HILLS BANCORPORATION - Quarter Report: 2019 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q



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

For the quarterly period ended September 30, 2019



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

For the transition period from ___________ to ___________

Commission file number: 0-12668

Hills Bancorporation



(State or other jurisdiction of incorporation or organization)	I.R.S. Employer Identification No.
Iowa	42-1208067

131 MAIN STREET, HILLS, Iowa 52235

Telephone number: (319) 679-2291

Securities registered pursuant to Section 12(b) of the Act:



Title of each class	Trading Symbol(s)	Name of each exchange on which registered

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. ☑ Yes ☐ No

Indicate by checkmark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit such files). ☑ Yes ☐ 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	☐	Accelerated Filer	☑
Non-accelerated filer	☐	Small Reporting Company	☐
Emerging Growth Company	☐

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. ☐

Indicate by checkmark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes ☑ No

Index

APPLICABLE ONLY TO CORPORATE ISSUERS:

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



		SHARES OUTSTANDING
CLASS		October 31, 2019

Common Stock	No par value	9,350,658

Index

HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION



		Page
		Number

Item 1.	Financial Statements

	Consolidated balance sheets, September 30, 2019 (unaudited) and December 31, 2018	4
	Consolidated statements of income (unaudited) for three and nine months ended September 30, 2019 and 2018	5
	Consolidated statements of comprehensive income (unaudited) for three and nine months ended September 30, 2019 and 2018	6
	Consolidated statements of stockholders' equity (unaudited) for three and nine months ended September 30, 2019 and 2018	7
	Consolidated statements of cash flows (unaudited) for nine months ended September 30, 2019 and 2018	9
	Notes to consolidated financial statements (condensed)	11

Item 2.	Management Discussion and Analysis of Financial Condition and Results of Operations	41

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	57

Item 4.	Controls and Procedures	58

	Part II
	OTHER INFORMATION

Item 1.	Legal proceedings	58

Item 1A.	Risk factors	58

Item 2.	Unregistered sales of equity securities and use of proceeds	59

Item 3.	Defaults upon senior securities	59

Item 4.	Mine safety disclosures	59

Item 5.	Other information	59

Item 6.	Exhibits	60

	Signatures	61

	Exhibits Index	62

Page 3

Index

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



	September 30, 2019			December 31, 2018
ASSETS	(Unaudited)			December 31, 2018
Cash and cash equivalents	$	315,134		$	43,305
Investment securities available for sale at fair value (amortized cost September 30, 2019 $319,037 December 31, 2018 $321,660)	323,377			318,926
Stock of Federal Home Loan Bank	12,265			12,172
Loans held for sale	24,857			1,984
Loans, net of allowance for loan losses (September 30, 2019 $35,570; December 31, 2018 $37,810)	2,603,311			2,591,085
Property and equipment, net	36,146			37,051
Tax credit real estate investment	8,416			9,193
Accrued interest receivable	13,502			11,784
Deferred income taxes, net	8,890			10,869
Goodwill	2,500			2,500
Other assets	9,334			3,595
Total Assets	$	3,357,732		$	3,042,464

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities
Noninterest-bearing deposits	$	372,020		$	372,152
Interest-bearing deposits	2,328,938			2,048,972
Total deposits	$	2,700,958		$	2,421,124
Federal Home Loan Bank borrowings	215,000			215,000
Accrued interest payable	2,591			1,812
Other liabilities	24,046			20,776
Total Liabilities	$	2,942,595		$	2,658,712

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	51,302		$	48,870

STOCKHOLDERS' EQUITY
Common stock, no par value; authorized 20,000,000 shares; issued September 30, 2019 10,325,757 shares; December 31, 2018 10,325,191 shares	$	—		$	—
Paid in capital	55,836			52,122
Retained earnings	397,896			371,848
Accumulated other comprehensive income (loss)	1,248			(3,250		)
Treasury stock at cost (September 30, 2019 984,397 shares; December 31, 2018 988,750 shares)	(39,843		)	(36,968		)
Total Stockholders' Equity	$	415,137		$	383,752
Less maximum cash obligation related to ESOP shares	51,302			48,870
Total Stockholders' Equity Less Maximum Cash Obligation Related to ESOP Shares	$	363,835		$	334,882
Total Liabilities & Stockholders' Equity	$	3,357,732		$	3,042,464

See Notes to Consolidated Financial Statements.

Page 4

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Amounts In Thousands, Except Per Share Amounts)



	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019			2018
Interest income:
Loans, including fees	$	30,857	$	28,280	$	90,825		$	81,276
Investment securities:
Taxable	825		758		2,375			2,003
Nontaxable	918		862		2,898			2,617
Federal funds sold	1,369		511		2,954			1,610
Total interest income	$	33,969	$	30,411	$	99,052		$	87,506
Interest expense:
Deposits	$	7,662	$	5,284	$	21,418		$	13,688
FHLB borrowings	1,612		1,607		4,778			5,182
Total interest expense	$	9,274	$	6,891	$	26,196		$	18,870
Net interest income	$	24,695	$	23,520	$	72,856		$	68,636
Provision for loan losses	144		1,593		(1,642		)	1,539
Net interest income after provision for loan losses	$	24,551	$	21,927	$	74,498		$	67,097
Noninterest income:
Net gain on sale of loans	$	1,197	$	453	$	2,060		$	1,227
Trust fees	2,427		2,105		7,107			7,753
Service charges and fees	2,695		2,839		7,618			7,475
Other noninterest income	295		1,271		982			2,075
Gain (loss) on sale of investment securities	24		—		(28		)	—
	$	6,638	$	6,668	$	17,739		$	18,530

Noninterest expenses:
Salaries and employee benefits	$	9,258	$	8,611	$	27,310		$	25,718
Occupancy	986		1,208		3,274			3,331
Furniture and equipment	1,699		1,693		5,036			4,657
Office supplies and postage	469		432		1,370			1,327
Advertising and business development	607		584		1,800			1,821
Outside services	2,729		2,767		7,824			7,692
FDIC insurance assessment	208		226		612			657
Other noninterest expense	648		434		1,787			1,688
	$	16,604	$	15,955	$	49,013		$	46,891
Income before income taxes	$	14,585	$	12,640	$	43,224		$	38,736
Income taxes	3,303		2,590		9,519			7,765
Net income	$	11,282	$	10,050	$	33,705		$	30,971

Earnings per share:
Basic	$	1.21	$	1.07	$	3.61		$	3.30
Diluted	$	1.21	$	1.07	$	3.61		$	3.30

See Notes to Consolidated Financial Statements.

Page 5

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited) (Amounts In Thousands)



	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
Net income	$	11,282		$	10,050		$	33,705		$	30,971

Other comprehensive income (loss)
Securities:
Net change in unrealized income (loss) on securities available for sale	$	495		$	(1,321	)	$	7,046		$	(3,849	)
Reclassification adjustment for net (gains) losses realized in net income	(24		)	—			28			—
Income taxes	(118		)	330			(1,765		)	960
Other comprehensive income (loss) on securities available for sale	$	353		$	(991	)	$	5,309		$	(2,889	)
Derivatives used in cash flow hedging relationships:
Net change in unrealized (loss) income on derivatives	$	(103	)	$	361		$	(1,081	)	$	1,887
Income taxes	26			(90		)	270			(470		)
Other comprehensive (loss) income on cash flow hedges	$	(77	)	$	271		$	(811	)	$	1,417

Other comprehensive income (loss), net of tax	$	276		$	(720	)	$	4,498		$	(1,472	)

Comprehensive income	$	11,558		$	9,330		$	38,203		$	29,499

See Notes to Consolidated Financial Statements.

Page 6

Index

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



Three Months Ended September 30, 2019 and 2018
	Paid In Capital			Retained Earnings		Accumulated Other Comprehensive Income (Loss)			Treasury Stock			Maximum Cash Obligation Related To ESOP Shares			Total
Balance, June 30, 2018	$	51,899		$	356,003	$	(3,724	)	$	(33,886	)	$	(46,144	)	$	324,148
Issuance of 843 shares of common stock	27			—		—			21			—			48
Issuance of 1,866 shares of common stock under the employee stock purchase plan	99			—		—			—			—			99
Unearned restricted stock compensation	207			—		—			—			—			207
Forfeiture of 234 shares of common stock	(9		)	—		—			—			—			(9		)
Change related to ESOP shares	—			—		—			—			(1,449		)	(1,449		)
Net income	—			10,050		—			—			—			10,050
Purchase of 40,818 shares of common stock	—			—		—			(2,390		)	—			(2,390		)
Other comprehensive loss	—			—		(720		)	—			—			(720		)
Balance, September 30, 2018	$	52,223		$	366,053	$	(4,444	)	$	(36,255	)	$	(47,593	)	$	329,984

Balance, June 30, 2019	55,515			386,614		972			(39,352		)	(50,225		)	353,524
Issuance of 1,468 shares of common stock	56			—		—			39			—			95
Issuance of 1,786 shares of common stock under the employee stock purchase plan	102			—		—			—			—			102
Unearned restricted stock compensation	165			—		—			—			—			165
Forfeiture of 134 shares of common stock	(8		)	—		—			—			—			(8		)
Share-based compensation	6			—		—			—			—			6
Change related to ESOP shares	—			—		—			—			(1,077		)	(1,077		)
Net income	—			11,282		—			—			—			11,282
Purchase of 8,209 shares of common stock	—			—		—			(530		)	—			(530		)
Other comprehensive income	—			—		276			—			—			276
Balance, September 30, 2019	$	55,836		$	397,896	$	1,248		$	(39,843	)	$	(51,302	)	$	363,835

