HILLS BANCORPORATION - Quarter Report: 2018 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2018

Commission file number: 0-12668

Hills Bancorporation



Incorporated in Iowa	I.R.S. Employer Identification
	No. 42-1208067

131 MAIN STREET, HILLS, IOWA 52235

Telephone number: (319) 679-2291

Indicate by checkmark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

þ Yes o No

Indicate by checkmark whether the Registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).

þ Yes o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.



Large accelerated filer o	Accelerated Filer þ
Non-accelerated filer o	Small Reporting Company o
Emerging Growth Company o

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

Indicate by checkmark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o Yes þ No

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APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date.



	SHARES OUTSTANDING
CLASS	July 31, 2018

Common Stock, no par value	9,352,074

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HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION



		Page
		Number

Item 1.	Financial Statements

	Consolidated balance sheets, June 30, 2018 (unaudited) and December 31, 2017	4
	Consolidated statements of income (unaudited) for three and six months ended June 30, 2018 and 2017	5
	Consolidated statements of comprehensive income (unaudited) for three and six months ended June 30, 2018 and 2017	6
	Consolidated statements of stockholders' equity (unaudited) for six months ended June 30, 2018 and 2017	7
	Consolidated statements of cash flows (unaudited) for six months ended June 30, 2018 and 2017	8
	Notes to consolidated financial statements (condensed)	10

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	52

Item 4.	Controls and Procedures	53

	Part II
	OTHER INFORMATION

Item 1.	Legal proceedings	53

Item 1A.	Risk factors	53

Item 2.	Unregistered sales of equity securities and use of proceeds	54

Item 3.	Defaults upon senior securities	54

Item 4.	Mine safety disclosures	54

Item 5.	Other information	54

Item 6.	Exhibits	55

	Signatures	56

	Exhibits Index	57

Page 3

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



	June 30, 2018			December 31, 2017
ASSETS	(Unaudited)			December 31, 2017
Cash and cash equivalents	$	148,231		$	154,353
Investment securities available for sale at fair value (amortized cost June 30, 2018 $292,170; December 31, 2017 $286,296)	288,501			285,155
Stock of Federal Home Loan Bank	12,173			15,005
Loans held for sale	5,757			5,162
Loans, net of allowance for loan losses (June 30, 2018 $29,510; December 31, 2017 $29,400)	2,474,291			2,431,165
Property and equipment, net	38,046			37,857
Tax credit real estate investment	9,425			10,076
Accrued interest receivable	11,047			10,772
Deferred income taxes, net	8,921			8,806
Goodwill	2,500			2,500
Other assets	4,063			2,509
Total Assets	$	3,002,955		$	2,963,360

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities
Noninterest-bearing deposits	$	386,020		$	363,817
Interest-bearing deposits	2,010,990			1,924,748
Total deposits	$	2,397,010		$	2,288,565
Federal Home Loan Bank borrowings	215,000			295,000
Accrued interest payable	1,506			1,290
Other liabilities	19,147			23,481
Total Liabilities	$	2,632,663		$	2,608,336

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	46,144		$	43,308

STOCKHOLDERS' EQUITY
Common stock, no par value; authorized 20,000,000 shares; issued June 30, 2018 10,321,836 shares; December 31, 2017 10,320,315 shares	$	—		$	—
Paid in capital	51,899			48,930
Retained earnings	356,003			341,558
Accumulated other comprehensive loss	(3,724		)	(2,446		)
Treasury stock at cost (June 30, 2018 948,170 shares; December 31, 2017 985,161 shares)	(33,886		)	(33,018		)
Total Stockholders' Equity	$	370,292		$	355,024
Less maximum cash obligation related to ESOP shares	46,144			43,308
Total Stockholders' Equity Less Maximum Cash Obligation Related to ESOP Shares	$	324,148		$	311,716
Total Liabilities & Stockholders' Equity	$	3,002,955		$	2,963,360

See Notes to Consolidated Financial Statements.

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HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Amounts In Thousands, Except Per Share Amounts)



	Three Months Ended June 30,				Six Months Ended June 30,
	2018		2017		2018			2017
Interest income:
Loans, including fees	$	26,968	$	24,845	$	52,996		$	48,735
Investment securities:
Taxable	682		407		1,245			800
Nontaxable	866		809		1,755			1,642
Federal funds sold	548		72		1,099			136
Total interest income	$	29,064	$	26,133	$	57,095		$	51,313
Interest expense:
Deposits	$	4,540	$	2,283	$	8,404		$	4,411
Short-term borrowings	—		27		—			49
FHLB borrowings	1,701		1,872		3,575			3,705
Total interest expense	$	6,241	$	4,182	$	11,979		$	8,165
Net interest income	$	22,823	$	21,951	$	45,116		$	43,148
Provision for loan losses	711		2,511		(54		)	1,697
Net interest income after provision for loan losses	$	22,112	$	19,440	$	45,170		$	41,451
Noninterest income:
Net gain on sale of loans	$	443	$	380	$	774		$	696
Trust fees	3,007		2,024		5,648			3,903
Service charges and fees	2,408		2,228		4,636			4,360
Other noninterest income	376		369		804			1,283
	$	6,234	$	5,001	$	11,862		$	10,242

Noninterest expenses:
Salaries and employee benefits	$	8,823	$	8,593	$	17,107		$	16,573
Occupancy	1,022		1,019		2,123			2,061
Furniture and equipment	1,490		1,436		2,964			2,865
Office supplies and postage	461		510		895			971
Advertising and business development	607		705		1,237			1,495
Outside services	2,347		1,858		4,925			3,866
FDIC insurance assessment	213		212		431			419
Other noninterest expense	717		868		1,254			1,362
	$	15,680	$	15,201	$	30,936		$	29,612
Income before income taxes	$	12,666	$	9,240	$	26,096		$	22,081
Income taxes	2,603		2,783		5,175			6,750
Net income	$	10,063	$	6,457	$	20,921		$	15,331

Earnings per share:
Basic	$	1.07	$	0.69	$	2.23		$	1.64
Diluted	$	1.07	$	0.69	$	2.23		$	1.64

See Notes to Consolidated Financial Statements.

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HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited) (Amounts In Thousands)



	Three Months Ended June 30,						Six Months Ended June 30,
	2018			2017			2018			2017
Net income	$	10,063		$	6,457		$	20,921		$	15,331

Other comprehensive income (loss)
Securities:
Net change in unrealized (loss) income on securities available for sale	$	(271	)	$	1,726		$	(2,528	)	$	3,099
Reclassification adjustment for net gains realized in net income	—			—			—			—
Income taxes	67			(660		)	630			(1,186		)
Other comprehensive (loss) income on securities available for sale	$	(204	)	$	1,066		$	(1,898	)	$	1,913
Derivatives used in cash flow hedging relationships:
Net change in unrealized income (loss) on derivatives	$	472		$	(134	)	$	1,526		$	215
Income taxes	(117		)	51			(380		)	(82		)
Other comprehensive income (loss) on cash flow hedges	$	355		$	(83	)	$	1,146		$	133

Other comprehensive income (loss), net of tax	$	151		$	983		$	(752	)	$	2,046

Comprehensive income	$	10,214		$	7,440		$	20,169		$	17,377

See Notes to Consolidated Financial Statements.

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



	Paid In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Unearned ESOP Shares		Treasury Stock			Maximum Cash Obligation Related To ESOP Shares			Total
Balance, December 31, 2016	$	44,606		$	319,982		$	(3,359	)	$	—	$	(31,178	)	$	(40,781	)	$	289,270
Issuance of 90,346 shares of common stock	4,139			—			—			—		4			—			4,143
Issuance of 2,402 shares of common stock under the employee stock purchase plan	113			—			—			—		—			—			113
Unearned restricted stock compensation	201			—			—			—		—			—			201
Forfeiture of 1,734 shares of common stock	(66		)															(66		)
Share-based compensation	97			—			—			—		—			—			97
Income tax benefit related to share-based compensation	—			—			—			—		—			—			—
Change related to ESOP shares	—			—			—			—		—			(1,266		)	(1,266		)
Net income	—			15,331			—			—		—			—			15,331
Cash dividends ($0.70 per share)	—			(6,486		)	—			—		—			—			(6,486		)
Purchase of 25,727 shares of common stock	—			—			—			—		(1,307		)	—			(1,307		)
Other comprehensive income	—			—			2,046			—		—			—			2,046
Balance, June 30, 2017	$	49,090		$	328,827		$	(1,313	)	$	—	$	(32,481	)	$	(42,047	)	$	302,076

Balance, December 31, 2017	$	48,930		$	341,558		$	(2,446	)	$	—	$	(33,018	)	$	(43,308	)	$	311,716
Issuance of 93,254 shares of common stock	2,721			—			—			—		2,331			—			5,052
Issuance of 4,283 shares of common stock under the employee stock purchase plan	214			—			—			—		—			—			214
Unearned restricted stock compensation	165			—			—			—		—			—			165
Forfeiture of 2,762 shares of common stock	(131		)	—			—			—		—			—			(131		)
Change related to ESOP shares	—			—			—			—		—			(2,836		)	(2,836		)
Net income	—			20,921			—			—		—			—			20,921
Cash dividends ($0.75 per share)	—			(7,002		)	—			—		—			—			(7,002		)
Reclassification of stranded tax effects due to the Tax Cuts and Jobs Act	—			526			(526		)	—		—			—			—
Purchase of 56,263 shares of common stock	—			—			—			—		(3,199		)	—			(3,199		)
Other comprehensive loss	—			—			(752		)	—		—			—			(752		)
Balance, June 30, 2018	$	51,899		$	356,003		$	(3,724	)	$	—	$	(33,886	)	$	(46,144	)	$	324,148

See Notes to Consolidated Financial Statements.

