 

 

Total
$

 
$

 
$
24,088

 
$
24,088

 
$
1,114


(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.



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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
December 31, 2017
 
Year Ended December 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
$

 
$

 
$
4,704

 
$
4,704

 
$
127

Commercial and financial

 

 
1,555

 
1,555

 
159

Real Estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential

 

 

 

 

Construction, land development and commercial

 

 
729

 
729

 

Mortgage, farmland

 

 
7,190

 
7,190

 

Mortgage, 1 to 4 family first liens

 

 
5,548

 
5,548

 
404

Mortgage, 1 to 4 family junior liens

 

 
25

 
25

 
88

Mortgage, multi-family

 

 
6,397

 
6,397

 

Mortgage, commercial

 

 
1,063

 
1,063

 
111

Loans to individuals

 

 

 

 
20

Foreclosed assets (5)

 

 

 

 

Total
$

 
$

 
$
27,211

 
$
27,211

 
$
909


(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.




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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 13.
Parent Company Only Financial Information

Following is condensed financial information of the Company (parent company only):

CONDENSED BALANCE SHEETS
December 31, 2018 and 2017
(Amounts In Thousands) 
ASSETS
2018
 
2017
Cash and cash equivalents at subsidiary bank
$
3,742

 
$
4,015

Investment in subsidiary bank
385,193

 
355,456

Other assets
1,231

 
1,393

Total assets
$
390,166

 
$
360,864

LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

Liabilities
$
6,414

 
$
5,840

Redeemable common stock held by ESOP
48,870

 
43,308

Stockholders' equity:
 

 
 

Capital stock
52,122

 
48,930

Retained earnings
371,848

 
341,558

Accumulated other comprehensive loss
(3,250
)
 
(2,446
)
Treasury stock at cost
(36,968
)
 
(33,018
)
 
383,752

 
355,024

Less maximum cash obligation related to ESOP shares
48,870

 
43,308

Total stockholders' equity
334,882

 
311,716

Total liabilities and stockholders' equity
$
390,166

 
$
360,864


CONDENSED STATEMENTS OF INCOME
Years Ended December 31, 2018, 2017 and 2016
(Amounts In Thousands) 
 
2018
 
2017
 
2016
Dividends received from subsidiary
$
11,502

 
$
7,485

 
$
8,560

Other expenses
(786
)
 
(741
)
 
(570
)
Income before income tax benefit and equity in undistributed income of subsidiary
10,716

 
6,744

 
7,990

Income tax benefit
273

 
73

 
292

 
10,989

 
6,817

 
8,282

Equity in undistributed income of subsidiary
25,778

 
21,244

 
23,273

Net income
$
36,767

 
$
28,061

 
$
31,555



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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

CONDENSED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2018, 2017 and 2016
(Amounts In Thousands) 
 
2018
 
2017
 
2016
Cash flows from operating activities:
 
 
 
 
 
Net income
$
36,767

 
$
28,061

 
$
31,555

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

 
 

 
 

Equity in undistributed income of subsidiary
(25,778
)
 
(21,244
)
 
(23,273
)
Share-based compensation

 
11

 
29

Compensation expensed through issuance of common stock
1,466

 
1,446

 
1,078

Excess tax benefits related to share-based compensation

 

 
(70
)
Forfeiture of common stock
(152
)
 
(156
)
 
(52
)
Decrease (increase) in other assets
162

 
237

 
(8
)
Increase in other liabilities
574

 
3,212

 
103

Net cash and cash equivalents provided by operating activities
13,039

 
11,567

 
9,362

Cash flows from financing activities:
 

 
 

 
 

Issuance of common stock, net of costs
4,713

 
3,762

 

Stock options exercised
41

 
238

 

Excess tax benefits related to share-based compensation

 

 
70

Purchase of treasury stock
(6,784
)
 
(2,435
)
 
(3,926
)
Proceeds from the issuance of common stock through the employee stock purchase plan
421