Page 7

Index

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



Nine Months Ended September 30, 2019 and 2018
	Paid In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Treasury Stock			Maximum Cash Obligation Related To ESOP Shares			Total
Balance, December 31, 2017	$	48,930		$	341,558		$	(2,446	)	$	(33,018	)	$	(43,308	)	$	311,716
Issuance of 94,097 shares of common stock	2,748			—			—			2,352			—			5,100
Issuance of 6,149 shares of common stock under the employee stock purchase plan	313			—			—			—			—			313
Unearned restricted stock compensation	372			—			—			—			—			372
Forfeiture of 2,996 shares of common stock	(140		)													(140		)
Change related to ESOP shares	—			—			—			—			(4,285		)	(4,285		)
Net income	—			30,971			—			—			—			30,971
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 97,081 shares of common stock	—			—			—			(5,589		)	—			(5,589		)
Other comprehensive loss	—			—			(1,472		)	—			—			(1,472		)
Balance, September 30, 2018	$	52,223		$	366,053		$	(4,444	)	$	(36,255	)	$	(47,593	)	$	329,984

Balance, December 31, 2018	52,122			371,848			(3,250		)	(36,968		)	(48,870		)	334,882
Issuance of 87,959 shares of common stock	3,072			—			—			2,302			—			5,374
Issuance of 5,821 shares of common stock under the employee stock purchase plan	325			—			—			—			—			325
Unearned restricted stock compensation	572			—			—			—			—			572
Forfeiture of 5,255 shares of common stock	(262		)	—			—			—			—			(262		)
Share-based compensation	7			—			—			—			—			7
Change related to ESOP shares	—			—			—			—			(2,432		)	(2,432		)
Net income	—			33,705			—			—			—			33,705
Cash dividends ($0.82 per share)	—			(7,657		)	—			—			—			(7,657		)
Purchase of 83,606 shares of common stock	—			—			—			(5,177		)	—			(5,177		)
Other comprehensive income	—			—			4,498			—			—			4,498
Balance, September 30, 2019	$	55,836		$	397,896		$	1,248		$	(39,843	)	$	(51,302	)	$	363,835

See Notes to Consolidated Financial Statements.

Page 8

Index

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



	Nine Months Ended September 30,
	2019			2018
Cash Flows from Operating Activities
Net income	$	33,705		$	30,971
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation	2,542			2,463
Provision for loan losses	(1,642		)	1,539
Net loss on sale of investment securities available for sale	28			—
Forfeiture of common stock	(262		)	(140		)
Share-based compensation	7			—
Compensation expensed through issuance of common stock	348			387
Provision for deferred income taxes	484			(379		)
Net (gain) loss on sale of other real estate owned and other repossessed assets	(11		)	3
Increase in accrued interest receivable	(1,718		)	(1,938		)
Amortization of premium on investment securities, net	303			370
Increase in other assets	(1,763		)	(2,120		)
Amortization of operating lease right-of-use assets	265			—
Decrease in accrued interest payable and other liabilities	(40		)	(1,358		)
Loans originated for sale	(201,514		)	(110,694		)
Proceeds on sales of loans	180,701			113,680
Net gain on sales of loans	(2,060		)	(1,227		)
Net cash and cash equivalents provided by operating activities	$	9,373		$	31,557

Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	51,275		$	51,224
Proceeds from sales of investment securities available for sale	12,467			—
Purchases of investment securities available for sale	(61,544		)	(59,757		)
Loans made to customers, net of collections	(11,296		)	(96,159		)
Proceeds on sale of other real estate owned and other repossessed assets	63			59
Purchases of property and equipment	(1,637		)	(2,088		)
Net changes from tax credit real estate investment	777			912
Net cash and cash equivalents used in investing activities	$	(9,895	)	$	(105,809	)

Cash Flows from Financing Activities
Net increase in deposits	$	279,834		$	200,187
Net decrease in FHLB borrowings	—			(80,000		)
Issuance of common stock, net of costs	5,026			4,713
Purchase of treasury stock	(5,177		)	(5,589		)
Proceeds from the issuance of common stock through the employee stock purchase plan	325			313
Dividends paid	(7,657		)	(7,002		)
Net cash and cash equivalents provided by financing activities	$	272,351		$	112,622

(Continued)

Page 9

Index

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

	Nine Months Ended September 30,
	2019		2018
Increase in cash and cash equivalents	$	271,829	$	38,370
Cash and cash equivalents:
Beginning of period	43,305		154,353
End of period	$	315,134	$	192,723

Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	20,639	$	13,270
Interest paid on other obligations	4,778		5,182
Income taxes paid	8,044		7,188

Noncash activities:
Increase in maximum cash obligation related to ESOP shares	$	2,432	$	4,285
Transfers to other real estate owned	712		65
Right-of-use assets obtained in exchange for operating lease obligations	3,581		—

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 nine month period ended September 30, 2019 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2019. 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, 2018 filed with the Securities Exchange Commission on March 5, 2019. The consolidated balance sheet as of December 31, 2018, 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.

A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity's obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. As of September 30, 2019, the Company did not have any significant contract balances.

An entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered. The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission). The Company utilizes the practical expedient which allows entities to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less. The Company has not incurred or capitalized any contract acquisition costs as of September 30, 2019.

Page 11

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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 on the recognition of revenue though did require additional disclosures on our material noninterest income streams discussed in revenue recognition above.

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 created Subtopic 321-10, Investments-Equity Securities which is applicable to all entities except those in industries that account for substantially all investments at fair value through earnings or the change in net assets. Under this new subtopic, equity securities are generally required to be measured at fair value with unrealized holding gains and losses reflected in net income. ASU 2016-01 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. The Company adopted ASU 2016-01 for the period ending March 31, 2018. There was no material impact on the financial statements however it required a change in disclosure and related methodology located in Note 7 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 (ROU) assets and lease liabilities for all leases other than those that meet the definition of short-term leases. For short-term leases, lessees may elect an accounting policy by class of underlying asset under which these assets and liabilities are not recognized and lease payments are generally recognized over the lease term on a straight-line basis. Under this new ASU, lessees will recognize right-of use assets and lease liabilities for most leases currently accounted for as operating leases under generally accepted accounting principles. For public companies, ASU 2016-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company adopted the ASU on January 1, 2019 and used the alternative transition approach which permits the effects of adoption to be applied at the effective date. Consequently, financial information will not be updated and the disclosures required under the new standard will not be provided for dates and periods before January 1, 2019. The new standard provides a number of optional practical expedients in transition. We elected the 'package of practical expedients', which permits us not to reassess under the new standard our prior conclusions about lease identification, lease classification and initial direct costs. We also elected the short-term lease exemption and combining the lease and nonlease components practical expedients. We did not elect the use-of-hindsight or the practical expedient pertaining to land easements; the latter not being applicable to us. The most significant impact upon adoption relates to the recognition of new ROU assets and lease liabilities on our balance sheet for our equipment and real estate operating leases. Upon adoption, we recognized additional operating liabilities of $3.58 million, with corresponding ROU assets of the same amount based on the present value of the remaining rental payments, including options to extend that are expected to be exercised, under current leasing standards for existing operating leases. There was no cumulative effect of adopting the standard.

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

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(Unaudited)

our allowance. For public companies, ASU 2016-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019, early adoption is permitted for the fiscal year beginning after December 15, 2018. The Company has implemented a software solution provided by a third party vendor to assist in the determination of the CECL model that will be implemented. We have completed substantially all of our CECL model, and we expect to complete the validation process for our CECL model during December 2019. Our current planned approach for estimating expected life-time credit losses for loans includes the following key components:


•	An initial forecast period of one year for all portfolio segments and off-balance-sheet credit exposures. This period reflects management’s expectation of losses based on forward-looking economic scenarios over that time.


•	A historical loss forecast period covering the remaining contractual life, adjusted for prepayments, by portfolio segment based on the change in key historical economic variables.


•	A reversion period of up to 3 years connecting the initial loss forecast to the historical loss forecast based on economic conditions at the measurement date.


•	We will primarily utilize discounted cash flow (DCF) methods to estimate credit losses by portfolio segment. The DCF methods would obtain estimated life-time credit losses using the conceptual components described above.

Based on our portfolio composition at September 30, 2019, and the current economic environment, we currently estimate an overall increase in our Allowance for Credit Losses (ACL) for loans of approximately $2 million to $4 million. As of September 30, 2019, the estimated range of our unfunded commitments liability will be $1.0 million to $2.5 million. We will continue to evaluate and refine the results of our loss estimates throughout 2019. The ultimate effect of CECL on our ACL will depend on the size and composition of our portfolio, the portfolio’s credit quality and economic conditions at the time of adoption, as well as any refinements to our model, methodology and other key assumptions. We expect to recognize a one-time cumulative-effect adjustment to our allowance for loan losses as of January 1, 2020 upon adoption of the new standard. An increase in the ACL will result in a decrease to our regulatory capital amounts and ratios.

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

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

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 Company adopted ASU No. 2017-12 for the period ending March 31, 2019. There was no material impact on the financial statements.

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(Unaudited)

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 for the period ending March 31, 2018.

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 Company adopted ASU No. 2018-07 for the period ending March 31, 2019. There was no material impact on the financial statements.

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

In August 2018, the FASB issued ASU No. 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40), Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangements That Is a Service Contract. The amendments in this ASU align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). ASU 2018-15 is effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption of the amendments in this ASU is permitted, including adoption in any interim period, for all entities. The amendments in this ASU should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. The adoption of ASU 2018-15 by the Company is not expected to have a material impact.

In October 2018, the FASB issued ASU No. 2018-16, Derivatives and Hedging (Topic 815), Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes. The amendments in this ASU permit use of the OIS rate based on SOFR as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815 in addition to the interest rates on direct Treasury obligations of the U.S. government, the London Interbank Offered Rate (LIBOR) swap rate, the Overnight Index Swap (OIS) Rate based on the Fed Funds Effective Rate and the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate. The amendments in this ASU are required to be adopted concurrently with the amendments in ASU 2017-12. For public companies, this would be for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018. The Company adopted ASU No. 2018-16 for the period ending March 31, 2019 concurrently with ASU 2017-12. There was no material impact on the financial statements.