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



	Six Months Ended June 30,
	2018			2017
Cash Flows from Operating Activities
Net income	$	20,921		$	15,331
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation	1,642			1,514
Provision for loan losses	(54		)	1,697
Share-based compensation	—			97
Forfeiture of common stock	(131		)	(66		)
Compensation expensed through issuance of common stock	339			139
Provision for deferred income taxes	135			(1,412		)
Net gain on sale of other real estate owned and other repossessed assets	(6		)	(56		)
Increase in accrued interest receivable	(275		)	(726		)
Amortization of premium on investment securities, net	258			296
(Increase) decrease in other assets	(1,541		)	843
(Decrease) increase in accrued interest payable and other liabilities	(2,427		)	938
Loans originated for sale	(73,464		)	(65,166		)
Proceeds on sales of loans	73,643			68,762
Net gain on sales of loans	(774		)	(696		)
Net cash and cash equivalents provided by operating activities	$	18,266		$	21,495

Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	42,728		$	39,396
Purchases of investment securities available for sale	(46,028		)	(22,433		)
Loans made to customers, net of collections	(43,134		)	(93,045		)
Proceeds on sale of other real estate owned and other repossessed assets	55			239
Purchases of property and equipment	(1,831		)	(1,662		)
Income from tax credit real estate, net	651			286
Net cash and cash equivalents used in investing activities	$	(47,559	)	$	(77,219	)

Cash Flows from Financing Activities
Net increase in deposits	$	108,445		$	49,678
Net decrease in other borrowings	—			(21,213		)
Net (decrease) increase in FHLB borrowings	(80,000		)	30,000
Issuance of common stock, net of costs	4,713			3,766
Stock options exercised	—			238
Purchase of treasury stock	(3,199		)	(1,307		)
Proceeds from the issuance of common stock through the employee stock purchase plan	214			113
Dividends paid	(7,002		)	(6,486		)
Net cash and cash equivalents provided by financing activities	$	23,171		$	54,789

(Continued)

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

	Six Months Ended June 30,
	2018			2017
Decrease in cash and cash equivalents	$	(6,122	)	$	(935	)
Cash and cash equivalents:
Beginning of period	154,353			38,197
End of period	$	148,231		$	37,262

Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	8,188		$	4,420
Interest paid on other obligations	3,575			3,754
Income taxes paid	4,357			6,851

Noncash activities:
Increase in maximum cash obligation related to ESOP shares	$	2,836		$	1,266
Transfers to other real estate owned	62			80
Sale and financing of other real estate owned	—			262

See Notes to Consolidated Financial Statements.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


Note 1.	Summary of Significant Accounting Policies

Basis of Presentation:

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and with instructions for Form 10-Q and Regulation S-X. These financial statements include all adjustments (consisting of normal recurring accruals) which in the opinion of management are considered necessary for the fair presentation of the financial position and results of operations for the periods shown. Certain prior year amounts have been reclassified to conform to the current year presentation. The Company considers that it operates as one business segment, a commercial bank.

Operating results for the six month period ended June 30, 2018 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2018. For further information, refer to the consolidated financial statements and footnotes thereto included in the Form 10-K Annual Report of Hills Bancorporation and subsidiary (the “Company”) for the year ended December 31, 2017 filed with the Securities Exchange Commission on March 5, 2018. The consolidated balance sheet as of December 31, 2017, has been derived from the audited consolidated financial statements for that period.

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

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.

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.

Effect of New Financial Accounting Standards:

In May 2014, The FASB and International Accounting Standards Board (IASB) issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). The core principle of ASU 2014-09 is that a company should recognize revenue to depict the transfer of promised good or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. ASU 2014-09 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. The adoption of ASU 2014-09 by the Company did not have a material impact and required 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

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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 a change in disclosure and related methodology located in Note 6 Fair Value Measurements.

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

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 is in the process of implementing a software solution to assist in the analysis of historical loan data to determine the CECL model that will be implemented. We expect to recognize a one-time cumulative-effect adjustment to our allowance for loan losses as of the beginning of the first reporting period in which the new standard is adopted. The amount of the one-time cumulative-effect adjustment has not yet been determined.

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

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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.


Note 2.	Earnings Per Share

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

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



	Three Months Ended June 30,						Six Months Ended June 30,
	2018			2017			2018		2017
Common shares outstanding at the beginning of the period	9,378,414			9,337,397			9,335,154		9,264,227
Weighted average number of net shares (redeemed) issued	(4,470		)	(2,552		)	52,041		65,871
Weighted average shares outstanding (basic)	9,373,944			9,334,845			9,387,195		9,330,098
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method	4,162			4,551			3,996		5,299
Weighted average number of shares (diluted)	9,378,106			9,339,396			9,391,191		9,335,397
Net income (In thousands)	$	10,063		$	6,457		$	20,921	$	15,331
Earnings per share:
Basic	$	1.07		$	0.69		$	2.23	$	1.64
Diluted	$	1.07		$	0.69		$	2.23	$	1.64

Page 12

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 3.	Other Comprehensive Income (Loss)

The following table summarizes the balances of each component of accumulated other comprehensive income (AOCI), included in stockholders’ equity, at June 30, 2018 and December 31, 2017:



	June 30, 2018			December 31, 2017
	(amounts in thousands)
Net unrealized loss on available-for-sale securities	$	(3,669	)	$	(1,141	)
Net unrealized loss on derivatives used for cash flow hedges	(1,293		)	(2,819		)
Tax effect	$	1,238		$	1,514
Net-of-tax amount	$	(3,724	)	$	(2,446	)


Note 4.	Securities

The carrying values of investment securities at June 30, 2018 and December 31, 2017 are summarized in the following table (dollars in thousands):



	June 30, 2018				December 31, 2017
	Amount		Percent		Amount		Percent
Securities available for sale
U.S. Treasury	$	80,440	27.89	%	$	54,318	19.05	%
Other securities (FHLB, FHLMC and FNMA)	34,753		12.04		43,959		15.42
State and political subdivisions	173,308		60.07		186,878		65.53
Total securities available for sale	$	288,501	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. There were no trading or held to maturity securities as of June 30, 2018 or December 31, 2017. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of June 30, 2018 and December 31, 2017 (in thousands):



	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Estimated Fair Value
June 30, 2018:
U.S. Treasury	$	81,541	$	5	$	(1,106	)	$	80,440
Other securities (FHLB, FHLMC and FNMA)	35,426		—		(673		)	34,753
State and political subdivisions	175,203		239		(2,134		)	173,308
Total	$	292,170	$	244	$	(3,913	)	$	288,501
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

Page 13

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at June 30, 2018, were as follows (in thousands):



	Amortized Cost		Fair Value
Due in one year or less	$	44,049	$	43,970
Due after one year through five years	175,532		173,535
Due after five years through ten years	71,768		70,175
Due over ten years	821		821
Total	$	292,170	$	288,501

As of June 30, 2018 investment securities with a carrying value of $14.72 million were pledged to collateralize repurchase agreements, derivative financial instruments, and other borrowings.

The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2018 and December 31, 2017 (in thousands):



	Less than 12 months								12 months or more								Total
June 30, 2018 Description of Securities	#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
U.S. Treasury	32	$	77,979	$	(1,106	)	1.42	%	—	$	—	$	—		—	%	32	$	77,979	$	(1,106	)	1.42	%

Other securities (FHLB, FHLMC and FNMA)	5	12,386		(116		)	0.94		9	22,367		(557		)	2.49		14	34,753		(673		)	1.94

State and political subdivisions	377	95,078		(1,503		)	1.58		68	15,635		(631		)	4.04		445	110,713		(2,134		)	1.93

Total temporarily impaired securities	414	$	185,443	$	(2,725	)	1.47	%	77	$	38,002	$	(1,188	)	3.13	%	491	$	223,445	$	(3,913	)	1.75	%



	Less than 12 months								12 months or more								Total
December 31, 2017 Description of Securities	#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
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		)	—		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 the credit quality of any of the issues that might result in the non-collection of contractual principal and interest.

Page 14

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The unrealized losses are due to changes in interest rates. The Company has not recognized any unrealized loss in income because management does not have the intent to sell the securities included in the previous table. Management has concluded that it is more likely than not that the Company will not be required to sell these securities prior to recovery of the amortized cost basis.


Note 5.	Loans

Classes of loans are as follows:



	June 30, 2018		December 31, 2017
	(Amounts In Thousands)
Agricultural	$	81,171	$	88,580
Commercial and financial	219,693		218,632
Real estate:
Construction, 1 to 4 family residential	68,918		69,738
Construction, land development and commercial	115,452		109,595
Mortgage, farmland	227,124		215,286
Mortgage, 1 to 4 family first liens	862,818		831,591
Mortgage, 1 to 4 family junior liens	148,018		144,200
Mortgage, multi-family	318,244		336,810
Mortgage, commercial	380,862		361,196
Loans to individuals	26,607		26,417
Obligations of state and political subdivisions	53,965		57,626
	$	2,502,872	$	2,459,671
Net unamortized fees and costs	929		894
	$	2,503,801	$	2,460,565
Less allowance for loan losses	29,510		29,400
	$	2,474,291	$	2,431,165

Page 15

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the three and six months ended June 30, 2018 were as follows:



	Three Months Ended June 30, 2018
	Agricultural			Commercial and Financial			Real Estate: Construction and land development		Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,253		$	4,658		$	2,780	$	3,709		$	8,655		$	5,794		$	1,061		$	28,910
Charge-offs	(5		)	(176		)	—		—			(205		)	(53		)	(108		)	(547		)
Recoveries	17			193			2		19			147			13			45			436
Provision	(194		)	365			272		(253		)	305			(57		)	273			711

Ending balance	$	2,071		$	5,040		$	3,054	$	3,475		$	8,902		$	5,697		$	1,271		$	29,510



	Six Months Ended June 30, 2018
	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,294		$	4,837		$	2,989		$	3,669		$	8,668		$	5,700		$	1,243		$	29,400
Charge-offs	(5		)	(206		)	—			—			(326		)	(54		)	(223		)	(814		)
Recoveries	29			441			145			19			245			17			82			978
Provision	(247		)	(32		)	(80		)	(213		)	315			34			169			(54		)

Ending balance	$	2,071		$	5,040		$	3,054		$	3,475		$	8,902		$	5,697		$	1,271		$	29,510

Ending balance, individually evaluated for impairment	$	189		$	706		$	36		$	13		$	71		$	443		$	60		$	1,518

Ending balance, collectively evaluated for impairment	$	1,882		$	4,334		$	3,018		$	3,462		$	8,831		$	5,254		$	1,211		$	27,992

Loans:

Ending balance	$	81,171		$	219,693		$	184,370		$	227,124		$	1,010,836		$	699,106		$	80,572		$	2,502,872