 
325

 
254

Capital contribution to subsidiary
(4,700
)
 
(3,500
)
 

Dividends paid
(7,003
)
 
(6,485
)
 
(6,060
)
Net cash and cash equivalents used by financing activities
(13,312
)
 
(8,095
)
 
(9,662
)
(Decrease) increase in cash and cash equivalents
(273
)
 
3,472

 
(300
)
Cash and cash equivalents:
 

 
 

 
 

Beginning of year
4,015

 
543

 
843

Ending of year
$
3,742

 
$
4,015

 
$
543



Note 14.
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 $97.42 million.  The concentrations of credit by type of loan are set forth in Note 3 to the Consolidated Financial Statements.  Outstanding letters of credit were granted primarily to commercial borrowers.  Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the economic conditions in Johnson, Linn and Washington Counties, Iowa.

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

Financial instruments with off-balance sheet risk:  The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit, credit card participations and standby letters of credit.  These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 December 31, 2018 and 2017 is as follows:

 
2018
 
2017
 
(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
 
 
 
Home equity loans
$
59,330

 
$
55,171

Credit cards
52,802

 
49,235

Commercial, real estate and home construction
89,171

 
117,021

Commercial lines and real estate purchase loans
174,637

 
159,450

Outstanding letters of credit
9,033

 
9,113


Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The Bank evaluates each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the party.  Collateral held varies, but may include accounts receivable, crops, livestock, inventory, property and equipment, residential real estate and income-producing commercial properties.  Credit card commitments are the unused portion of the holders' credit limits.  Such amounts represent the maximum amount of additional unsecured borrowings.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements and, generally, have terms of one year or less.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.  The Bank holds collateral, which may include accounts receivable, inventory, property, equipment, and income-producing properties, supporting those commitments if deemed necessary.  In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Bank would be required to fund the commitment.  The maximum potential amount of future payments the Bank could be required to make is represented by the contractual amount shown in the summary above.  If the commitment is funded the Bank would be entitled to seek recovery from the customer.  At December 31, 2018 and 2017, no amounts have been recorded as liabilities for the Bank’s potential obligations under these guarantees.

Lease commitments: The Company leases certain facilities under operating leases.  The minimum future rental commitments as of December 31, 2018 for all non-cancelable leases relating to Bank premises were as follows:
Year ending December 31:
(Amounts In Thousands)
2019
$
464

2020
467

2021
371

2022
315

2023
308

Thereafter
80

 
$
2,005


Rent expense was $0.36 million, $0.37 million and $0.36 million for the years ended December 31, 2018, 2017 and 2016, respectively.


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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 15.
Quarterly Results of Operations (unaudited, amounts in thousands, except per share amounts)
 
Quarter Ended
 
March
 
June
 
September
 
December
 
Year
2018
 
 
 
 
 
 
 
 
 
Interest income
$
28,031

 
$
29,064

 
$
30,411

 
$
31,291

 
$
118,797

Interest expense
5,738

 
6,241

 
6,891

 
7,453

 
26,323

Net interest income
$
22,293

 
$
22,823

 
$
23,520

 
$
23,838

 
$
92,474

Provision for loan losses
(765
)
 
711

 
1,593

 
6,958

 
8,497

Other income
5,628

 
6,234

 
6,668

 
5,288

 
23,818

Other expense
15,256

 
15,680

 
15,955

 
15,232

 
62,123

Income before income taxes
$
13,430

 
$
12,666

 
$
12,640


$
6,936

 
$
45,672

Income taxes
2,572

 
2,603

 
2,590

 
1,140

 
8,905

Net income
$
10,858

 
$
10,063

 
$
10,050

 
$
5,796

 
$
36,767

Basic earnings per share
$
1.16

 
$
1.07

 
$
1.07

 
$
0.63

 
$
3.93

Diluted earnings per share
1.16

 
1.07

 
1.07

 
0.62

 
3.92

2017
 
 
 
 
 
 
 