In July 2019, the FASB issued ASU No. 2019-07, Codification Updates to SEC Sections, Amendments to SEC Paragraphs Pursuant to SEC Final Rule Releases No. 33-10532, Disclosure Update and Simplification, and Nos. 33-10231 and 33-10442, Investment Company Reporting Modernization, and Miscellaneous Updates. The amendments in this ASU update the Codification to reflect the amendments of various SEC disclosure requirements that the agency determined were redundant, duplicative, overlapping, outdated or superseded. The SEC amended its disclosure rules in 2018 with the aim of providing investors with useful disclosure information and to simplify compliance without significantly altering the mix of the information being provided. This ASU was effective upon release and there was no material impact on the financial statements.

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(Unaudited)


Note 2.	Earnings Per Share

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

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



	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019		2018
Common shares outstanding at the beginning of the period	9,346,449			9,373,666			9,336,441		9,335,154
Weighted average number of net shares (redeemed) issued	(160		)	(22,223		)	21,712		40,123
Weighted average shares outstanding (basic)	9,346,289			9,351,443			9,358,153		9,375,277
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method	4,284			4,245			4,146		4,067
Weighted average number of shares (diluted)	9,350,573			9,355,688			9,362,299		9,379,344
Net income (In thousands)	$	11,282		$	10,050		$	33,705	$	30,971
Earnings per share:
Basic	$	1.21		$	1.07		$	3.61	$	3.30
Diluted	$	1.21		$	1.07		$	3.61	$	3.30

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(Unaudited)


Note 3.	Other Comprehensive Income (Loss)

The following table summarizes the balances of each component of accumulated other comprehensive income (AOCI), included in stockholders’ equity, at September 30, 2019 and December 31, 2018:



	September 30, 2019			December 31, 2018
	(amounts in thousands)
Net unrealized income (loss) on available-for-sale securities	$	4,340		$	(2,734	)
Net unrealized loss on derivatives used for cash flow hedges	(2,677		)	(1,596		)
Tax effect	$	(415	)	$	1,080
Net-of-tax amount	$	1,248		$	(3,250	)


Note 4.	Securities

The carrying values of investment securities at September 30, 2019 and December 31, 2018 are summarized in the following table (dollars in thousands):



	September 30, 2019				December 31, 2018
	Amount		Percent		Amount		Percent
Securities available for sale
U.S. Treasury	$	115,949	35.86	%	$	83,155	26.07	%
Other securities (FHLB, FHLMC and FNMA)	20,198		6.24		34,871		10.93
State and political subdivisions	187,230		57.90		200,900		63.00
Total securities available for sale	$	323,377	100.00	%	$	318,926	100.00	%

Investment securities have been classified in the consolidated balance sheets according to management’s intent. Available-for-sale securities consist of debt securities not classified as trading or held to maturity. Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity. There were no trading or held to maturity securities as of September 30, 2019 or December 31, 2018. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of September 30, 2019 and December 31, 2018 (in thousands):



	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Estimated Fair Value
September 30, 2019
U.S. Treasury	$	114,153	$	1,843	$	(47	)	$	115,949
Other securities (FHLB, FHLMC and FNMA)	20,306		—		(108		)	20,198
State and political subdivisions	184,578		2,806		(154		)	187,230
Total	$	319,037	$	4,649	$	(309	)	$	323,377
December 31, 2018:
U.S. Treasury	$	83,839	$	124	$	(808	)	$	83,155
Other securities (FHLB, FHLMC and FNMA)	35,371		—		(500		)	34,871
State and political subdivisions	202,450		278		(1,828		)	200,900
Total	$	321,660	$	402	$	(3,136	)	$	318,926

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(Unaudited)

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at September 30, 2019, were as follows (in thousands):



	Amortized Cost		Fair Value
Due in one year or less	$	49,028	$	48,979
Due after one year through five years	180,354		182,558
Due after five years through ten years	83,351		85,521
Due over ten years	6,304		6,319
Total	$	319,037	$	323,377

As of September 30, 2019 investment securities with a carrying value of $12.92 million were pledged to collateralize derivative financial instruments and other borrowings.

Sales proceeds and gross realized gains and losses on available-for-sale securities were as follows (in thousands):



	September 30, 2019		September 30, 2018
Sales proceeds	$	12,467	$	—
Gross realized gains	24		—
Gross realized losses	52		—

The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2019 and December 31, 2018 (in thousands):



	Less than 12 months								12 months or more								Total
September 30, 2019 Description of Securities	#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
U.S. Treasury	6	$	15,168	$	(38	)	0.25	%	2	$	4,985	$	(9	)	0.18	%	8	$	20,153	$	(47	)	0.23	%

Other securities (FHLB, FHLMC and FNMA)	—	—		—			—		8	20,198		(108		)	0.53		8	20,198		(108		)	0.53

State and political subdivisions	98	25,496		(127		)	0.50		20	3,817		(27		)	0.71		118	29,313		(154		)	0.53

Total temporarily impaired securities	104	$	40,664	$	(165	)	0.41	%	30	$	29,000	$	(144	)	0.50	%	134	$	69,664	$	(309	)	0.44	%

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(Unaudited)



	Less than 12 months								12 months or more								Total
December 31, 2018 Description of Securities	#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
U.S. Treasury	6	$	14,644	$	(49	)	0.33	%	19	$	46,443	$	(759	)	1.63	%	25	$	61,087	$	(808	)	1.32	%

Other securities (FHLB, FHLMC and FNMA)	—	—		—			—		14	34,871		(500		)	1.43		14	34,871		(500		)	1.43

State and political subdivisions	113	31,022		(162		)	0.52		325	77,921		(1,666		)	2.14		438	108,943		(1,828		)	1.68

Total temporarily impaired securities	119	$	45,666	$	(211	)	0.46	%	358	$	159,235	$	(2,925	)	1.84	%	477	$	204,901	$	(3,136	)	1.53	%

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


Note 5.	Loans

Classes of loans are as follows:



	September 30, 2019		December 31, 2018
	(Amounts In Thousands)
Agricultural	$	91,621	$	92,673
Commercial and financial	219,362		229,501
Real estate:
Construction, 1 to 4 family residential	80,969		72,279
Construction, land development and commercial	108,662		113,807
Mortgage, farmland	237,513		236,454
Mortgage, 1 to 4 family first liens	913,206		912,059
Mortgage, 1 to 4 family junior liens	149,969		152,625
Mortgage, multi-family	350,378		352,434
Mortgage, commercial	401,615		383,314
Loans to individuals	32,613		30,072
Obligations of state and political subdivisions	52,030		52,725
	$	2,637,938	$	2,627,943
Net unamortized fees and costs	943		952
	$	2,638,881	$	2,628,895
Less allowance for loan losses	35,570		37,810
	$	2,603,311	$	2,591,085

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(Unaudited)

Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the three and nine months ended September 30, 2019 were as follows:



	Three Months Ended September 30, 2019
	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	$	2,535		$	5,603		$	2,646	$	3,891	$	11,384		$	8,194		$	1,397		$	35,650
Charge-offs	(135		)	(177		)	—		—		(332		)	—			(92		)	(736		)
Recoveries	18			128			2		—		317			12			35			512
Provision	288			(143		)	240		96		(166		)	(110		)	(61		)	144

Ending balance	$	2,706		$	5,411		$	2,888	$	3,987	$	11,203		$	8,096		$	1,279		$	35,570



	Nine Months Ended September 30, 2019
	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	$	2,789		$	5,826		$	3,292		$	3,972	$	12,516		$	8,165		$	1,250		$	37,810
Charge-offs	(135		)	(641		)	(9		)	—		(711		)	(133		)	(326		)	(1,955		)
Recoveries	87			451			6			5		576			100			132			1,357
Provision	(35		)	(225		)	(401		)	10		(1,178		)	(36		)	223			(1,642		)

Ending balance	$	2,706		$	5,411		$	2,888		$	3,987	$	11,203		$	8,096		$	1,279		$	35,570

Ending balance, individually evaluated for impairment	$	341		$	1,008		$	—		$	—	$	65		$	1		$	2		$	1,417

Ending balance, collectively evaluated for impairment	$	2,365		$	4,403		$	2,888		$	3,987	$	11,138		$	8,095		$	1,277		$	34,153

Loans:

Ending balance	$	91,621		$	219,362		$	189,631		$	237,513	$	1,063,175		$	751,993		$	84,643		$	2,637,938

Ending balance, individually evaluated for impairment	$	1,865		$	3,176		$	456		$	4,117	$	7,729		$	2,043		$	2		$	19,388

Ending balance, collectively evaluated for impairment	$	89,756		$	216,186		$	189,175		$	233,396	$	1,055,446		$	749,950		$	84,641		$	2,618,550

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(Unaudited)

Changes in the allowance for loan losses for the three and nine months ended September 30, 2018 were as follows:



	Three Months Ended September 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	$	2,071		$	5,040		$	3,054		$	3,475	$	8,902		$	5,697		$	1,271		$	29,510
Charge-offs	(68		)	(241		)	—			—		(280		)	(107		)	(197		)	(893		)
Recoveries	74			415			2			10		187			80			32			800
Provision	(47		)	(133		)	(188		)	50		1,756			193			(38		)	1,593

Ending balance	$	2,030		$	5,081		$	2,868		$	3,535	$	10,565		$	5,863		$	1,068		$	31,010



	Nine Months Ended September 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	(72		)	(447		)	—			—			(607		)	(161		)	(420		)	(1,707		)
Recoveries	102			856			147			29			433			97			114			1,778
Provision	(294		)	(165		)	(268		)	(163		)	2,071			227			131			1,539

Ending balance	$	2,030		$	5,081		$	2,868		$	3,535		$	10,565		$	5,863		$	1,068		$	31,010

Ending balance, individually evaluated for impairment	$	118		$	1,165		$	3		$	—		$	91		$	40		$	48		$	1,465