Ending balance, individually evaluated for impairment	$	3,718		$	3,524		$	942		$	4,276		$	6,980		$	7,958		$	60		$	27,458

Ending balance, collectively evaluated for impairment	$	77,453		$	216,169		$	183,428		$	222,848		$	1,003,856		$	691,148		$	80,512		$	2,475,414

Page 16

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Changes in the allowance for loan losses for the three and six months ended June 30, 2017 were as follows:



	Three Months Ended June 30, 2017
	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,505		$	3,899		$	3,094		$	3,507	$	8,172		$	4,358		$	915		$	26,450
Charge-offs	(39		)	(237		)	(114		)	—		(63		)	(43		)	(110		)	(606		)
Recoveries	29			210			29			—		234			49			44			595
Provision	(154		)	714			156			502		(3		)	1,050			246			2,511

Ending balance	$	2,341		$	4,586		$	3,165		$	4,009	$	8,340		$	5,414		$	1,095		$	28,950



	Six Months Ended June 30, 2017
	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,947		$	4,531		$	2,890		$	3,417	$	7,677		$	4,045		$	1,023		$	26,530
Charge-offs	(39		)	(457		)	(114		)	—		(208		)	(43		)	(298		)	(1,159		)
Recoveries	67			664			410			—		367			229			145			1,882
Provision	(634		)	(152		)	(21		)	592		504			1,183			225			1,697

Ending balance	$	2,341		$	4,586		$	3,165		$	4,009	$	8,340		$	5,414		$	1,095		$	28,950

Ending balance, individually evaluated for impairment	$	447		$	908		$	33		$	814	$	56		$	889		$	95		$	3,242

Ending balance, collectively evaluated for impairment	$	1,894		$	3,678		$	3,132		$	3,195	$	8,284		$	4,525		$	1,000		$	25,708

Loans:

Ending balance	$	80,434		$	203,150		$	196,925		$	207,412	$	933,441		$	668,234		$	81,103		$	2,370,699

Ending balance, individually evaluated for impairment	$	5,052		$	2,405		$	690		$	8,111	$	5,540		$	8,313		$	95		$	30,206

Ending balance, collectively evaluated for impairment	$	75,382		$	200,745		$	196,235		$	199,301	$	927,901		$	659,921		$	81,008		$	2,340,493

Page 17

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The following table presents the credit quality indicators by type of loans in each category as of June 30, 2018 and December 31, 2017, respectively (amounts in thousands):



	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
June 30, 2018
Grade:
Excellent	$	3,493	$	2,467	$	—	$	398
Good	13,250		50,563		9,802		21,057
Satisfactory	40,896		119,579		41,096		42,916
Monitor	17,055		33,179		16,277		45,800
Special Mention	1,091		8,721		1,743		4,203
Substandard	5,386		5,184		—		1,078
Total	$	81,171	$	219,693	$	68,918	$	115,452



	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
June 30, 2018
Grade:
Excellent	$	3,780	$	2,407	$	529	$	22,575
Good	50,146		32,860		4,147		72,219
Satisfactory	119,995		715,151		134,934		172,536
Monitor	38,152		80,797		4,715		44,581
Special Mention	4,551		10,255		1,667		—
Substandard	10,500		21,348		2,026		6,333
Total	$	227,124	$	862,818	$	148,018	$	318,244



	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
June 30, 2018
Grade:
Excellent	$	35,486	$	—	$	8,457	$	79,592
Good	97,498		119		15,977		367,638
Satisfactory	184,328		25,551		26,058		1,623,040
Monitor	54,361		620		3,473		339,010
Special Mention	6,463		163		—		38,857
Substandard	2,726		154		—		54,735
Total	$	380,862	$	26,607	$	53,965	$	2,502,872

Page 18

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)



	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
December 31, 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
December 31, 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
December 31, 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 19

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The below are descriptions of the credit quality indicators:

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

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

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

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

Special Mention – Special mention rated loans are supported by a marginal payment capacity and are marginally protected by collateral. There are identified weaknesses that if not monitored and corrected may adversely affect the Company’s credit position. A special mention credit would typically have a weakness in one of the general categories (cash flow, collateral position or payment history) but not in all categories.

Substandard – Substandard loans are not adequately supported by the paying capacity of the borrower and may be inadequately collateralized. These loans have a well-defined weakness or weaknesses. For these loans, it is more probable than not that the Company could sustain some loss if the deficiency(ies) is not corrected.

Page 20

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Past due loans as of June 30, 2018 and December 31, 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)
June 30, 2018
Agricultural	$	1,003	$	—	$	195	$	1,198	$	79,973	$	81,171	$	—
Commercial and financial	484		860		64		1,408		218,285		219,693		—
Real estate:
Construction, 1 to 4 family residential	344		362		—		706		68,212		68,918		—
Construction, land development and commercial	4,295		59		—		4,354		111,098		115,452		—
Mortgage, farmland	242		—		516		758		226,366		227,124		516
Mortgage, 1 to 4 family first liens	1,087		1,227		2,930		5,244		857,574		862,818		430
Mortgage, 1 to 4 family junior liens	66		25		54		145		147,873		148,018		54
Mortgage, multi-family	665		—		28		693		317,551		318,244		—
Mortgage, commercial	1,875		351		144		2,370		378,492		380,862		—
Loans to individuals	101		98		—		199		26,408		26,607		—
Obligations of state and political subdivisions	—		—		—		—		53,965		53,965		—
	$	10,162	$	2,982	$	3,931	$	17,075	$	2,485,797	$	2,502,872	$	1,000

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

Page 21

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

Certain impaired loan information by loan type at June 30, 2018 and December 31, 2017, was as follows:



	June 30, 2018						December 31, 2017
	Non-accrual loans (1)		Accruing loans past due 90 days or more		TDR loans		Non- accrual loans (1)		Accruing loans past due 90 days or more		TDR loans
	(Amounts In Thousands)						(Amounts In Thousands)
Agricultural	$	1,483	$	—	$	90	$	1,651	$	—	$	2,309
Commercial and financial	497		—		1,974		825		—		1,943
Real estate:
Construction, 1 to 4 family residential	—		—		—		—		—		—
Construction, land development and commercial	—		—		333		—		—		339
Mortgage, farmland	1,174		516		4,541		1,391		—		1,451
Mortgage, 1 to 4 family first liens	4,645		430		1,940		4,407		971		1,357
Mortgage, 1 to 4 family junior liens	—		54		25		7		—		25
Mortgage, multi-family	183		—		—		218		—		—
Mortgage, commercial	652		—		1,023		597		—		1,046
	$	8,634	$	1,000	$	9,926	$	9,096	$	971	$	8,470


(1)	There were $3.31 million and $3.62 million of TDR loans included within nonaccrual loans as of June 30, 2018 and December 31, 2017, respectively.

Loans 90 days or more past due that are still accruing interest increased $0.29 million from December 31, 2017 to June 30, 2018 due to an increase in the average accruing balance of loans past due greater than 90 days. As of June 30, 2018 there were 7 accruing loans past due 90 days or more. The average accruing loans past due as of June 30, 2018 are $0.14 million. There were 8 accruing loans past due 90 days or more as of December 31, 2017 and the average loan balance was $0.12 million. The accruing loans past due 90 days or more balances are believed to be adequately collateralized and the Company expects to collect all principal and interest as contractually due under these loans.

The Company may modify the terms of a loan to maximize the collection of amounts due. Such a modification is considered a troubled debt restructuring (“TDR”). In most cases, the modification is either a reduction in interest rate, conversion to interest only payments or an extension of the maturity date. The borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term, so a concessionary modification is granted to the borrower that would otherwise not be considered. TDR loans accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance at a level commensurate with the modified terms over several payment cycles.

Page 22

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Below is a summary of information for TDR loans as of June 30, 2018 and December 31, 2017:



	June 30, 2018					December 31, 2017
	Number of contracts	Recorded investment		Commitments outstanding		Number of contracts	Recorded investment		Commitments outstanding
		(Amounts In Thousands)					(Amounts In Thousands)
Agricultural	5	$	1,369	$	1,002	9	$	3,628	$	321
Commercial and financial	13	2,318		78		14	2,575		169
Real estate:
Construction, 1 to 4 family residential	—	—		—		—	—		16
Construction, land development and commercial	2	333		—		2	339		—
Mortgage, farmland	8	5,641		—		7	2,761		—
Mortgage, 1 to 4 family first liens	18	2,019		—		13	1,442		—
Mortgage, 1 to 4 family junior liens	1	25		—		1	25		24
Mortgage, multi-family	—	—		—		—	—		—
Mortgage, commercial	9	1,532		—		8	1,324		—
Loans to individuals	—	—		—		—	—		—
	56	$	13,237	$	1,080	54	$	12,094	$	530

The following is a summary of TDR loans that were modified during the three and six months ended June 30, 2018:



	Three Months Ended June 30, 2018					Six Months Ended June 30, 2018
	Number of contracts	Pre-modification recorded investment		Post-modification recorded investment		Number of contracts	Pre-modification recorded investment		Post-modification recorded investment
		(Amounts In Thousands)					(Amounts In Thousands)
Agricultural	—	$	—	$	—	—	$	—	$	—
Commercial and financial	2	461		461		2	461		461
Real estate:
Construction, 1 to 4 family residential	—	—		—		—	—		—
Construction, land development and commercial	—	—		—		—	—		—
Mortgage, farmland	1	3,644		3,644		2	4,944		4,944
Mortgage, 1 to 4 family first lien	—	—		—		6	627		627
Mortgage, 1 to 4 family junior liens	—	—		—		—	—		—
Mortgage, multi-family	—	—		—		—	—		—
Mortgage, commercial	—	—		—		1	274		274
	3	$	4,105	$	4,105	11	$	6,306	$	6,306

Page 23

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The Company had commitments to lend $1.08 million in additional borrowings to restructured loan customers as of June 30, 2018. The Company had commitments to lend $0.53 million in additional borrowings to restructured loan customers as of December 31, 2017. These commitments were in the normal course of business. The additional borrowings were not used to facilitate payments on these loans.

There was one TDR loan that was in payment default (defined as past due 90 days or more) totaling $0.52 million during the period ended June 30, 2018 and none for the year ended December 31, 2017.