 
 
Interest income
$
25,180

 
$
26,133

 
$
26,872

 
$
27,767

 
$
105,952

Interest expense
3,983

 
4,182

 
4,652

 
5,155

 
17,972

Net interest income
$
21,197

 
$
21,951

 
$
22,220

 
$
22,612

 
$
87,980

Provision for loan losses
(814
)
 
2,511

 
130

 
(139
)
 
1,688

Other income
5,241

 
5,001

 
5,005

 
5,571

 
20,818

Other expense
14,411

 
15,201

 
14,821

 
15,079

 
59,512

Income before income taxes
$
12,841

 
$
9,240

 
$
12,274

 
$
13,243

 
47,598

Income taxes
3,967

 
2,783

 
3,722

 
9,065

 
19,537

Net income
$
8,874

 
$
6,457

 
$
8,552

 
$
4,178

 
$
28,061

Basic earnings per share
$
0.95

 
$
0.69

 
$
0.92

 
$
0.45

 
$
3.01

Diluted earnings per share
0.95

 
0.69

 
0.92

 
0.45

 
3.01


Note 16.
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 consolidated financial statements and are measured at fair value.  The Bank’s objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates.  The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amount to be exchanged between the counterparties.  The Bank is exposed to credit risk in the event of nonperformance by counterparties to financial instruments.  The Bank minimizes this risk by entering into derivative contracts with large, stable financial institutions.  The Bank has not experienced any losses from nonperformance by counterparties.  The Bank monitors counterparty risk in accordance with the provisions of ASC 815.  In addition, the Bank’s interest rate-related derivative instruments contain language outlining collateral pledging requirements for each counterparty.  Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty.  The Bank was required to pledge $1.60 million of collateral as of December 31, 2018.


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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 December 31, 2018 and 2017
 
Notional
Amount
 
Fair Value
 
Balance
Sheet
Category
 
Maturity
 
(Amounts in Thousands)
 
 
December 31, 2018
 
 
 
 
 
 
    
Interest rate swap
$
25,000

 
$
(120
)
 
Other Liabilities
 
11/9/2020
Interest rate swap
25,000

 
(1,476
)
 
Other Liabilities
 
11/7/2023
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
    
Interest rate swap
$
25,000

 
$
(582
)
 
Other Liabilities
 
11/9/2020
Interest rate swap
25,000

 
(2,237
)
 
Other Liabilities
 
11/7/2023
 
The table below identifies the gains and losses recognized on the Bank’s derivative instruments designated as cash flow hedges for the years ended December 31, 2018 and 2017:

 
Effective Portion
 
Ineffective Portion
 
Recognized in OCI
 
Reclassified 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)
December 31, 2018
 
 
 
 
 
 
 
 
 
Interest rate swap
$
347

 
Interest Expense
 
$

 
Other Income
 
$

Interest rate swap
571

 
Interest Expense
 

 
Other Income
 

 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
Interest rate swap
$
318

 
Interest Expense
 
$

 
Other Income
 
$

Interest rate swap
373

 
Interest Expense
 

 
Other Income
 


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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 17.
Subsequent Events

In February 2019, the Company entered into a Letter of Intent to invest in a limited partnership, as limited partner, which will own and operate an affordable housing property in Iowa City, Iowa. The Company will provide construction financing for the project beginning in April 2019 and will contribute capital of $4.18 million upon construction completion which is anticipated to be in 2020.

Subsequent events have been evaluated through March 5, 2019.
Item 9.
Changes In and Disagreements with Accountants on Accounting and Financial Disclosure

None.
Item 9A.
Controls and Procedures

Disclosure Controls and Procedures

As of the end of the period covered by this report, 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) and Rule 15d-15(e) under the Securities Exchange Act of 1934).  Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective.