Ending balance, collectively evaluated for impairment	$	1,912		$	3,916		$	2,865		$	3,535		$	10,474		$	5,823		$	1,020		$	29,545

Loans:

Ending balance	$	79,155		$	214,681		$	171,944		$	230,032		$	1,049,249		$	729,626		$	81,095		$	2,555,782

Ending balance, individually evaluated for impairment	$	2,342		$	3,288		$	927		$	3,729		$	6,728		$	8,217		$	48		$	25,279

Ending balance, collectively evaluated for impairment	$	76,813		$	211,393		$	171,017		$	226,303		$	1,042,521		$	721,409		$	81,047		$	2,530,503

Page 20

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The following table presents the credit quality indicators by type of loans in each category as of September 30, 2019 and December 31, 2018, respectively (amounts in thousands):



	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
September 30, 2019
Grade:
Excellent	$	3,484	$	3,078	$	—	$	194
Good	12,754		40,411		8,071		24,959
Satisfactory	42,257		120,698		55,490		41,622
Monitor	26,226		44,518		14,856		33,714
Special Mention	2,700		7,069		2,552		7,539
Substandard	4,200		3,588		—		634
Total	$	91,621	$	219,362	$	80,969	$	108,662



	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family
September 30, 2019
Grade:
Excellent	$	6,268	$	1,859	$	607	$	21,016
Good	40,387		33,034		4,014		49,684
Satisfactory	131,790		752,092		136,188		187,940
Monitor	48,244		100,469		6,070		57,945
Special Mention	3,056		9,111		1,455		27,729
Substandard	7,768		16,641		1,635		6,064
Total	$	237,513	$	913,206	$	149,969	$	350,378



	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
September 30, 2019
Grade:
Excellent	$	34,016	$	—	$	7,652	$	78,174
Good	81,831		224		16,438		311,807
Satisfactory	193,035		31,635		20,128		1,712,875
Monitor	82,657		560		7,416		422,675
Special Mention	6,122		172		396		67,901
Substandard	3,954		22		—		44,506
Total	$	401,615	$	32,613	$	52,030	$	2,637,938

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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, 2018
Grade:
Excellent	$	3,667	$	3,322	$	—	$	209
Good	15,342		51,562		13,029		16,667
Satisfactory	39,897		121,759		42,043		68,123
Monitor	27,510		35,897		15,045		19,888
Special Mention	647		11,418		1,767		7,635
Substandard	5,610		5,543		395		1,285
Total	$	92,673	$	229,501	$	72,279	$	113,807



	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family
December 31, 2018
Grade:
Excellent	$	5,619	$	2,715	$	520	$	22,058
Good	52,364		33,134		4,569		60,047
Satisfactory	126,706		752,473		138,533		187,641
Monitor	41,486		96,187		6,242		60,398
Special Mention	1,055		10,439		1,130		16,065
Substandard	9,224		17,111		1,631		6,225
Total	$	236,454	$	912,059	$	152,625	$	352,434



	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
December 31, 2018
Grade:
Excellent	$	34,096	$	—	$	8,117	$	80,323
Good	86,453		315		15,652		349,134
Satisfactory	177,271		28,797		20,685		1,703,928
Monitor	74,990		647		8,271		386,561
Special Mention	3,228		217		—		53,601
Substandard	7,276		96		—		54,396
Total	$	383,314	$	30,072	$	52,725	$	2,627,943

Page 22

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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 23

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Past due loans as of September 30, 2019 and December 31, 2018 were as follows:



	30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Loans Receivable		Accruing Loans Past Due 90 Days or More
	(Amounts In Thousands)
September 30, 2019
Agricultural	$	1,438	$	246	$	—	$	1,684	$	89,937	$	91,621	$	—
Commercial and financial	271		200		103		574		218,788		219,362		102
Real estate:
Construction, 1 to 4 family residential	1,109		438		—		1,547		79,422		80,969		—
Construction, land development and commercial	1,041		—		33		1,074		107,588		108,662		—
Mortgage, farmland	964		406		—		1,370		236,143		237,513		—
Mortgage, 1 to 4 family first liens	973		2,874		3,276		7,123		906,083		913,206		641
Mortgage, 1 to 4 family junior liens	430		133		61		624		149,345		149,969		61
Mortgage, multi-family	—		101		—		101		350,277		350,378		—
Mortgage, commercial	598		276		182		1,056		400,559		401,615		—
Loans to individuals	144		30		3		177		32,436		32,613		—
Obligations of state and political subdivisions	—		—		—		—		52,030		52,030		—
	$	6,968	$	4,704	$	3,658	$	15,330	$	2,622,608	$	2,637,938	$	804

December 31, 2018
Agricultural	$	1,026	$	—	$	135	$	1,161	$	91,512	$	92,673	$	—
Commercial and financial	988		459		225		1,672		227,829		229,501		—
Real estate:
Construction, 1 to 4 family residential	—		—		212		212		72,067		72,279		212
Construction, land development and commercial	233		202		—		435		113,372		113,807		—
Mortgage, farmland	193		388		—		581		235,873		236,454		—
Mortgage, 1 to 4 family first liens	3,972		833		3,234		8,039		904,020		912,059		158
Mortgage, 1 to 4 family junior liens	199		36		—		235		152,390		152,625		—
Mortgage, multi-family	—		—		—		—		352,434		352,434		—
Mortgage, commercial	733		344		—		1,077		382,237		383,314		—
Loans to individuals	195		—		22		217		29,855		30,072		—
Obligations of state and political subdivisions	—		—		—		—		52,725		52,725		—
	$	7,539	$	2,262	$	3,828	$	13,629	$	2,614,314	$	2,627,943	$	370

Page 24

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

Certain impaired loan information by loan type at September 30, 2019 and December 31, 2018, was as follows:



	September 30, 2019						December 31, 2018
	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	$	1,114	$	—	$	543	$	1,338	$	—	$	120
Commercial and financial	820		102		2,053		1,476		—		2,686
Real estate:
Construction, 1 to 4 family residential	—		—		—		—		212		—
Construction, land development and commercial	33		—		323		—		—		328
Mortgage, farmland	986		—		3,131		1,062		—		3,301
Mortgage, 1 to 4 family first liens	6,093		641		1,011		5,799		158		1,143
Mortgage, 1 to 4 family junior liens	—		61		24		—		—		24
Mortgage, multi-family	101		—		—		145		—		—
Mortgage, commercial	1,039		—		903		1,009		—		937
	$	10,186	$	804	$	7,988	$	10,829	$	370	$	8,539


(1)	There were $4.03 million and $4.84 million of TDR loans included within nonaccrual loans as of September 30, 2019 and December 31, 2018, respectively.

Loans 90 days or more past due that are still accruing interest increased $0.43 million from December 31, 2018 to September 30, 2019 due to an increase in the number of accruing loans past due 90 days or more. As of September 30, 2019 there were 9 accruing loans past due 90 days or more. The average accruing loans past due as of September 30, 2019 are $0.09 million. There were 2 accruing loans past due 90 days or more as of December 31, 2018 and the average loan balance was $0.19 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 25

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Below is a summary of information for TDR loans as of September 30, 2019 and December 31, 2018:



	September 30, 2019					December 31, 2018
	Number of contracts	Recorded investment		Commitments outstanding		Number of contracts	Recorded investment		Commitments outstanding
		(Amounts In Thousands)					(Amounts In Thousands)
Agricultural	9	$	1,657	$	3	5	$	1,316	$	91
Commercial and financial	15	2,703		95		13	3,867		75
Real estate:
Construction, 1 to 4 family residential	—	—		—		—	—		—
Construction, land development and commercial	2	323		—		2	328		—
Mortgage, farmland	8	4,049		—		8	4,291		—
Mortgage, 1 to 4 family first liens	14	1,535		—		16	1,710		—
Mortgage, 1 to 4 family junior liens	1	24		—		1	24		—
Mortgage, multi-family	—	—		—		—	—		—
Mortgage, commercial	8	1,724		—		9	1,839		—
Loans to individuals	—	—		—		—	—		—
	57	$	12,015	$	98	54	$	13,375	$	166

The following is a summary of TDR loans that were modified during the three and nine months ended September 30, 2019:



	Three Months Ended September 30, 2019					Nine Months Ended September 30, 2019
	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)
Agricultural	—	$	—	$	—	4	$	574	$	574
Commercial and financial	—	—		—		3	303		303
Real estate:
Construction, 1 to 4 family residential	—	—		—		—	—		—
Construction, land development and commercial	—	—		—		—	—		—
Mortgage, farmland	—	—		—		1	620		620
Mortgage, 1 to 4 family first lien	—	—		—		—	—		—
Mortgage, 1 to 4 family junior liens	—	—		—		—	—		—
Mortgage, multi-family	—	—		—		—	—		—
Mortgage, commercial	—	—		—		—	—		—
	—	$	—	$	—	8	$	1,497	$	1,497

Page 26

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The Company had commitments to lend $0.10 million in additional borrowings to restructured loan customers as of September 30, 2019. The Company had commitments to lend $0.17 million in additional borrowings to restructured loan customers as of December 31, 2018. These commitments were in the normal course of business. The additional borrowings were not used to facilitate payments on these loans.

There were no TDR loans that were in payment default (defined as past due 90 days or more) during the period ended September 30, 2019 and none for the year ended December 31, 2018.