Page 24

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Information regarding impaired loans as of and for the three and six months ended June 30, 2018 is as follows:



	June 30, 2018						Three Months Ended June 30, 2018				Six Months Ended June 30, 2018
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	3,529	$	3,977	$	—	$	2,601	$	12	$	2,674	$	25
Commercial and financial	2,110		2,809		—		2,266		20		2,363		42
Real estate:
Construction, 1 to 4 family residential	111		148		—		112		1		113		3
Construction, land development and commercial	333		350		—		334		3		336		7
Mortgage, farmland	3,760		4,174		—		3,687		30		3,141		45
Mortgage, 1 to 4 family first liens	5,676		7,158		—		5,754		16		5,801		31
Mortgage, 1 to 4 family junior liens	—		258		—		—		—		—		—
Mortgage, multi-family	183		322		—		185		—		187		—
Mortgage, commercial	1,599		2,337		—		1,627		11		1,509		22
Loans to individuals	—		14		—		—		—		—		—
	$	17,301	$	21,547	$	—	$	16,566	$	93	$	16,124	$	175

With an allowance recorded:
Agricultural	$	189	$	189	$	189	$	194	$	3	$	95	$	3
Commercial and financial	1,414		1,512		706		1,446		17		1,572		39
Real estate:
Construction, 1 to 4 family residential	—		—		—		—		—		—		—
Construction, land development and commercial	498		498		36		498		6		501		11
Mortgage, farmland	516		516		13		525		6		525		12
Mortgage, 1 to 4 family first liens	1,226		1,288		68		1,231		11		1,246		22
Mortgage, 1 to 4 family junior liens	78		98		3		88		1		89		2
Mortgage, multi-family	6,099		6,099		442		6,134		69		6,139		138
Mortgage, commercial	77		77		1		77		1		78		2
Loans to individuals	60		60		60		62		2		71		4
	$	10,157	$	10,337	$	1,518	$	10,255	$	116	$	10,316	$	233

Total:
Agricultural	$	3,718	$	4,166	$	189	$	2,795	$	15	$	2,769	$	28
Commercial and financial	3,524		4,321		706		3,712		37		3,935		81
Real estate:
Construction, 1 to 4 family residential	111		148		—		112		1		113		3
Construction, land development and commercial	831		848		36		832		9		837		18
Mortgage, farmland	4,276		4,690		13		4,212		36		3,666		57
Mortgage, 1 to 4 family first liens	6,902		8,446		68		6,985		27		7,047		53
Mortgage, 1 to 4 family junior liens	78		356		3		88		1		89		2
Mortgage, multi-family	6,282		6,421		442		6,319		69		6,326		138
Mortgage, commercial	1,676		2,414		1		1,704		12		1,587		24
Loans to individuals	60		74		60		62		2		71		4
	$	27,458	$	31,884	$	1,518	$	26,821	$	209	$	26,440	$	408

Page 25

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Information regarding impaired loans as of December 31, 2017 is as follows:



	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	1,822	$	2,193	$	—
Commercial and financial	1,725		2,487		—
Real estate:
Construction, 1 to 4 family residential	114		150		—
Construction, land development and commercial	338		371		—
Mortgage, farmland	2,523		2,902		—
Mortgage, 1 to 4 family first liens	6,045		7,507		—
Mortgage, 1 to 4 family junior liens	7		482		—
Mortgage, multi-family	218		355		—
Mortgage, commercial	1,564		2,274		—
Loans to individuals	—		14		—
	$	14,356	$	18,735	$	—

With an allowance recorded:
Agricultural	$	3,094	$	3,149	$	133
Commercial and financial	1,043		1,043		1,018
Real estate:
Construction, 1 to 4 family residential	—		—		—
Construction, land development and commercial	505		505		39
Mortgage, farmland	5,439		5,439		238
Mortgage, 1 to 4 family first liens	577		593		63
Mortgage, 1 to 4 family junior liens	25		25		3
Mortgage, multi-family	6,179		6,179		480
Mortgage, commercial	79		79		2
Loans to individuals	190		190		190
	$	17,131	$	17,202	$	2,166

Total:
Agricultural	$	4,916	$	5,342	$	133
Commercial and financial	2,768		3,530		1,018
Real estate:
Construction, 1 to 4 family residential	114		150		—
Construction, land development and commercial	843		876		39
Mortgage, farmland	7,962		8,341		238
Mortgage, 1 to 4 family first liens	6,622		8,100		63
Mortgage, 1 to 4 family junior liens	32		507		3
Mortgage, multi-family	6,397		6,534		480
Mortgage, commercial	1,643		2,353		2
Loans to individuals	190		204		190
	$	31,487	$	35,937	$	2,166

Page 26

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Impaired loans decreased $4.03 million from December 31, 2017 to June 30, 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 Company expects to be unable to collect in full according to the contractual terms of the original loan agreement. Impaired loans were 1.10% of loans held for investment as of June 30, 2018 and 1.28% as of December 31, 2017. The decrease in impaired loans is due mainly to a decrease in nonaccrual loans of $0.46 million, a decrease of $6.97 million in relationships with a specific allowance for losses, and is offset by a $0.29 million increase in 90 days or more accruing loans, an increase in impaired loans without a specific allowance for losses of $2.95 million and an increase in TDR loans of $1.14 million from December 31, 2017 to June 30, 2018.

The Company regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans are impaired in accordance with ASC 310. If the loans are impaired, the Company determines if a specific allowance is appropriate. In addition, the Company's management also reviews and, where determined necessary, provides allowances for particular loans based upon (1) reviews of specific borrowers and (2) management’s assessment of areas that management considers are of higher credit risk, including loans that have been restructured. Loans that are determined not to be impaired and for which there are no specific allowances are classified into one or more risk categories. Based upon the risk category assigned, the Company allocates a percentage, as determined by management, for a required allowance needed. The determination of the appropriate percentage begins with historical loss experience factors, which are then adjusted for levels and trends in past due loans, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in restructured loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.

Specific allowances for losses on impaired loans are established if the loan balances exceed the net present value of the relevant future cash flows or the fair value of the relevant collateral based on updated appraisals and/or updated collateral analysis for the properties if the loan is collateral dependent. The Company may recognize a charge off or record a specific allowance related to an impaired loan if there is a collateral shortfall or it is unlikely the borrower can make all principal and interest payments as contractually due.

For loans that are collateral dependent, losses are evaluated based on the portion of a loan that exceeds the fair market value of the collateral. In general, this is the amount that the carrying value of the loan exceeds the related appraised value less estimated costs to sell the collateral. Generally, it is the Company’s policy not to rely on appraisals that are older than one year prior to the date the impairment is being measured. The most recent appraisal values may be adjusted if, in the Company’s judgment, experience and other market data indicate that the property’s value, use, condition, exit market or other variable affecting its value may have changed since the appraisal was performed, consistent with the December 2006 joint interagency guidance on the allowance for loan losses. The charge off or loss adjustment supported by an appraisal is considered the minimum charge off. Any adjustments made to the appraised value are to provide an additional charge off or specific reserve based on the applicable facts and circumstances. In instances where there is an estimated decline in value, a specific reserve may be provided or a charge off taken pending confirmation of the amount of the loss from an updated appraisal. Upon receipt of the new appraisals, an additional specific reserve may be provided or charge off taken based on the appraised value of the collateral. On average, appraisals are obtained within one month of order.

Page 27

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 6.	Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments as of June 30, 2018 are as follows:



	June 30, 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	$	148,231	$	148,231	$	148,231	$	—	$	—
Investment securities	300,674		300,674		—		300,674		—
Loans held for sale	5,757		5,757		—		—		5,757
Loans
Agricultural	79,100		80,756		—		—		80,756
Commercial and financial	214,653		214,189		—		—		214,189
Real estate:
Construction, 1 to 4 family residential	67,747		68,151		—		—		68,151
Construction, land development and commercial	113,569		113,063		—		—		113,063
Mortgage, farmland	223,649		223,300		—		—		223,300
Mortgage, 1 to 4 family first liens	856,158		858,840		—		—		858,840
Mortgage, 1 to 4 family junior liens	146,705		142,556		—		—		142,556
Mortgage, multi-family	315,624		307,750		—		—		307,750
Mortgage, commercial	377,785		369,529		—		—		369,529
Loans to individuals	25,768		26,485		—		—		26,485
Obligations of state and political subdivisions	53,533		50,459		—		—		50,459
Accrued interest receivable	11,047		11,047		—		11,047		—
Total financial instrument assets	$	2,940,000	$	2,920,787	$	148,231	$	311,721	$	2,460,835
Financial instrument liabilities
Deposits
Noninterest-bearing deposits	$	386,020	$	386,020	$	—	$	386,020	$	—
Interest-bearing deposits	2,010,990		2,013,572		—		2,013,572		—
Other borrowings	—		—		—		—		—
Federal Home Loan Bank borrowings	215,000		207,465		—		207,465		—
Interest rate swaps	1,293		1,293		—		1,293		—
Accrued interest payable	1,506		1,506		—		1,506		—
Total financial instrument liabilities	$	2,614,809	$	2,609,856	$	—	$	2,609,856	$	—

	Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	426,009	$	—	$	—	$	—	$	—
Letters of credit	10,418		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	436,427	$	—	$	—	$	—	$	—


(1)	Considered Level 1 under Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”).


(2)	Considered Level 2 under ASC 820.


(3)	Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

Page 28

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The carrying value and estimated fair values of the Company's financial instruments as of December 31, 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		—		300,160		—
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	$	154,353	$	316,094	$	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		—
Other borrowings	—		—		—		—		—
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 ASC 820.


(2)	Considered Level 2 under ASC 820.


(3)	Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

Page 29

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Fair value of financial instruments: FASB ASC 820, Fair Value Measurements and Disclosures (“ASC 820”) provides a single definition for fair value, a framework for measuring fair value and expanded disclosures concerning fair value. Fair value is defined under ASC 820 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

The Company determines the fair market value of its financial instruments based on the fair value hierarchy established in ASC 820. There are three levels of inputs that may be used to measure fair value as follows:



	Level 1	Quoted prices in active markets for identical assets or liabilities.



	Level 2	Observable inputs other than quoted prices included within Level 1. Observable inputs include the quoted prices for similar assets or liabilities in markets that are not active and inputs other than quoted prices that are observable for the asset or liability.