Management’s Report on Internal Control over Financial Reporting

The Company’s management is responsible for establishing and maintaining an adequate system of internal control over financial reporting (as defined in Rule 13a-15(f) and Rule 15d-15(f) under the Securities Exchange Act of 1934).  Internal control over financial reporting of the Company includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the Company’s consolidated financial statements.  Important features of the Company’s system of internal control over financial reporting include the adoption and implementation of written policies and procedures, careful selection and training of financial management personnel, a continuing management commitment to the integrity of the system and through examinations by an internal audit function that coordinates its activities with the Company’s Independent Registered Public Accounting Firm.

All internal control systems, no matter how well designed, have inherent limitations, including the possibility of human error and the circumvention of overriding controls.  Accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation.  Further, because of changes in conditions, the effectiveness of internal control may vary over time.

The Company’s management conducted an evaluation of the effectiveness of the Company’s internal controls over financial reporting as of December 31, 2018.  Management’s assessment is based on the criteria described in “Internal Control – Integrated Framework” issued in 2013 by the Committee of Sponsoring Organizations of the Treadway Commission.  Based on this assessment, the Company’s management concluded that the Company maintained effective internal control over financial reporting as of December 31, 2018.


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Attestation Report of the Registered Public Accounting Firm

The Company’s independent registered public accounting firm that audited the consolidated financial statements included in this annual report, has issued a report on the Company’s internal control over financial reporting as of December 31, 2018.  Reference is made to the Report of Independent Registered Public Accounting Firm included in this Annual Report.

Changes in Internal Control over Financial Reporting

There was no change in the Company’s internal control over financial reporting during the most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Item 9B.
Other Information

Not applicable.

PART III

Item 10.
Directors, Executive Officers and Corporate Governance

The information required by Item 10 of Part III is presented under the items entitled “Information Concerning Nominees for Election as Directors,” "Information Concerning Directors other than Nominees," "Corporate Governance and Board of Directors," and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s Definitive Proxy Statement dated March 15, 2019 for the Annual Meeting of Stockholders on April 15, 2019.  Such information is incorporated herein by reference.

The Company has a Code of Ethics in place for the Chief Executive Officer and Chief Financial Officer.  A copy of the Company’s Code of Ethics will be provided free of charge, upon written request to:

Shari DeMaris
Treasurer
Hills Bancorporation
131 Main Street
PO Box 160
Hills, Iowa  52235

Executive Officers of the Registrant
The executive officers of the Company and the Bank, along with their respective ages and positions held, are identified in the table below.
Name
Age
 Position
Company
 
 
Dwight O. Seegmiller
66
Mr. Seegmiller, who joined the Company in 1975, has served as its President since 1986.   Prior to 1986, Mr. Seegmiller was the Senior Vice President of Lending.
 
 
 
Shari J. DeMaris
49
Ms. DeMaris has held the position of Secretary, Treasurer and Principal Financial Officer since 2012.
 
 
 
Bank
 
 
Timothy D. Finer
57
Mr. Finer has held the position of Senior Vice President, Director of Real Estate Lending since 2005.
 
 
 
Steven R. Ropp
58
Mr. Ropp has held the position of Senior Vice President, Director of Commercial Banking since 2008.
 
 
 
Bradford C. Zuber
62
Mr. Zuber has held the position of Senior Vice President, Director of Trust Services since 1987.

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Item 11.
Executive Compensation

The information required by Item 11 of Part III is presented under the items entitled  “Compensation Discussion and Analysis,” “Summary of Cash and Certain Other Compensation Paid to the Named Executive Officers,” “Compensation and Incentive Stock Committee Interlocks and Certain other Transactions with Executive Officers and Directors,” "Schedule of Director Fees," "Director Compensation Table," and “Compensation and Incentive Stock Committee Report”  in the Company’s Definitive Proxy Statement dated March 15, 2019 for the Annual Meeting of Stockholders on April 15, 2019. Such information is incorporated herein by reference.

Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information required by Item 12 of Part III is presented under the item entitled “Security Ownership of Principal Stockholders and Management” in the Company’s Definitive Proxy Statement dated March 15, 2019 for the Annual Meeting of Stockholders on April 15, 2019.  Such information is incorporated herein by reference.