Page 27

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Information regarding impaired loans as of and for the three and nine months ended September 30, 2019 is as follows:



	September 30, 2019						Three Months Ended September 30, 2019				Nine Months Ended September 30, 2019
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	1,524	$	2,007	$	—	$	1,535	$	1	$	1,611	$	4
Commercial and financial	1,541		2,702		—		1,875		15		2,151		51
Real estate:
Construction, 1 to 4 family residential	101		144		—		101		—		106		—
Construction, land development and commercial	355		379		—		356		4		362		13
Mortgage, farmland	4,117		4,633		—		4,144		40		4,162		118
Mortgage, 1 to 4 family first liens	6,052		7,955		—		6,108		8		6,124		22
Mortgage, 1 to 4 family junior liens	—		248		—		—		—		—		—
Mortgage, multi-family	101		213		—		103		—		123		—
Mortgage, commercial	1,871		2,702		—		1,888		10		1,980		29
Loans to individuals	—		14		—		—		—		—		—
	$	15,662	$	20,997	$	—	$	16,110	$	78	$	16,619	$	237

With an allowance recorded:
Agricultural	$	341	$	341	$	341	$	464	$	7	$	491	$	21
Commercial and financial	1,635		1,670		1,008		1,607		21		1,715		67
Real estate:
Construction, 1 to 4 family residential	—		—		—		—		—		—		—
Construction, land development and commercial	—		—		—		—		—		—		—
Mortgage, farmland	—		—		—		—		—		—		—
Mortgage, 1 to 4 family first liens	1,593		1,700		62		1,613		12		1,529		36
Mortgage, 1 to 4 family junior liens	84		84		3		86		1		89		3
Mortgage, multi-family	—		—		—		—		—		—		—
Mortgage, commercial	71		71		1		72		1		73		3
Loans to individuals	2		2		2		2		—		2		—
	$	3,726	$	3,868	$	1,417	$	3,844	$	42	$	3,899	$	130

Total:
Agricultural	$	1,865	$	2,348	$	341	$	1,999	$	8	$	2,102	$	25
Commercial and financial	3,176		4,372		1,008		3,482		36		3,866		118
Real estate:
Construction, 1 to 4 family residential	101		144		—		101		—		106		—
Construction, land development and commercial	355		379		—		356		4		362		13
Mortgage, farmland	4,117		4,633		—		4,144		40		4,162		118
Mortgage, 1 to 4 family first liens	7,645		9,655		62		7,721		20		7,653		58
Mortgage, 1 to 4 family junior liens	84		332		3		86		1		89		3
Mortgage, multi-family	101		213		—		103		—		123		—
Mortgage, commercial	1,942		2,773		1		1,960		11		2,053		32
Loans to individuals	2		16		2		2		—		2		—
	$	19,388	$	24,865	$	1,417	$	19,954	$	120	$	20,518	$	367

Page 28

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Information regarding impaired loans as of December 31, 2018 is as follows:



	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	1,395	$	1,663	$	—
Commercial and financial	1,650		2,503		—
Real estate:
Construction, 1 to 4 family residential	111		148		—
Construction, land development and commercial	328		344		—
Mortgage, farmland	3,612		4,071		—
Mortgage, 1 to 4 family first liens	6,089		7,819		—
Mortgage, 1 to 4 family junior liens	—		254		—
Mortgage, multi-family	145		213		—
Mortgage, commercial	1,871		2,486		—
Loans to individuals	—		14		—
	$	15,201	$	19,515	$	—

With an allowance recorded:
Agricultural	$	1,065	$	1,229	$	479
Commercial and financial	2,512		2,512		1,189
Real estate:
Construction, 1 to 4 family residential	698		698		4
Construction, land development and commercial	—		—		—
Mortgage, farmland	—		—		—
Mortgage, 1 to 4 family first liens	899		974		70
Mortgage, 1 to 4 family junior liens	24		24		2
Mortgage, multi-family	7,447		7,447		305
Mortgage, commercial	75		75		1
Loans to individuals	64		64		64
	$	12,784	$	13,023	$	2,114

Total:
Agricultural	$	2,460	$	2,892	$	479
Commercial and financial	4,162		5,015		1,189
Real estate:
Construction, 1 to 4 family residential	809		846		4
Construction, land development and commercial	328		344		—
Mortgage, farmland	3,612		4,071		—
Mortgage, 1 to 4 family first liens	6,988		8,793		70
Mortgage, 1 to 4 family junior liens	24		278		2
Mortgage, multi-family	7,592		7,660		305
Mortgage, commercial	1,946		2,561		1
Loans to individuals	64		78		64
	$	27,985	$	32,538	$	2,114

Page 29

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Impaired loans decreased $8.60 million from December 31, 2018 to September 30, 2019. Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans. Impaired loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement. Impaired loans were 0.73% of loans held for investment as of September 30, 2019 and 1.06% as of December 31, 2018. The decrease in impaired loans is due to a decrease of $7.83 million in loans with a specific reserve, a decrease in TDR loans of $0.55 million, a decrease in nonaccrual loans of $0.64 million, and is offset by a $0.43 million increase in 90 days or more accruing loans from December 31, 2018 to September 30, 2019.

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.


Note 6.	Leases

The Bank leases branch offices, parking facilities and certain equipment under operating leases. The leases have remaining lease terms of 1 year to 16 years, some of which include options to extend the leases for up to 10 years, and some of which include options to terminate the leases within 1 year. As the options are reasonably certain to be exercised, they are recognized as part of the right-of-use assets and lease liabilities.

For the nine months ended September 30, 2019, total operating lease expense was $0.47 million included in occupancy expenses in the consolidated statement of income. Included in this were $0.40 million of operating lease costs, $0.02 million of short term lease costs, and $0.05 million of variable lease costs.

For the nine months ended September 30, 2019, cash paid for amounts included in the measurement of operating lease liabilities was $0.40 million and right-of-use assets obtained in exchange for lease obligations was $3.58 million.

Page 30

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

As of September 30, 2019, operating lease right-of-use assets included in other assets was $3.30 million and liabilities was $3.32 million. The weighted average remaining lease term for operating leases was 10.99 years and the weighted average discount rate for operating leases was 3.45%. Discount rates used were determined from FHLB borrowing rates for comparable terms.

As of September 30, 2019, maturities of lease liabilities were as follows:



Year ending December 31:	(Amounts In Thousands)
2019	$	117
2020	470
2021	456
2022	447
2023	301
Thereafter	2,259
Total lease payments	4,050
Less imputed interest	(734		)
Total operating lease liabilities	$	3,316

Page 31

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 7.	Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments as of September 30, 2019 are as follows:



	September 30, 2019
	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	$	315,134	$	315,134	$	315,134	$	—	$	—
Investment securities	335,642		335,642		115,949		219,693		—
Loans held for sale	24,857		24,857		—		24,857		—
Loans
Agricultural	88,915		91,215		—		—		91,215
Commercial and financial	213,951		218,564		—		—		218,564
Real estate:
Construction, 1 to 4 family residential	79,640		81,500		—		—		81,500
Construction, land development and commercial	107,103		108,135		—		—		108,135
Mortgage, farmland	233,526		233,940		—		—		233,940
Mortgage, 1 to 4 family first liens	904,581		903,249		—		—		903,249
Mortgage, 1 to 4 family junior liens	148,334		144,653		—		—		144,653
Mortgage, multi-family	346,532		350,285		—		—		350,285
Mortgage, commercial	397,365		395,913		—		—		395,913
Loans to individuals	31,854		33,164		—		—		33,164
Obligations of state and political subdivisions	51,510		51,620		—		—		51,620
Accrued interest receivable	13,502		13,502		—		13,502		—
Total financial instrument assets	$	3,292,446	$	3,301,373	$	431,083	$	258,052	$	2,612,238
Financial instrument liabilities
Deposits
Noninterest-bearing deposits	$	372,020	$	372,020	$	—	$	372,020	$	—
Interest-bearing deposits	2,328,938		2,342,313		—		2,342,313		—
Federal Home Loan Bank borrowings	215,000		208,682		—		208,682		—
Interest rate swaps	2,677		2,677		—		2,677		—
Accrued interest payable	2,591		2,591		—		2,591		—
Total financial instrument liabilities	$	2,921,226	$	2,928,283	$	—	$	2,928,283	$	—

	Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	452,367	$	—	$	—	$	—	$	—
Letters of credit	7,725		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	460,092	$	—	$	—	$	—	$	—


(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.

The carrying value and estimated fair values of the Company's financial instruments as of December 31, 2018 are as follows:

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(Unaudited)



	December 31, 2018
	Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)
	(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents	$	43,305	$	43,305	$	43,305	$	—	$	—
Investment securities	331,098		331,098		83,155		247,943		—
Loans held for sale	1,984		1,984		—		1,984		—
Loans
Agricultural	89,884		93,736		—		—		93,736
Commercial and financial	223,675		227,774		—		—		227,774
Real estate:
Construction, 1 to 4 family residential	70,982		72,419		—		—		72,419
Construction, land development and commercial	111,812		112,960		—		—		112,960
Mortgage, farmland	232,482		235,771		—		—		235,771
Mortgage, 1 to 4 family first liens	902,261		882,908		—		—		882,908
Mortgage, 1 to 4 family junior liens	150,859		148,128		—		—		148,128
Mortgage, multi-family	348,351		342,099		—		—		342,099
Mortgage, commercial	379,232		376,257		—		—		376,257
Loans to individuals	29,349		29,962		—		—		29,962
Obligations of state and political subdivisions	52,198		51,945		—		—		51,945
Accrued interest receivable	11,784		11,784		—		11,784		—
Total financial instrument assets	$	2,979,256	$	2,962,130	$	126,460	$	261,711	$	2,573,959
Financial instrument liabilities:
Deposits
Noninterest-bearing deposits	$	372,152	$	372,152	$	—	$	372,152	$	—
Interest-bearing deposits	2,048,972		2,059,336		—		2,059,336		—
Federal Home Loan Bank borrowings	215,000		207,948		—		207,948		—
Interest rate swaps	1,596		1,596				1,596
Accrued interest payable	1,812		1,812		—		1,812		—
Total financial instrument liabilities	$	2,639,532	$	2,642,844	$	—	$	2,642,844	$	—

	Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	375,940	$	—	$	—	$	—	$	—
Letters of credit	9,033		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	384,973	$	—	$	—	$	—	$	—


(1)	Considered Level 1 under 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.

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

defined under ASC 820 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

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



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



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



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

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

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

ASSETS

Investment securities available for sale: Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If a quoted price is not available, the fair value is obtained from benchmarking the security against similar securities. U.S. Treasury securities are considered Level 1 with the remaining securities considered Level 2.