	Level 3	Unobservable inputs supported by little or no market activity for financial instruments. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. The Company is required to use observable inputs, to the extent available, in the fair value estimation process unless that data results from forced liquidations or distressed sales.

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value and for estimating fair value for assets or liabilities not recorded at fair value.

ASSETS

Cash and cash equivalents: The carrying amounts reported in the consolidated balance sheets for cash and short-term instruments approximate their fair values (Level 1).

Investment securities available for sale: Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If a quoted price is not available, the fair value is obtained from benchmarking the security against similar securities. All of the Company’s securities are considered Level 2.

The pricing for investment securities is obtained from an independent source. There are no Level 1 or Level 3 investment securities owned by the Company. The Company obtains an understanding of the independent source’s valuation methodologies used to determine fair value by level of security. The Company validates assigned fair values on a sample basis using an additional third-party provider pricing service to determine if the fair value measurement is reasonable. Due to the nature of our investment portfolio, we do not expect significant and unusual fluctuations as fair value changes primarily relate to interest rate changes. No unusual fluctuations were identified during the six months ended June 30, 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 is 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.

Page 30

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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 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.

Foreclosed assets: The Company does not record foreclosed assets at fair value on a recurring basis. Foreclosed assets consist mainly of other real estate owned but may include other types of assets repossessed by the Company. Foreclosed assets are adjusted to the lower of carrying value or fair value less the cost of disposal. Fair value is generally based upon independent market prices or appraised values of the collateral, and may include a marketability discount as deemed necessary by management based on its experience with similar types of real estate. The value of foreclosed assets is evaluated periodically as a nonrecurring fair value adjustment. Foreclosed assets are classified as Level 3.

Off-balance sheet instruments: Fair values for outstanding letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. The fair value of the outstanding letters of credit is not significant. Unfunded loan commitments are not valued since the loans are generally priced at market at the time of funding (Level 2).

Accrued interest receivable: The fair value of accrued interest receivable equals the amount receivable due to the current nature of the amounts receivable (Level 2).

Non-marketable equity investments: Non-marketable equity investments are recorded under the cost or equity method of accounting. There are generally restrictions on the sale and/or liquidation of these investments, including stock of the Federal Home Loan Bank. The carrying value of stock of the Federal Home Loan Bank approximates fair value (Level 2).

LIABILITIES

Deposit liabilities: Deposit liabilities are carried at historical cost. The fair value of demand deposits, savings accounts and certain money market account deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. If the fair value of the fixed maturity certificates of deposit is calculated at less than the carrying amount, the carrying value of these deposits is reported as the fair value (Level 2). Deposit liabilities are classified as Level 2 due to available prices for similar liabilities in the market.

Other borrowings: Other borrowings are carried at historical cost and include federal funds purchased and securities sold under agreements to repurchase. The carrying amount is a reasonable estimate of fair value because of the relatively short time between the origination of the liability and its expected realization (Level 2). Other borrowings are classified as Level 2 due to available prices for similar liabilities in the market.

Federal Home Loan Bank borrowings: Federal Home Loan Bank borrowings are recorded at historical cost. The fair values of the Company’s Federal Home Loan Bank borrowings are estimated using discounted cash flow analysis, based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements (Level 2). Federal Home Loan Bank borrowings are classified as Level 2 due to available prices for similar liabilities in the market.

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

Accrued interest payable: The fair value of accrued interest payable equals the amount payable due to the current nature of the amounts payable (Level 2).

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below represents the balances of assets and liabilities measured at fair value on a recurring basis:



	June 30, 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	$	—	$	80,440		$	—	$	80,440
State and political subdivisions	—		173,308			—		173,308
Other securities (FHLB, FHLMC and FNMA)	—		34,753			—		34,753
Derivative Financial Instruments
Interest rate swaps	$	—	(1,293		)	$	—	(1,293		)
Total	$	—	$	287,208		$	—	$	287,208



	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	$	—	$	282,336		$	—	$	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 six months ended June 30, 2018 and the year ended December 31, 2017.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The Company is required to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. The valuation methodologies used to measure these fair value adjustments are described above. The following tables present the Company’s assets that are measured at fair value on a nonrecurring basis.



	June 30, 2018								Three Months Ended June 30, 2018		Six Months Ended June 30, 2018
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses		Total Losses
	(Amounts in Thousands)
Loans (4)
Agricultural	$	—	$	—	$	1,499	$	1,499	$	53	$	63
Commercial and financial	—		—		2,227		2,227		78		136
Real Estate:											—
Construction, 1 to 4 family residential	—		—		—		—		—		—
Construction, land development and commercial	—		—		683		683		—		—
Mortgage, farmland	—		—		5,200		5,200		—		—
Mortgage, 1 to 4 family first liens	—		—		6,367		6,367		57		144
Mortgage, 1 to 4 family junior liens	—		—		25		25		46		60
Mortgage, multi-family	—		—		5,839		5,839		—		—
Mortgage, commercial	—		—		1,109		1,109		22		72
Loans to individuals	—		—		—		—		—		—
Foreclosed assets (5)	—		—		—		—		—		—
Total	$	—	$	—	$	22,949	$	22,949	$	256	$	475


(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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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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



	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	—		—		729		729		—
Construction, land development and commercial	—		—		—		—		—
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.


Note 7.	Stock Repurchase Program

On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 1,500,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2019. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors. The Company has purchased 1,066,181 shares of its common stock in privately negotiated transactions from August 1, 2005 through June 30, 2018. Of these 1,066,181 shares, 8,831 shares were purchased during the quarter ended June 30, 2018, at an average price per share of $57.36.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 8.	Commitments and Contingencies

Concentrations of credit risk: The Bank’s loans, commitments to extend credit, unused lines of credit and outstanding letters of credit have been granted to customers within the Bank's market area. Investments in securities issued by state and political subdivisions within the state of Iowa totaled approximately $74.69 million. The concentrations of credit by type of loan are set forth in Note 5 to the Consolidated Financial Statements. Outstanding letters of credit were granted primarily to commercial borrowers. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the economic conditions in Johnson, Linn and Washington Counties, Iowa.

Contingencies: In the normal course of business, the Company and Bank are involved in various legal proceedings. While the ultimate outcome of such legal proceedings cannot be predicted with certainty, after reviewing pending and threatened litigation with counsel, management believes at this time that the outcome of such litigation will not have a material adverse effect on the Company's business, financial condition or results of operations.

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

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments at June 30, 2018 and December 31, 2017 is as follows:



	June 30, 2018		December 31, 2017
	(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	60,215	$	55,171
Credit cards	52,126		49,235
Commercial, real estate and home construction	114,864		117,021
Commercial lines and real estate purchase loans	198,804		159,450
Outstanding letters of credit	10,418		9,113


Note 9.	Income Taxes

Federal income tax expense for the six months ended June 30, 2018 and 2017 was computed using the consolidated effective federal tax rate. The Company also recognized income tax expense pertaining to state franchise taxes payable individually by the subsidiary bank. The Company files a consolidated tax return for federal purposes and separate tax returns for State of Iowa purposes. The tax years ended December 31, 2017, 2016, and 2015 remain subject to examination by the Internal Revenue Service. For state tax purposes, the tax years ended December 31, 2017, 2016, and 2015 remain open for examination. There were no material unrecognized tax benefits at June 30, 2018 and December 31, 2017 and therefore no interest or penalties on unrecognized tax benefits has been recorded. As of June 30, 2018, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending June 30, 2019. Income taxes as a percentage of income before taxes were 19.83% for the six months ended June 30, 2018 and 30.57% for the same period 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.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 10.	Derivative Financial Instruments

In the normal course of business, the Bank may use derivative financial instruments to manage its interest rate risk. These instruments carry varying degrees of credit, interest rate and market or liquidity risks. Derivative instruments are recognized as either assets or liabilities in the accompanying financial statement and are measured at fair value. The Bank’s objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates. The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amount to be exchanged between the counterparties. The Bank is exposed to credit risk in the event of nonperformance by counterparties to financial instruments. The Bank minimizes this risk by entering into derivative contracts with large, stable financial institutions. The Bank has not experienced any losses from nonperformance by counterparties. The Bank monitors counterparty risk in accordance with the provisions of ASC 815. In addition, the Bank’s interest rate-related derivative instruments contain language outlining collateral pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty. The Bank was required to pledge $1.29 million of collateral as of June 30, 2018.

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 June 30, 2018 and December 31, 2017:



	Notional Amount		Fair Value			Balance Sheet Category	Maturity
	(Amounts in Thousands)
June 30, 2018
Interest rate swap	$	25,000	$	(67	)	Other Liabilities	11/9/2020
Interest rate swap	25,000		(1,226		)	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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The table below identifies the gains and losses recognized on the Bank’s derivative instruments designated as cash flow hedges for the six months ended June 30, 2018 and year ended December 31, 2017:



	Effective Portion					Ineffective Portion
	Recognized in OCI		Reclassifed from AOCI into Income			Recognized in Income on Derivatives
	Amount of Gain (Loss)		Category	Amount of Gain (Loss)		Category	Amount of Gain (Loss)
	(Amounts in Thousands)
June 30, 2018
Interest rate swap	$	387	Interest Expense	$	—	Other Income	$	—
Interest rate swap	759		Interest Expense	—		Other Income	—

December 31, 2017
Interest rate swap	$	318	Interest Expense	$	—	Other Income	$	—
Interest rate swap	373		Interest Expense	—		Other Income	—



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

The following is management’s discussion and analysis of the financial condition of Hills Bancorporation (“Hills Bancorporation” or “the Company”) and its banking subsidiary Hills Bank and Trust Company (“the Bank”) for the dates and periods indicated. The discussion and analysis should be read in conjunction with the consolidated financial statements and the accompanying footnotes.

Special Note Regarding Forward Looking Statements

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

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


•	The strength of the United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company’s assets.


•	The effects of recent financial market disruptions, and monetary and other governmental actions designed to address such disruptions.


•	The financial strength of the counterparties with which the Company or the Company’s customers do business and as to which the Company has investment or financial exposure.

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•	The credit quality and credit agency ratings of the securities in the Company’s investment securities portfolio, a deterioration or downgrade of which could lead to other-than-temporary impairment of the affected securities and the recognition of an impairment loss.


•	The effects of, and changes in, laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters as well as any laws otherwise affecting the Company.


•	The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.


•	The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.