The following table sets forth information regarding the Company’s equity compensation plan as of December 31, 2018, all of which relates to stock options issued under stock option plans approved by stockholders of the Company.

 
 Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
Weighted-average
exercise price of
outstanding options,
warrants and rights
Number of securities
remaining available for future
issuance under equity
compensation plans
[excluding securities
reflected in column (a)]
Plan Category
(a)
(b)
(c)
Equity compensation plans approved by security holders
9,020

$
33.30

38,125

Equity compensation plans not approved by security holders



Total
9,020

$
33.30

38,125

 
Item 13.
Certain Relationships and Related Transactions, and Director Independence

The information required by Item 13 of Part III is presented under the items entitled “Corporate Governance and the Boards of Directors,” and “Compensation and Incentive Stock Committee Interlocks and Certain other Transactions with Executive Officers and Directors” in the Company’s Definitive Proxy Statement dated March 15, 2019 for the Annual Meeting of Stockholders on April 15, 2019. Such information is incorporated herein by reference.

Item 14.
Principal Accounting Fees and Services

Information required by this item is contained in the Company’s Definitive Proxy Statement dated March 15, 2019 for the Annual Meeting of Shareholders on April 15, 2019, under the heading “Audit Committee,” which information is incorporated herein by this reference.



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PART IV

Item 15.
Exhibits, Consolidated Financial Statement Schedules

 
 
 
 
 
 
 
 
Form 10-K
(a)
 
1
 
 
 
Financial Statements
 
Reference
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Independent registered public accounting firm's report on the financial statements
 
Page 51-53
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated balance sheets as of December 31, 2018 and 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated statements of income for the years ended December 31, 2018, 2017, and 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated statements of comprehensive income for the years ended December 31, 2018, 2017 and 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated statements of stockholders' equity for the years ended December 31, 2018, 2017 and 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated statements of cash flows for the years ended December 31, 2018, 2017 and 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Notes to consolidated financial statements
 
 
 
 
 
 
 
 
 
 
 
 
2
 
 
 
Financial Statements Schedules
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
All schedules are omitted because they are not applicable or not required, or because the required information is included in the consolidated financial statements or notes thereto.
 
 
 
 
 
 
 
 
 
 
 
(b)
 
3
 
 
 
Exhibits
 
 
 
 
 
 
 
 
 
 
 
 
 
3.1
 
 
 
Restated Articles of Incorporation filed as Exhibit 3.1 in Form 10-K for the year ended December 31, 2014 is incorporated by reference.
 
 
 
 
 
 
 
 
 
 
 
 
 
3.2
 
 
 
Amended and Restated ByLaws filed as Exhibit 3.2 in Form 10-K for the year ended December 31, 2014 is incorporated by reference.
 
 
 
 
 
 
 
 
 
 
 
 
 
10.1
 
 
 
1995 Deferred Compensation Plans filed as Exhibit 10(c) in Form 10-K for the year ended December 31, 1995 is incorporated by reference.
 
 
 
 
 
 
 
 
 
 
 
 
 
10.2
 
 
 
2010 Stock Option and Incentive Plan filed on Form S-8 dated June 29, 2012 is incorporated by reference.
 
 
 
 
 
 
 
 
 
 
 
 
 
10.3
 
 
 
Form of Stock Option Grant Agreement under the 2010 Stock Option and Incentive Plan is attached on Page 111.
 
 

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10.4
 
 
 
Form of Restricted Stock 5 Year Agreement under the 2010 Stock Option and Incentive Plan is attached on Page 117.
 
 
 
 
 
 
 
 
 
 
 
 
 
10.5
 
 
 
Form of Restricted Stock 8 Year Agreement under the 2010 Stock Option and Incentive Plan is attached on Page 124.
 