The pricing for investment securities is obtained from an independent source. There are no Level 3 investment securities owned by the Company. The Company obtains an understanding of the independent source’s valuation methodologies used to determine fair value by level of security. The Company validates assigned fair values on a sample basis using an additional third-party provider pricing service to determine if the fair value measurement is reasonable. Due to the nature of our investment portfolio, we do not expect significant and unusual fluctuations as fair value changes primarily relate to interest rate changes. No unusual fluctuations were identified during the nine months ended September 30, 2019. 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 2016-01, 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. Therefore, the fair value presented herein may not be comparable to prior periods. Methodologies utilized for this financial statement period are as follows:

•Income Approach: Fair value is determined based on a discounted cash flow analysis. The discounted cash flow analysis was based on the contractual maturity of the loan and market indications of rates, prepayment speeds, defaults and credit risk.

•Asset Approach: Fair value is determined based on the estimated values of the underlying collateral or individual analysis of receipts. This provides a better indication of value than the contractual income streams as these loans are not performing or exhibit strong signs indicative of non-performance.

Fair value has been estimated in accordance with ASC 820, Fair Value Measurements and Disclosures, and is intended to represent the price that would be received in an orderly transaction between market participants as of the measurement date. In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, at least one significant 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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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.

Loans held for sale are carried at historical cost. The carrying amount is a reasonable estimate of fair value because of the short time between origination of the loan and its sale on the secondary market (Level 2). The market is active for these loans and as a result prices for similar assets are available.

Impaired loans: A loan is considered to be impaired when it is probable that all of the principal and interest due may not be collected according to its contractual terms. Generally, when a loan is considered impaired, the amount of reserve required under ASC 310, Receivables, is measured based on the fair value of the underlying collateral. The Company makes such measurements on all material loans deemed impaired using the fair value of the collateral for collateral dependent loans or based on the present value of the estimated future cash flows of interest and principal discounted at the loans effective interest rate or the fair value of the loan if determinable. The fair value of collateral used by the Company is determined by obtaining an observable market price or by obtaining an appraised value from an independent, licensed or certified appraiser, using observable market data. This data includes information such as selling price of similar properties and capitalization rates of similar properties sold within the market, expected future cash flows or earnings of the subject property based on current market expectations, and other relevant factors. All appraised values are adjusted for market-related trends based on the Company's experience in sales and other appraisals of similar property types as well as estimated selling costs. Each quarter management reviews all collateral dependent impaired loans on a loan-by-loan basis to determine whether updated appraisals are necessary based on loan performance, collateral type and guarantor support. At times, the Company measures the fair value of collateral dependent impaired loans using appraisals with dates prior to one year from the date of review. These appraisals are discounted by applying current, observable market data about similar property types such as sales contracts, estimations of value by individuals familiar with the market, other appraisals, sales or collateral assessments based on current market activity until updated appraisals are obtained. Depending on the length of time since an appraisal was performed, the data provided through reviews and estimated selling costs, collateral values are typically discounted by 0-35%. These loans are considered Level 3 as the instruments used to determine fair market value require significant management judgment and estimation.

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

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

LIABILITIES

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

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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:



	September 30, 2019
	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	$	115,949	$	—		$	—	$	115,949
State and political subdivisions	—		187,230			—		187,230
Other securities (FHLB, FHLMC and FNMA)	—		20,198			—		20,198
Derivative Financial Instruments
Interest rate swaps	$	—	(2,677		)	$	—	(2,677		)
Total	$	115,949	$	204,751		$	—	$	320,700



	December 31, 2018
	Readily Available Market Prices(1)		Observable Market Prices(2)			Company Determined Market Prices(3)		Total at Fair Value
Securities available for sale	(Amounts In Thousands)
U.S. Treasury	$	83,155	$	—		$	—	$	83,155
State and political subdivisions	—		200,900			—		200,900
Other securities (FHLB, FHLMC and FNMA)	—		34,871			—		34,871
Derivative Financial Instruments
Interest rate swaps	—		(1,596		)	—		(1,596		)
Total	$	83,155	$	234,175		$	—	$	317,330


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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

There were no transfers between Levels 1, 2 or 3 during the nine months ended September 30, 2019 and the year ended December 31, 2018.

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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.



	September 30, 2019								Three Months Ended September 30, 2019		Nine Months Ended September 30, 2019
	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	$	—	$	—	$	1,200	$	1,200	$	—	$	—
Commercial and financial	—		—		1,975		1,975		92		342
Real Estate:											—
Construction, 1 to 4 family residential	—		—		—		—		—		—
Construction, land development and commercial	—		—		249		249		—		8
Mortgage, farmland	—		—		3,612		3,612		—		—
Mortgage, 1 to 4 family first liens	—		—		6,912		6,912		142		261
Mortgage, 1 to 4 family junior liens	—		—		23		23		—		—
Mortgage, multi-family	—		—		100		100		—		—
Mortgage, commercial	—		—		1,479		1,479		—		97
Loans to individuals	—		—		—		—		—		—
Foreclosed assets (5)	—		—		—		—		—		—
Total	$	—	$	—	$	15,550	$	15,550	$	234	$	708


(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, 2018								Year Ended December 31, 2018
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses
	(Amounts in Thousands)
Loans (4)
Agricultural	$	—	$	—	$	1,160	$	1,160	$	63
Commercial and financial	—		—		2,882		2,882		122
Real Estate:
Construction, 1 to 4 family residential	—		—		—		—		—
Construction, land development and commercial	—		—		703		703		—
Mortgage, farmland	—		—		3,848		3,848		—
Mortgage, 1 to 4 family first liens	—		—		6,729		6,729		520
Mortgage, 1 to 4 family junior liens	—		—		22		22		60
Mortgage, multi-family	—		—		7,286		7,286		—
Mortgage, commercial	—		—		1,458		1,458		349
Loans to individuals	—		—		—		—		—
Foreclosed assets (5)	—		—		—		—		—
Total	$	—	$	—	$	24,088	$	24,088	$	1,114


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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


(4)	Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully-charged off is zero.


(5)	Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.


Note 8.	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, 2020. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors. The Company has purchased 1,210,485 shares of its common stock in privately negotiated transactions from August 1, 2005 through September 30, 2019. Of these 1,210,485 shares, 8,209 shares were purchased during the quarter ended September 30, 2019, at an average price per share of $64.49.

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(Unaudited)


Note 9.	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 $77.58 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 its subsidiaries are subject to pending and threatened legal actions, some of which seek substantial relief or damages. While the ultimate outcome of such legal proceedings cannot be predicted with certainty, after reviewing pending and threatened litigation with counsel, management believes at this time that the outcome of such litigation will not have a material adverse effect on the Company’s business, financial conditions, or results of operations.

On April 10, 2019, Hills Bank was sued in a class action lawsuit. The lawsuit seeks class action status for customers who had paid overdraft fees on debit card transactions that were authorized into a positive account, but settled into a negative account. Plaintiff contends that these overdraft fees breached the terms of Hills Bank’s account documents. Plaintiff seeks compensatory and punitive damages for breach of contract. The Bank disputes the merits of Plaintiff’s claims and filed a motion to dismiss the case, which the Court denied. At this stage of the proceedings, it is not possible for management of the Bank to determine the probability of an adverse outcome or reasonably estimate the amount of any potential loss.

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

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments at September 30, 2019 and December 31, 2018 is as follows:



	September 30, 2019		December 31, 2018
	(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	67,224	$	59,330
Credit cards	55,879		52,802
Commercial, real estate and home construction	119,866		89,171
Commercial lines and real estate purchase loans	209,398		174,637
Outstanding letters of credit	7,725		9,033


Note 10.	Income Taxes

Federal income tax expense for the nine months ended September 30, 2019 and 2018 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, 2018, 2017, and 2016 remain subject to examination by the Internal Revenue Service. For state tax purposes, the tax years ended December 31, 2018, 2017, and 2016 remain open for examination. There were no material unrecognized tax benefits at September 30, 2019 and December 31, 2018 and therefore no interest or penalties on unrecognized tax benefits has been recorded. As of September 30, 2019, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending September 30, 2020. Income taxes as a percentage of income before taxes were 22.02% for the nine months ended September 30, 2019 and 20.05% for the same period in 2018.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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.


Note 11.	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 $2.68 million of collateral as of September 30, 2019.

Cash Flow Hedges:

The Bank executed two forward-starting interest rate swap transactions on November 7, 2013. One of the interest rate swap transactions had an effective date of November 9, 2015, and an expiration date of November 9, 2020, effectively converting $25.00 million of variable rate debt to fixed rate debt. The other interest rate swap transaction had an effective date of November 7, 2016 and an expiration date of November 7, 2023, effectively converting $25.00 million of variable rate debt to fixed rate debt. For accounting purposes, these swap transactions are designated as a cash flow hedge of the changes in cash flows attributable to changes in three-month LIBOR, the benchmark interest rate being hedged, associated with the interest payments made on an amount of the Bank’s debt principal equal to the then-outstanding swap notional amount. At inception, the Bank asserted that the underlying principal balance would remain outstanding throughout the hedge transaction making it probable that sufficient LIBOR-based interest payments would exist through the maturity date of the swaps.