•	The ability of the Company to obtain new customers and to retain existing customers.


•	The timely development and acceptance of products and services, including products and services offered through alternative electronic delivery channels.


•	Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers.


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


•	The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.


•	Consumer spending and saving habits which may change in a manner that affects the Company’s business adversely.


•	The economic impact of natural disasters, terrorist attacks and military actions.


•	Business combinations and the integration of acquired businesses and assets which may be more difficult or expensive than expected.


•	The costs, effects and outcomes of existing or future litigation.


•	Changes in accounting policies and practices that may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board.


•	The ability of the Company to manage the risks associated with the foregoing as well as anticipated.

These risks and uncertainties should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company’s financial results, is included in the Company’s filings with the Securities and Exchange Commission.

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Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these financial statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses. The Company's allowance for loan losses methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company's markets, including

economic conditions throughout the Midwest and the state of certain industries. Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position. Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations. Although management believes the levels of the allowance as of June 30, 2018 and December 31, 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.

Overview

This overview highlights selected information and may not contain all of the information that is important to you in understanding our performance during the period. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources, and critical accounting estimates, you should carefully read this entire report.

The Company is a holding company engaged in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids, Marion, and Washington, Iowa. At June 30, 2018, the Bank has nineteen full-service locations.

Net income for the six month period ended June 30, 2018 was $20.92 million compared to $15.33 million for the same six months of 2017, an increase of 36.46%. The $5.59 million increase in net income was caused by a number of factors. The principal factors in the increase in net income for the first six months of 2018 are an increase in net interest income of $1.97 million, an increase in noninterest income of $1.62 million, a decrease in income tax expense of $1.58 million, and a decrease in the provision for loan losses of $1.75 million. These changes were offset by an increase in noninterest expenses of $1.32 million.

The Company achieved a return on average assets of 1.17% and a return on average equity of 10.82% for the twelve months ended June 30, 2018, compared to the twelve months ended June 30, 2017, which were 1.19% and 10.82%, respectively. Dividends of $0.75 per share were paid in January 2018 to 2,481 shareholders. The 2017 dividend was $0.70 per share.

The Company’s net interest income is the largest component of revenue and it is primarily a function of the average earning assets and the net interest margin percentage. The Company achieved a net interest margin on a tax-equivalent basis of 3.26% for the six months ended June 30, 2018 compared to 3.46% for the same six months of 2017. Average earning assets were $2.879 billion year to date in 2018 and $2.594 billion in 2017.

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Highlights noted on the balance sheet as of June 30, 2018 for the Company included the following:


•	Total assets were $3.003 billion, an increase of $39.60 million since December 31, 2017.


•	Cash and cash equivalents were $148.23 million, an decrease of $6.12 million since December 31, 2017.


•	Net loans were $2.480 billion, an increase of $43.72 million since December 31, 2017. Loans held for sale increased $0.60 million since December 31, 2017.


•	Deposits increased $108.45 million since December 31, 2017.

Reference is made to Note 6 for a discussion of fair value measurements which relate to methods used by the Company in recording assets and liabilities on its financial statements.

Financial Condition

Loan demand is expected to remain steady throughout the year ending December 31, 2018 and into 2019. As indicated in the table below, growth is primarily in land development and commercial construction, farmland, mortgage 1 to 4 family first liens and commercial real estate loans.

The following table sets forth the composition of the loan portfolio as of June 30, 2018 and December 31, 2017:



	June 30, 2018				December 31, 2017
	Amount		Percent		Amount		Percent
	(Amounts In Thousands)				(Amounts In Thousands)
Agricultural	$	81,171	3.24	%	$	88,580	3.60	%
Commercial and financial	219,693		8.78		218,632		8.89
Real estate:
Construction, 1 to 4 family residential	68,918		2.75		69,738		2.84
Construction, land development and commercial	115,452		4.61		109,595		4.46
Mortgage, farmland	227,124		9.07		215,286		8.75
Mortgage, 1 to 4 family first liens	862,818		34.47		831,591		33.81
Mortgage, 1 to 4 family junior liens	148,018		5.91		144,200		5.86
Mortgage, multi-family	318,244		12.72		336,810		13.69
Mortgage, commercial	380,862		15.22		361,196		14.68
Loans to individuals	26,607		1.06		26,417		1.07
Obligations of state and political subdivisions	53,965		2.16		57,626		2.34
	$	2,502,872	100.00	%	$	2,459,671	100.00	%
Net unamortized fees and costs	929				894
	$	2,503,801			$	2,460,565
Less allowance for loan losses	29,510				29,400
	$	2,474,291			$	2,431,165

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The Bank has an established formal loan origination policy. In general, the loan origination policy attempts to reduce the risk of credit loss to the Bank by requiring, among other things, maintenance of minimum loan to value ratios, evidence of appropriate levels of insurance carried by borrowers and documentation of appropriate types and amounts of collateral and sources of expected payment. The collateral relied upon in the loan origination policy is generally the property being financed by the Bank. The source of expected payment is generally the income produced from the property being financed. Personal guarantees are required of individuals owning or controlling at least 20% of the ownership of an entity. Limited or proportional guarantees may be accepted in circumstances if approved by the Company’s Board of Directors. Financial information provided by the borrower is verified as considered necessary by reference to tax returns, or audited, reviewed or compiled financial statements. The Bank does not originate subprime loans. In order to modify, restructure or otherwise change the terms of a loan, the Bank’s policy is to evaluate each borrower situation individually. Modifications, restructures, extensions and other changes are done to improve the Bank’s position and to protect the Bank’s capital. If a borrower is not current with its payments, any additional loans to such borrowers are evaluated on an individual borrower basis.

The Company has not experienced any significant time lapses in recognizing the required provisions for collateral dependent loans, nor has the Company delayed appropriate charge offs. When an updated appraisal value has been obtained, the Company has used the appraisal amount in determining the appropriate charge off or required reserve. The Company also evaluates any changes in the financial condition of the borrower and guarantors (if applicable), economic conditions, and the Company’s loss experience with the type of property in question. Any information utilized in addition to the appraisal is intended to identify additional charge offs or provisions, not to override the appraised value.

In accordance with Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues, the Company determines and assigns ratings to loans using factors that include the following: an assessment of the financial condition of the borrower; a realistic determination of the value and adequacy of underlying collateral; the condition of the local economy and the condition of the specific industry of the borrower; an analysis of the levels and trends of loan categories; and a review of delinquent and classified loans.

Through the credit risk rating process, loans are reviewed to determine if they are performing in accordance with the original contractual terms. If the borrower has failed to comply with the original contractual terms, further action may be required by the Company, including a downgrade in the credit risk rating, movement to non-accrual status, a charge-off or the establishment of a specific impairment reserve. In the event a collateral shortfall is identified during the credit review process, the Company will work with the borrower for a principal reduction and/or a pledge of additional collateral and/or additional guarantees. In the event that these options are not available, the loan may be subject to a downgrade of the credit risk rating. If the Company determines a loan amount or portion thereof, is uncollectible, the loan’s credit risk rating may be downgraded and the uncollectible amount charged-off or recorded as a specific allowance for losses. The Bank’s credit and legal departments undertake a thorough and ongoing analysis to determine if additional impairment and/or charge-offs are appropriate and to begin a workout plan for the loan to minimize actual losses.

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The following table presents the allowance for loan losses on loans by loan category, the percentage of the allowance for each category to the total allowance, and the percentage of all loans in each category to total loans as of June 30, 2018 and December 31, 2017:



	June 30, 2018						December 31, 2017
	Amount		% of Total Allowance		% of Loans to Total Loans		Amount		% of Total Allowance		% of Loans to Total Loans
	(In Thousands)						(In Thousands)
Agricultural	$	2,071	7.02	%	3.24	%	$	2,294	7.80	%	3.60	%
Commercial and financial	5,040		17.08		8.78		4,837		16.45		8.89
Real estate:
Construction, 1 to 4 family residential	1,171		3.97		2.75		1,193		4.06		2.84
Construction, land development and commercial	1,883		6.38		4.61		1,796		6.11		4.46
Mortgage, farmland	3,475		11.78		9.07		3,669		12.48		8.75
Mortgage, 1 to 4 family first liens	7,589		25.73		34.47		7,369		25.07		33.81
Mortgage, 1 to 4 family junior liens	1,313		4.45		5.91		1,299		4.42		5.86
Mortgage, multi-family	2,620		8.88		12.72		2,791		9.49		13.69
Mortgage, commercial	3,077		10.43		15.22		2,909		9.89		14.68
Loans to individuals	839		2.84		1.06		782		2.66		1.07
Obligations of state and political subdivisions	432		1.45		2.16		461		1.57		2.34
	$	29,510	100.00	%	100.00	%	$	29,400	100.00	%	100.00	%

The allowance for loan losses totaled $29.51 million at June 30, 2018 compared to $29.40 million at December 31, 2017. The percentage of the allowance to outstanding loans was 1.18% and 1.20% at June 30, 2018 and December 31, 2017, respectively. The allowance was based on management’s consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks and the overall amount of loans outstanding. The increase in the allowance in 2018 is the result of change in the composition and allocation of loans within credit quality ratings and a slight increase in outstanding loan balances and net chargeoffs for the quarter.

The adequacy of the allowance is reviewed quarterly and adjusted as appropriate after consideration has been given to the impact of economic conditions on the borrowers’ ability to repay, loan collateral values, past collection experience, the risk characteristics of the loan portfolio and such other factors that deserve current recognition. The growth of the loan portfolio and the trends in problem and watch loans are significant elements in the determination of the provision for loan losses. Quantitative factors include the Company’s historical loss experience, which is then adjusted for levels and trends in past due, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in restructured loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.

Management has determined that the allowance for loan losses was appropriate at June 30, 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, well documented, and consistently applied analysis of the Company’s loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for loan losses is reviewed and compared to industry data. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.

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

Investment securities available for sale held by the Company increased by $3.35 million from December 31, 2017 to June 30, 2018. The fair value of securities available for sale was $3.67 million less than the amortized cost of such securities as of June 30, 2018. At December 31, 2017, the fair value of the securities available for sale was $1.14 million less than the amortized cost of such securities.