 
 
 
 
 
 
 
 
 
 
 
 
11
 
 
 
Statement Regarding Computation of Basic and Diluted Earnings Per Share. (Note:  Statement included in Note 1 under Item 8 of Part II above)
 
 
 
 
 
 
 
 
 
 
 
 
 
21
 
 
 
Subsidiary of the Registrant is attached on Page 131.
 
 
 
 
 
 
 
 
 
 
 
 
 
23.1
 
 
 
Consent of Independent Registered Public Accounting Firm is attached on Page 132. BKD LLP
 
 
 
 
 
 
 
 
 
 
 
 
 
31
 
 
 
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 on Pages 133-134.
 
 
 
 
 
 
 
 
 
 
 
 
 
32
 
 
 
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002 on Page 135.
 
 
 
 
 
 
 
 
 
 
 
 
 
101.INS
 
 
 
XBRL Instance Document
 
 
 
 
 
 
 
 
 
 
 
 
 
101.SCH
 
 
 
XBRL Taxonomy Extension Schema Document
 
 
 
 
 
 
 
 
 
 
 
 
 
101.CAL
 
 
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
 
 
 
 
 
 
 
 
 
 
 
101.LAB
 
 
 
XBRL Taxonomy Extension Label Linkbase Document
 
 
 
 
 
 
 
 
 
 
 
 
 
101.PRE
 
 
 
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
 
 
 
 
 
 
 
 
 
 
 
101.DED
 
 
 
XBRL Taxonomy Extension Definitions Linkbase Document
 
 


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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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:
March 5, 2019
By: /s/Dwight O. Seegmiller
 
 
 
Dwight O. Seegmiller, Director, President and Chief Executive Officer
 
 
 
 
 
Date:
March 5, 2019
By: /s/Shari DeMaris
 
 
 
Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer
 
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
 
 
 
DIRECTORS OF THE REGISTRANT
 
 
 
 
 
Date:
March 5, 2019
By: /s/Michael S. Donovan
 
 
 
Michael S. Donovan, Director
 
 
 
 
 
Date:
March 5, 2019
By: /s/Thomas J. Gill
 
 
 
Thomas J. Gill, Director
 
 
 
 
 
Date:
March 5, 2019
By: /s/Michael E. Hodge
 
 
 
Michael E. Hodge, Director
 
 
 
 
 
Date:
March 5, 2019
By: /s/Emily A. Hughes
 
 
 
Emily A. Hughes, Director
 
 
 
 
 
Date:
March 5, 2019
By: /s/James A. Nowak
 
 
 
James A. Nowak, Director
 
 
 
 
 
Date:
March 5, 2019
By: /s/Theodore H. Pacha
 
 
 
Theodore H. Pacha, Director
 
 
 
 
 
Date:
March 5, 2019
By: /s/John W. Phelan
 
 
 
John W. Phelan, Director
 
 
 
 
 
Date:
March 5, 2019
By: /s/Ann M. Rhodes
 
 
 
Ann M. Rhodes, Director
 
 
 
 
 
Date:
March 5, 2019
By: /s/Thomas R. Wiele
 
 
 
Thomas R. Wiele, Director
 
 
 
 
 
Date:
March 5, 2019
By: /s/Sheldon E. Yoder
 
 
 
Sheldon E. Yoder, Director
 



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HILLS BANCORPORATION
ANNUAL REPORT OF FORM 10-K FOR THE
FISCAL YEAR ENDED DECEMBER 31, 2018

 
 
Page Number
 
 
In The Sequential
Exhibit
 
Numbering System
Number
Description
For 2018 Form 10-K
 
 
 
10.3

 
 
 
10.4

 
 
 
10.5

 
 
 
11
Statement Re Computation of Basic and Diluted Earnings Per Share
 
 
(Note:  Statement included in Note 1 under Item 8 of Part II above)
 
 
 
 
21
 
 
 
23.1
 
 
 
31.1
 
 
 
31.2
 
 
 
32
 
 


Page 110