The table below identifies the balance sheet category and fair values of the Bank’s derivative instruments designated as cash flow hedges as of September 30, 2019 and December 31, 2018:



	Notional Amount		Fair Value			Balance Sheet Category	Maturity
	(Amounts in Thousands)
September 30, 2019
Interest rate swap	$	25,000	$	(326	)	Other Liabilities	11/9/2020
Interest rate swap	25,000		(2,351		)	Other Liabilities	11/7/2023

December 31, 2018
Interest rate swap	$	25,000	$	(120	)	Other Liabilities	11/9/2020
Interest rate swap	25,000		(1,476		)	Other Liabilities	11/7/2023

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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 nine months ended September 30, 2019 and year ended December 31, 2018:




	Recognized in OCI			Reclassified from AOCI into Income			Recognized in Income on Derivatives
	Amount of Gain (Loss)			Category	Amount of Gain (Loss)		Category	Amount of Gain (Loss)
	(Amounts in Thousands)
September 30, 2019
Interest rate swap	$	(155	)	Interest Expense	$	—	Other Income	$	—
Interest rate swap	(656		)	Interest Expense	—		Other Income	—

December 31, 2018
Interest rate swap	$	347		Interest Expense	$	—	Other Income	$	—
Interest rate swap	571			Interest Expense	—		Other Income	—



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

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

Special Note Regarding Forward Looking Statements

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

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


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


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


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

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


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


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


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


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


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


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


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


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


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


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


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


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


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


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

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

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Critical Accounting Policies

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

economic conditions throughout the Midwest and the state of certain industries. Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position. Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations. Although management believes the levels of the allowance as of September 30, 2019 and December 31, 2018 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

Overview

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

The Company is a holding company engaged in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids, Marion, and Washington, Iowa. At September 30, 2019, the Bank has nineteen full-service locations.

Net income for the nine month period ended September 30, 2019 was $33.71 million compared to $30.97 million for the same nine months of 2018, an increase of 8.83%. The $2.73 million increase in net income was caused by a number of factors. The principal factors in the increase in net income for the first nine months of 2019 are an increase in net interest income of $4.22 million and a decrease in the provision for loan losses of $3.18 million. These changes were offset by a decrease in noninterest income of $0.79 million, an increase in income tax expense of $1.75 million and an increase in noninterest expenses of $2.12 million.

The Company achieved a return on average assets of 1.25% and a return on average equity of 11.38% for the twelve months ended September 30, 2019, compared to the twelve months ended September 30, 2018, which were 1.20% and 11.12%, respectively. Dividends of $0.82 per share were paid in January 2019 to 2,481 shareholders. The 2018 dividend was $0.75 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 3.20% for the nine months ended September 30, 2019 compared to 3.24% for the same nine months of 2018. Average earning assets were $3.108 billion year to date in 2019 and $2.891 billion in 2018.

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Highlights noted on the balance sheet as of September 30, 2019 for the Company included the following:


•	Total assets were $3.358 billion, an increase of $315.27 million since December 31, 2018.


•	Cash and cash equivalents were $315.13 million, an increase of $271.83 million since December 31, 2018. Cash and cash equivalents growth included approximately $122 million of certificates of deposit and approximately $5.56 million of brokered deposits.


•	Net loans were $2.628 billion, an increase of $35.10 million since December 31, 2018. Loans held for sale increased $22.87 million since December 31, 2018.


•	Deposits increased $279.83 million since December 31, 2018.

Reference is made to Note 7 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, 2019 and into 2020. As indicated in the table below, growth is primarily in 1 to 4 family residential construction and commercial real estate loans.

The following table sets forth the composition of the loan portfolio as of September 30, 2019 and December 31, 2018:



	September 30, 2019				December 31, 2018
	Amount		Percent		Amount		Percent
	(Amounts In Thousands)				(Amounts In Thousands)
Agricultural	$	91,621	3.47	%	$	92,673	3.53	%
Commercial and financial	219,362		8.32		229,501		8.73
Real estate:
Construction, 1 to 4 family residential	80,969		3.07		72,279		2.75
Construction, land development and commercial	108,662		4.12		113,807		4.33
Mortgage, farmland	237,513		9.00		236,454		9.00
Mortgage, 1 to 4 family first liens	913,206		34.62		912,059		34.71
Mortgage, 1 to 4 family junior liens	149,969		5.69		152,625		5.81
Mortgage, multi-family	350,378		13.28		352,434		13.41
Mortgage, commercial	401,615		15.22		383,314		14.58
Loans to individuals	32,613		1.24		30,072		1.14
Obligations of state and political subdivisions	52,030		1.97		52,725		2.01
	$	2,637,938	100.00	%	$	2,627,943	100.00	%
Net unamortized fees and costs	943				952
	$	2,638,881			$	2,628,895
Less allowance for loan losses	35,570				37,810
	$	2,603,311			$	2,591,085

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

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

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

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

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The following table presents the allowance for loan losses on loans by loan category, the percentage of the allowance for each category to the total allowance, and the percentage of all loans in each category to total loans as of September 30, 2019 and December 31, 2018:



	September 30, 2019						December 31, 2018
	Amount		% of Total Allowance		% of Loans to Total Loans		Amount		% of Total Allowance		% of Loans to Total Loans
	(In Thousands)						(In Thousands)
Agricultural	$	2,706	7.61	%	3.47	%	$	2,789	7.38	%	3.53	%
Commercial and financial	5,411		15.21		8.32		5,826		15.41		8.73
Real estate:
Construction, 1 to 4 family residential	1,329		3.74		3.07		1,297		3.43		2.75
Construction, land development and commercial	1,559		4.38		4.12		1,995		5.28		4.33
Mortgage, farmland	3,987		11.21		9.00		3,972		10.51		9.00
Mortgage, 1 to 4 family first liens	9,568		26.90		34.62		10,750		28.43		34.71
Mortgage, 1 to 4 family junior liens	1,635		4.60		5.69		1,766		4.67		5.81
Mortgage, multi-family	3,846		10.81		13.28		4,083		10.80		13.41
Mortgage, commercial	4,250		11.95		15.22		4,082		10.80		14.58
Loans to individuals	759		2.13		1.24		723		1.91		1.14
Obligations of state and political subdivisions	520		1.46		1.97		527		1.38		2.01
	$	35,570	100.00	%	100.00	%	$	37,810	100.00	%	100.00	%

The allowance for loan losses totaled $35.57 million at September 30, 2019 compared to $37.81 million at December 31, 2018. The percentage of the allowance to outstanding loans was 1.35% and 1.44% at September 30, 2019 and December 31, 2018, respectively. The allowance was based on management’s consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks and the overall amount of loans outstanding. The decrease in the allowance in 2019 is the result of change in the composition and allocation of loans within credit quality ratings, improvements in the credit quality of the Bank's loan portfolio, decreases in specific allowances on loans and improving qualitative factors.

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

Management has determined that the allowance for loan losses was appropriate at September 30, 2019, 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 $4.45 million from December 31, 2018 to September 30, 2019. The fair value of securities available for sale was $4.34 million more than the amortized cost of such securities as of September 30, 2019. At December 31, 2018, the fair value of the securities available for sale was $2.73 million less than the amortized cost of such securities.

Deposits increased $279.83 million in the first nine months of 2019 primarily due to broker deposits and rate specials on certificate of deposits. 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 $138.03 million as of September 30, 2019 with an average rate of 2.22%. Brokered deposits were $132.46 million as of December 31, 2018 with an average interest rate of 2.46%. As of September 30, 2019 and December 31, 2018, brokered deposits were 5.11% and 5.47% of total deposits, respectively.

Federal Home Loan Bank (FHLB) borrowings were $215 million as of September 30, 2019 and December 31, 2018. 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 2019, Hills Bancorporation paid a dividend of $7.66 million or $0.82 per share. The dividend was $0.75 per share in January 2018. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of September 30, 2019 totaled $363.84 million. On January 1, 2015, the final rules of the Federal Reserve Board went into effect implementing in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision. The final rule also adopted changes to the agencies’ regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

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



	Actual				For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Ratio		Ratio
As of September 30, 2019:
Company:
Total risk-based capital	$	442,360	17.89	%	8.000	%	10.000	%
Tier 1 risk-based capital	411,389		16.63		6.000		8.000
Tier 1 common equity	411,389		16.63		4.500		6.500
Leverage ratio	411,389		12.46		4.000		5.000
Bank:
Total risk-based capital	443,870		17.96		8.000		10.000
Tier 1 risk-based capital	412,915		16.71		6.000		8.000
Tier 1 common equity	412,915		16.71		4.500		6.500
Leverage ratio	412,915		12.51		4.000		5.000

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	Actual				For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Ratio		Ratio
As of December 31, 2018:
Company:
Total risk-based capital	$	414,772	17.18	%	8.00	%	10.00	%
Tier 1 risk-based capital	384,502		15.93		6.00		8.00
Tier 1 common equity	384,502		15.93		4.50		6.50
Leverage ratio	384,502		12.68		4.00		5.00
Bank:
Total risk-based capital	416,198		17.25		8.00		10.00
Tier 1 risk-based capital	385,943		16.00		6.00		8.00
Tier 1 common equity	385,943		16.00		4.50		6.50
Leverage ratio	385,943		12.73		4.00		5.00

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Discussion of operations for the nine months ended September 30, 2019 and 2018

Net Income Overview

Net income increased $2.73 million for the nine months ended September 30, 2019 compared to the first nine months of 2018. Total net income was $33.71 million in 2019 and $30.97 million in the comparable period in 2018, an increase of 8.83%. The changes in net income in 2019 from the first nine months of 2018 were primarily the result of the following:


•	Net interest income increased by $4.22 million, before provision expense. Total interest income increased by $11.55 million as a result of growth in the volume of earning assets and rising interest rates. Total interest expense increased by $7.33 million primarily due to rising interest rates increasing the costs of funding.


•	The provision for loan losses decreased by $3.18 million.


•	Noninterest income decreased by $0.79 million.


•	Noninterest expenses increased by $2.12 million.


•	Income tax expense increased by $1.75 million.

For the nine month period ended September 30, 2019 and September 30, 2018 basic earnings per share was $3.61 and $3.30, respectively. Diluted earnings per share was $3.61 for the nine months ended September 30, 2019 compared to $3.30 for the same period in 2018.