Deposits increased $108.45 million in the first six months of 2018. In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Brokered deposits are included in total deposits and totaled $118.85 million as of June 30, 2018 with an average rate of 2.02%. Brokered deposits were $284.41 million as of December 31, 2017 with an average interest rate of 1.35%. As of June 30, 2018 and December 31, 2017, brokered deposits were 4.96% and 12.43% of total deposits, respectively. Brokered deposits decreased as of June 30, 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.

Federal Home Loan Bank (FHLB) borrowings were $215 million and $295 million as of June 30, 2018 and December 31, 2017, respectively. The reduction of $80 million included a scheduled maturity of $20 million in the second quarter of 2018 and repayment of $60 million borrowed in 2017 to satisfy a short-term funding need. It is expected that the FHLB funding source 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 are favorable compared to other funding alternatives.

Dividends and Equity

In January 2018, Hills Bancorporation paid a dividend of $7.00 million or $0.75 per share. The dividend was $0.70 per share in January 2017. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of June 30, 2018 totaled $324.15 million. On January 1, 2015, the final rules of the Federal Reserve Board went into effect implementing in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision. The final rule also adopted changes to the agencies’ regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Under the BASEL III rules, the minimum capital ratios are 4% for Tier 1 Leverage Capital Ratio, 4.5% for the Common Equity Tier 1 Capital Ratio, 6% for the Tier 1 Risk-Based Capital Ratio and 8% for the Total Risk-Based Capital Ratio. A new capital conservation buffer is being phased in beginning January 1, 2016, at 0.625% of risk-weighted assets and increased each subsequent year by an additional 0.625% until reaching 2.5% on January 1, 2019. As of June 30, 2018 and December 31, 2017, the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements. The actual amounts and capital ratios as of June 30, 2018 and December 31, 2017 are presented below (amounts in thousands):

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	Actual				For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Ratio		Ratio
As of June 30, 2018:
Company:
Total risk-based capital	$	400,587	17.23	%	8.000	%	10.000	%
Tier 1 risk-based capital	371,516		15.98		6.000		8.000
Tier 1 common equity	371,516		15.98		4.500		6.500
Leverage ratio	371,516		12.48		4.000		5.000
Bank:
Total risk-based capital	401,489		17.28		8.000		10.000
Tier 1 risk-based capital	372,438		16.03		6.000		8.000
Tier 1 common equity	372,438		16.03		4.500		6.500
Leverage ratio	372,438		12.52		4.000		5.000



	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

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Discussion of operations for the six months ended June 30, 2018 and 2017

Net Income Overview

Net income increased $5.59 million for the six months ended June 30, 2018 compared to the first six months of 2017. Total net income was $20.92 million in 2018 and $15.33 million in the comparable period in 2017, an increase of 36.46%. The changes in net income in 2018 from the first six months of 2017 were primarily the result of the following:


•	Net interest income increased by $1.97 million, before provision expense. Total interest income increased by $5.78 million as a result of growth in the volume of earning assets.


•	The provision for loan losses decreased by $1.75 million.


•	Noninterest income increased by $1.62 million.


•	Noninterest expenses increased by $1.32 million.


•	Income tax expense decreased by $1.58 million.

For the six month period ended June 30, 2018 and June 30, 2017 basic earnings per share was $2.23 and $1.64, respectively. Diluted earnings per share was $2.23 for the six months ended June 30, 2018 compared to $1.64 for the same period in 2017.

The Company’s net income continues to be driven primarily by three important factors. The first important factor is the interaction between changes in net interest margin and changes in average volumes of the Bank's earnings assets. Net interest income of $45.12 million for the first six months of 2018 was derived from the Company’s $2.879 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.26%. Average earning assets in the six months ended June 30, 2017 were $2.594 billion and the tax-equivalent net interest margin was 3.46%. The importance of net interest margin is illustrated by the fact that an increase or decrease in the net interest margin of 10 basis points would have resulted approximately in a $1.44 million change in income before income taxes in the six month period ended June 30, 2018. Net interest income for the Company increased primarily as a result of growth in the volume of earning assets. The Company expects net interest compression to impact earnings for the foreseeable future. The Company believes growth in net interest income will be contingent on the growth of the Company’s earnings assets.

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $2.480 billion at June 30, 2018. The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historically higher credit risk. The provision for loan losses was a reduction of expense of $0.54 million in 2018 compared to an expense of $1.70 million in 2017. The Company believes that the provision for loan losses may increase for the foreseeable future resulting from projected increases in the size of the Company’s loan portfolio.

The third significant factor affecting the Company’s net income is income tax expense. Federal and state income tax expenses were $5.18 million and $6.75 million for the six months ended June 30, 2018 and 2017, respectively. Income taxes as a percentage of income before taxes were 19.83% in 2018 and 30.57% 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.

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Discussion of operations for the six months ended June 30, 2018 and 2017

Net Interest Income

Net interest income increased for the six months ended June 30, 2018 compared to the comparable period in 2017. The increase was as a result of growth in the average volume of earning assets. Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the average volume of earning assets for the period and the net interest margin. The net interest margin for the first six months of 2018 was 3.26% compared to 3.46% in 2017 for the same period. Interest expense increased $3.81 million for the six months ended June 30, 2018 compared to the six months ended June 30, 2017 primarily due to increasing interest rates on deposits. The measure is shown on a tax-equivalent basis using a tax rate of 21% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the six months ended in 2018 compared to the comparable period in 2017 are shown in the following table:



						Increase (Decrease) in Net Interest Income
	Change in Average Balance			Change in Average Rate		Volume Changes			Rate Changes			Net Change
	(Amounts in Thousands)
Interest income:
Loans, net	$	151,981		0.08	%	$	3,291		$	997		$	4,288
Taxable securities	20,531			0.45		168			277			445
Nontaxable securities	10,141			0.04		147			31			178
Federal funds sold	102,980			0.73		487			476			963
	$	285,633				$	4,093		$	1,781		$	5,874

Interest expense:
Interest-bearing demand deposits	$	122,124		0.39	%	$	(100	)	$	(1,246	)	$	(1,346	)
Savings deposits	53,774			0.32		(108		)	(1,276		)	(1,384		)
Time deposits	77,974			0.30		(495		)	(768		)	(1,263		)
Other borrowings	—			—		—			—			—
FHLB borrowings	4,634			(0.17	)	(73		)	203			130
Interest-bearing other liabilities	(29,015		)	1.69		49			—			49
	$	229,491				$	(727	)	$	(3,087	)	$	(3,814	)
Change in net interest income						$	3,366		$	(1,306	)	$	2,060

Rate/volume variances are allocated on a consistent basis using the absolute values of changes in volume compared to the absolute values of the changes in rates. Loan fees included in interest income are not material. Interest on nontaxable securities and loans is shown on a tax-equivalent basis.

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



(Tax Equivalent Basis)	2018		2017
Yield on average interest-earning assets	4.10	%	4.09	%
Rate on average interest-bearing liabilities	1.08		0.82
Net interest spread	3.02	%	3.27	%
Effect of noninterest-bearing funds	0.24		0.19
Net interest margin (tax equivalent interest income divided by average interest-earning assets)	3.26	%	3.46	%

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Discussion of operations for the six months ended June 30, 2018 and 2017

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. The Federal Open Market Committee met three times during the first six months of 2018. The target rate was increased in June, 2018 to 2.00%. Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate. As of June 30, 2018, the rate indexes for the one, three and five year indexes were 2.33%, 2.63% and 2.73%, respectively. The one year index increased 87.90% from 1.24% at June 30, 2017, the three year index increased 69.68% and the five year index increased 44.44%. The three year index was 1.55% and the five year index was 1.89% at June 30, 2017. The targeted federal funds rate was 2.00% and 1.25% at June 30, 2018 and 2017, respectively. The Company anticipates possible increases in short term and long term rates in the indexes for 2018.

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $0.54 million for the six months ended June 30, 2018 compared to an expense of $1.70 million in 2017, a reduction of expense of $1.75 million. The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio. The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks. The decrease in expense in 2018 is the net result of the reduction of specific allowances for 3 loan relationships by $2.26 million and a change in the composition and allocation of loans within credit quality ratings as compared to June 30, 2017.

The allowance for loan losses increased $0.11 million during the first six months of 2018 as compared to December 31, 2017. In the first six months of 2018, there was a increase of $0.30 million due to increases in average balances and composition of loans outstanding and a $0.19 million decrease in the amount allocated to the allowance due to improvements in credit quality.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the six months ended June 30, 2018 and 2017, recoveries were $0.98 million and $1.88 million, respectively; and charge-offs were $0.81 million in 2018 and $1.16 million in 2017. The allowance for loan losses totaled $29.51 million at June 30, 2018 compared to $29.40 million at December 31, 2017. The allowance represented 1.18% and 1.20% of loans held for investment at June 30, 2018 and December 31, 2017.

Noninterest Income

The following table sets forth the various categories of noninterest income for the six months ended June 30, 2018 and 2017.



	Six Months Ended June 30,
	2018		2017		$ Change			% Change
	(Amounts in thousands)
Net gain on sale of loans	$	774	$	696	$	78		11.21	%
Trust fees	5,648		3,903		1,745			44.71
Service charges and fees	4,636		4,360		276			6.33
Other noninterest income	804		1,283		(479		)	(37.33	)
	$	11,862	$	10,242	$	1,620		15.82

The $1.75 million increase in trust fees results from growth in trust assets under management. As of June 30, 2018 trust assets under management were $1.696 billion compared to $1.515 billion as of June 30, 2017.

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Discussion of operations for the six months ended June 30, 2018 and 2017

Loans originated for sale in the first six months of 2018 totaled $73.46 million compared to $65.17 million in the same period in 2017, an increase of 12.72%. In the six months ended June 30, 2018 and 2017, the net gain on sale of loans was $0.77 million and $0.70 million, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income. The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the six months ended June 30, 2018 and 2017.



	Six Months Ended June 30,
	2018		2017		$ Change			% Change
	(Amounts in thousands)
Salaries and employee benefits	$	17,107	$	16,573	$	534		3.22	%
Occupancy	2,123		2,061		62			3.01
Furniture and equipment	2,964		2,865		99			3.46
Office supplies and postage	895		971		(76		)	(7.83	)
Advertising and business development	1,237		1,495		(258		)	(17.26	)
Outside services	4,925		3,866		1,059			27.39
FDIC insurance assessment	431		419		12			2.86
Other noninterest expense	1,254		1,362		(108		)	(7.93	)
	$	30,936	$	29,612	$	1,324		4.47

In the six months ended June 30, 2018 and 2017, salaries and employee benefits expense increased $0.53 million. The increase is primarily the result of annual salary adjustments and hiring of additional employees to staff growth.

Advertising and business development expense decreased $0.26 million for the six months ended June 30, 2018 compared to June 30, 2017 primarily due to discontinuation of a debit card reward program and decreased television advertising.

Outside services increased $1.06 for the six months ended June 30, 2018 due to outsourcing services previously managed by the Company.

Other noninterest expense categories experienced marginal period-to-period fluctuations for the six months ended June 30, 2018.

Discussion of operations for the three months ended June 30, 2018 and 2017

Net Income Overview

Net income increased $3.61 million for the three months ended June 30, 2018 compared to the same period in 2017. Total net income was $10.06 million in 2018 and $6.46 million in the comparable period in 2017, an increase of 55.85%. For the three month period ended June 30, 2018 and June 30, 2017 basic earning per share was $1.07 and $0.69, respectively. Diluted earnings per share was $1.07 for the three months ended June 30, 2018 compared to $0.69 for the same period in 2017.

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Discussion of operations for the three months ended June 30, 2018 and 2017

Net Interest Income

Net interest income increased for the three months ended June 30, 2018 compared to the comparable period in 2017. The increase was primarily the result of growth in the volume of earning assets. Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. Interest expense increased $2.06 million for the three months ended June 30, 2018 compared to the three months ended June 30, 2017 primarily due to increasing interest rates on deposits.The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin. The net interest margin for the three months ended June 30, 2018 was 3.28% compared to 3.47% in 2017 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 21% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2018 compared to the comparable period in 2017 are shown in the following table:



						Increase (Decrease) in Net Interest Income
	Change in Average Balance			Change in Average Rate		Volume Changes			Rate Changes			Net Change
	(Amounts in Thousands)
Interest income:
Loans, net	$	137,340		0.11	%	$	1,507		$	627		$	2,134
Taxable securities	24,639			0.53		98			177			275
Nontaxable securities	11,386			0.03		85			7			92
Federal funds sold	94,381			0.78		239			237			476
	$	267,746				$	1,929		$	1,048		$	2,977

Interest expense:
Interest-bearing demand deposits	$	99,045		0.41	%	$	(43	)	$	(653	)	$	(696	)
Savings deposits	55,186			0.37		(64		)	(744		)	(808		)
Time deposits	91,074			0.36		(291		)	(462		)	(753		)
Short-term borrowings	—			—		—			—			—
FHLB borrowings	(11,607		)	(0.14	)	91			80			171
Interest-bearing other liabilities	(24,166		)	2.10		27			—			27
	$	209,532				$	(280	)	$	(1,779	)	$	(2,059	)
Change in net interest income						$	1,649		$	(731	)	$	918

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



(Tax Equivalent Basis)	2018		2017
Yield on average interest-earning assets	4.14	%	4.11	%
Rate on average interest-bearing liabilities	1.12		0.83
Net interest spread	3.02	%	3.28	%
Effect of noninterest-bearing funds	0.26		0.19
Net interest margin (tax equivalent interest income divided by average interest-earning assets)	3.28	%	3.47	%

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Discussion of operations for the three months ended June 30, 2018 and 2017

Provision for Loan Losses

The provision for loan losses was an expense of $0.71 million for the three months ended June 30, 2018 compared to an expense of $2.51 million in 2017, an expense decrease of $1.80 million. The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio. The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks. The decrease in expense in 2018 is the net result of the reduction of specific allowances for 3 loan relationships by $2.26 million and a change in the composition and allocation of loans within credit quality ratings as compared to June 30, 2017.

The allowance for loan losses increased $0.60 million during the three months ended June 30, 2018 compared to March 31, 2018. In the three months ended June 30, 2018, there was a $0.17 million increase in the amount allocated to the allowance due to credit quality and a $0.43 million increase due to the composition of loans outstanding.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the three months ended June 30, 2018 and 2017, recoveries were $0.44 million and $0.60 million, respectively; and charge-offs were $0.55 million in 2018 and $0.61 million in 2017. The allowance for loan losses totaled $29.51 million at June 30, 2018 compared to $29.40 million at December 31, 2017. The allowance represented 1.18% and 1.20% of loans held for investment at June 30, 2018 and December 31, 2017, respectively.

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended June 30, 2018 and 2017.



	Three Months Ended June 30,
	2018		2017		$ Change		% Change
	(Amounts in thousands)
Net gain on sale of loans	$	443	$	380	$	63	16.58	%
Trust fees	3,007		2,024		983		48.57
Service charges and fees	2,408		2,228		180		8.08
Other noninterest income	376		369		7		1.90
	$	6,234	$	5,001	$	1,233	24.66

In the three months ended June 30, 2018 and 2017, the net gain on sale of loans was $0.44 million and $0.38 million , respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income. The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

Trust fees increased $0.98 million in the three months ended June 30, 2018 compared to June 30, 2017 due to growth in trust assets under management. As of June 30, 2018 trust assets under management were $1.696 billion compared to $1.515 billion as of June 30, 2017.

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Discussion of operations for the three months ended June 30, 2018 and 2017

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended June 30, 2018 and 2017.



	Three Months Ended June 30,
	2018		2017		$ Change			% Change
	(Amounts in thousands)
Salaries and employee benefits	$	8,823	$	8,593	$	230		2.68	%
Occupancy	1,022		1,019		3			0.29
Furniture and equipment	1,490		1,436		54			3.76
Office supplies and postage	461		510		(49		)	(10	)
Advertising and business development	607		705		(98		)	(13.90	)
Outside services	2,347		1,858		489			26.32
FDIC insurance assessment	213		212		1			0.47
Other noninterest expense	717		868		(151		)	(17.40	)
	$	15,680	$	15,201	$	479		3.15

In the three months ended June 30, 2018 and 2017, salaries and employee benefits expense increased $0.23 million. The increase is primarily the result of annual salary adjustments and hiring of additional employees to staff branch growth. Outside business services increased $0.49 million for the three months ended June 30, 2018 due to outsourcing services previously managed by the Company. Other noninterest expense categories experienced marginal period-to-period fluctuations for the three months ended June 30, 2018.

Income Taxes

Federal and state income tax expenses were $2.60 million and $2.78 million for the three months ended June 30, 2018 and 2017, respectively. Income taxes as a percentage of income before taxes were 20.55% in 2018 and 30.12% 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 makes broad and complex changes to the U.S. tax code that affects 2017, including, but not limited to, accelerated depreciation that will allow for full expensing of qualified property. The Tax Act also established new tax laws that reduced the U.S. federal corporate income tax rate from 35% to 21%. in 2018. The decrease in the corporation income tax rate was the primary factor in the reduction of federal income tax expense for the three months ended June 30, 2018.

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Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs. Federal funds sold and investment securities available for sale are readily marketable assets. Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position. Investment securities available for sale comprised 9.61% of the Company’s total assets at June 30, 2018 compared to 9.62% at December 31, 2017.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position. As of June 30, 2018, the Company had borrowed $215.00 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. Advances are used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk. The Company had additional borrowing capacity available from the FHLB of approximately $625.99 million at June 30, 2018.

As additional sources of liquidity, the Company has the ability to borrow up to $10.00 million from the Federal Reserve Bank of Chicago, and has lines of credit with three banks totaling $427.44 million. The borrowings under these credit lines would be secured by the Bank’s investment securities. The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at June 30, 2018.

As of June 30, 2018, investment securities with a carrying value of $14.72 million were pledged to collateralize public and trust deposits, derivative financial instruments, and other borrowings. As of December 31, 2017, investment securities with a carrying value of $14.85 million were pledged.

Contractual Obligations

There have been no material changes with regard to contractual obligations disclosed in the Company’s Form 10-K for the year ended December 31, 2017.



Item 3.	Quantitative and Qualitative Disclosures about Market Risk

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

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

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HILLS BANCORPORATION

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

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

The Bank's interest rate risk, as monitored by management, has not changed materially from December 31, 2017.



Item 4.	Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission. There have been no changes in the Company’s internal controls over financial reporting during the six months ended June 30, 2018 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

HILLS BANCORPORATION

PART II - OTHER INFORMATION



Item 1.	Legal Proceedings

None



Item 1A.	Risk Factors

There have been no material changes from the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2017.

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Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds

The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended June 30, 2018:



Period	Total number of shares purchased	Average price paid per share		Total number of shares purchased as part of publicly announced plans or programs	Maximum number of shares that may yet be purchased under the plans or programs (1)
April 1 to April 30	4,650	$	57.00	4,650	438,001
May 1 to May 31	4,043	57.75		4,043	433,958
June 1 to June 30	138	58.00		138	433,820
Total	8,831	$	57.36	8,831	433,820

(1) On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 1,500,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2019. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.



Item 3.	Defaults upon Senior Securities

Hills Bancorporation has no senior securities.



Item 4.	Mine Safety Disclosure

Not applicable.



Item 5.	Other Information

None

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Item 6.	Exhibits



3.1	Restated Articles of Incorporation, incorporated by reference to Exhibit 3.1 to the Company's Form 10-Q Filed with the Commission on May 6, 2015.
3.2	Amended and Restated Bylaws, incorporated by reference to Exhibit 3.2 to the Company's Form 10-K Filed with the Commission on March 11, 2015.
31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
101.INS	XBRL Instance Document (1)
101.SCH	XBRL Taxonomy Extension Schema Document (1)
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document (1)
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document (1)
101.LAB	XBRL Taxonomy Extension Label Linkbase Document (1)
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document (1)


(1)	Users of this data are advised that, pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934, and are otherwise not subject to liability under these sections.

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SIGNATURES

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



		HILLS BANCORPORATION

Date:	August 3, 2018	By: /s/ Dwight O. Seegmiller
		Dwight O. Seegmiller, Director, President and Chief Executive Officer

Date:	August 3, 2018	By: /s/ Shari DeMaris
		Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer

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HILLS BANCORPORATION

QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED JUNE 30, 2018



Exhibit Number	Description	Page Number In The Sequential Numbering System June 30, 2018 Form 10-Q

31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	58-59

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	60

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