The Company’s net income is 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 $72.86 million for the first nine months of 2019 was derived from the Company’s $3.108 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.20%. Average earning assets in the nine months ended September 30, 2018 were $2.891 billion and the tax-equivalent net interest margin was 3.24%. 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 $2.33 million change in income before income taxes in the nine month period ended September 30, 2019. 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 with increased costs of funding in the short-term due to competition for deposits combined with the potential future interest rate decreases by the Federal Reserve Board. 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 $2.628 billion at September 30, 2019. 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 $1.64 million in 2019 compared to an expense of $1.54 million in 2018. The reduction is primarily attributable to a decrease in specific reserves on loans and decreases in qualitative factors related to land development and commercial construction, multi-family real estate, commercial real estate and 1 to 4 family first lien mortgages. 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 $9.52 million and $7.77 million for the nine months ended September 30, 2019 and 2018, respectively. Income taxes as a percentage of income before taxes were 22.02% in 2019 and 20.05% in 2018. The increase in income taxes as a percentage of income before taxes is due to tax credits related to investments in tax credit real estate being fully utilized. 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. The quarter ended March 31, 2019 was the first with all comparable periods on a Post-Tax Act basis, therefore the Company expects income taxes as a percentage of income before taxes to be more comparable in current and future periods than it was over the previous fiscal year.

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Discussion of operations for the nine months ended September 30, 2019 and 2018

Net Interest Income

Net interest income increased for the nine months ended September 30, 2019 compared to the comparable period in 2018. The increase was as a result of growth in the average volume of earning assets. Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the average volume of earning assets for the period and the net interest margin. The net interest margin for the first nine months of 2019 was 3.20% compared to 3.24% in 2018 for the same period. Interest expense increased $7.33 million for the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018 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 nine months ended in 2019 compared to the comparable period in 2018 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	$	147,468		0.24	%	$	4,993		$	4,565		$	9,558
Taxable securities	10,767			0.19		197			175			372
Nontaxable securities	9,418			0.14		183			195			378
Federal funds sold	49,762			0.53		659			685			1,344
	$	217,415				$	6,032		$	5,620		$	11,652

Interest expense:
Interest-bearing demand deposits	$	61,508		0.30	%	$	(266	)	$	(1,589	)	$	(1,855	)
Savings deposits	24,334			0.27		(150		)	(1,736		)	(1,886		)
Time deposits	124,502			0.51		(1,539		)	(2,450		)	(3,989		)
FHLB borrowings	(17,422		)	(0.01	)	388			16			404
Interest-bearing other liabilities	(2		)	0.76		—			—			—
	$	192,920				$	(1,567	)	$	(5,759	)	$	(7,326	)
Change in net interest income						$	4,465		$	(139	)	$	4,326

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)	2019		2018
Yield on average interest-earning assets	4.32	%	4.11	%
Rate on average interest-bearing liabilities	1.44		1.12
Net interest spread	2.88	%	2.99	%
Effect of noninterest-bearing funds	0.32		0.25
Net interest margin (tax equivalent interest income divided by average interest-earning assets)	3.20	%	3.24	%

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Discussion of operations for the nine months ended September 30, 2019 and 2018

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. The Federal Open Market Committee met six times during the first nine months of 2019. The target rate decreased to 2.00% as of September 30, 2019. Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate. As of September 30, 2019, the rate indexes for the one, three and five year indexes were 1.75%, 1.56% and 1.55%, respectively. The one year index decreased 32.43% from 2.59% at September 30, 2018, the three year index decreased 45.83% and the five year index decreased 42.28%. The three year index was 2.88% and the five year index was 2.94% at September 30, 2018. The targeted federal funds rate was 2.00% and 2.25% at September 30, 2019 and 2018, respectively. The Company anticipates short term and long term rates in the indexes to remain consistent for 2019.

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $1.64 million for the nine months ended September 30, 2019 compared to an expense of $1.54 million in 2018, a reduction of expense of $3.18 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 historically higher credit risks. The decrease in expense in 2019 is the result of a change in the composition and allocation of loans within credit quality ratings as compared to September 30, 2018 and improvements in the credit quality of the Bank's loan portfolio.

The allowance for loan losses decreased $2.24 million during the first nine months of 2019 as compared to December 31, 2018. In the first nine months of 2019, there was a decrease of $1.44 million due to changes in average balances and composition of loans outstanding and a $0.80 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 nine months ended September 30, 2019 and 2018, recoveries were $1.36 million and $1.78 million, respectively; and charge-offs were $1.96 million in 2019 and $1.71 million in 2018. The allowance for loan losses totaled $35.57 million at September 30, 2019 compared to $37.81 million at December 31, 2018. The allowance represented 1.35% and 1.44% of loans held for investment at September 30, 2019 and December 31, 2018.

Noninterest Income

The following table sets forth the various categories of noninterest income for the nine months ended September 30, 2019 and 2018.



	Nine Months Ended September 30,
	2019			2018		$ Change			% Change
	(Amounts in thousands)
Net gain on sale of loans	$	2,060		$	1,227	$	833		67.89	%
Trust fees	7,107			7,753		(646		)	(8.33	)
Service charges and fees	7,618			7,475		143			1.91
Other noninterest income	982			2,075		(1,093		)	(52.67	)
Loss on sale of investment securities	(28		)	—		(28		)	—
	$	17,739		$	18,530	$	(791	)	(4.27	)

Loans originated for sale in the first nine months of 2019 totaled $201.51 million compared to $110.69 million in the same period in 2018, an increase of 82.05%. In the nine months ended September 30, 2019 and 2018, the net gain on sale of loans was $2.06 million and $1.23 million, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can

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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.

Other noninterest income decreased $1.09 million in the nine months ended September 30, 2019 compared to September 30, 2018 primarily due to the sale of the insurance department in August 2018 for a gain of $885,000.

Other noninterest income categories experienced marginal period-to-period fluctuations for the nine months ended September 30, 2019.

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HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2019 and 2018

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the nine months ended September 30, 2019 and 2018.



	Nine Months Ended September 30,
	2019		2018		$ Change			% Change
	(Amounts in thousands)
Salaries and employee benefits	$	27,310	$	25,718	$	1,592		6.19	%
Occupancy	3,274		3,331		(57		)	(1.71	)
Furniture and equipment	5,036		4,657		379			8.14
Office supplies and postage	1,370		1,327		43			3.24
Advertising and business development	1,800		1,821		(21		)	(1.15	)
Outside services	7,824		7,692		132			1.72
FDIC insurance assessment	612		657		(45		)	(6.85	)
Other noninterest expense	1,787		1,688		99			5.86
	$	49,013	$	46,891	$	2,122		4.53

In the nine months ended September 30, 2019 and 2018, salaries and employee benefits expense increased $1.59 million. The increase is primarily the result of annual salary adjustments and hiring of additional employees to staff growth.

Other noninterest expense categories experienced marginal period-to-period fluctuations for the nine months ended September 30, 2019.

Discussion of operations for the three months ended September 30, 2019 and 2018

Net Income Overview

Net income increased $1.23 million for the three months ended September 30, 2019 compared to the same period in 2018. Total net income was $11.28 million in 2019 and $10.05 million in the comparable period in 2018, an increase of 12.26%. For the three month period ended September 30, 2019 and September 30, 2018 basic earnings per share was $1.21 and $1.07, respectively. Diluted earnings per share was $1.21 for the three months ended September 30, 2019 compared to $1.07 for the same period in 2018.

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Discussion of operations for the three months ended September 30, 2019 and 2018

Net Interest Income

Net interest income increased for the three months ended September 30, 2019 compared to the comparable period in 2018. 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 $2.38 million for the three months ended September 30, 2019 compared to the three months ended September 30, 2018 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 September 30, 2019 was 3.13% compared to 3.27% in 2018 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 2019 compared to the comparable period in 2018 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	$	116,080		0.20	%	$	1,388		$	1,201		$	2,589
Taxable securities	10,355			0.03		78			(11		)	67
Nontaxable securities	5,315			0.08		36			37			73
Federal funds sold	148,587			0.18		747			111			858
	$	280,337				$	2,249		$	1,338		$	3,587

Interest expense:
Interest-bearing demand deposits	$	114,140		0.27	%	$	(185	)	$	(492	)	$	(677	)
Savings deposits	2,919			0.12		11			(273		)	(262		)
Time deposits	134,439			0.48		(604		)	(835		)	(1,439		)
FHLB borrowings	3			0.01		—			(5		)	(5		)
Interest-bearing other liabilities	(3		)	(0.09	)	—			—			—
	$	251,498				$	(778	)	$	(1,605	)	$	(2,383	)
Change in net interest income						$	1,471		$	(267	)	$	1,204

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



(Tax Equivalent Basis)	2019		2018
Yield on average interest-earning assets	4.28	%	4.20	%
Rate on average interest-bearing liabilities	1.47		1.21
Net interest spread	2.81	%	2.99	%
Effect of noninterest-bearing funds	0.32		0.28
Net interest margin (tax equivalent interest income divided by average interest-earning assets)	3.13	%	3.27	%

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Discussion of operations for the three months ended September 30, 2019 and 2018

Provision for Loan Losses

The provision for loan losses was an expense of $0.14 million for the three months ended September 30, 2019 compared to an expense of $1.59 million in 2018, an expense decrease of $1.45 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 2019 is the result of changes in the composition and allocation of loans within credit quality ratings as compared to September 30, 2018 and a reduction in specific reserves as of September 30, 2019 as compared to September 30, 2018.

The allowance for loan losses decreased $0.08 million during the three months ended September 30, 2019 compared to September 30, 2018. In the three months ended September 30, 2019, there was a $0.08 million decrease in the amount allocated to the allowance due to credit quality and no material change 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 September 30, 2019 and 2018, recoveries were $0.51 million and $0.80 million, respectively; and charge-offs were $0.74 million in 2019 and $0.89 million in 2018. The allowance for loan losses totaled $35.57 million at September 30, 2019 compared to $37.81 million at December 31, 2018. The allowance represented 1.35% and 1.44% of loans held for investment at September 30, 2019 and December 31, 2018, respectively.

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended September 30, 2019 and 2018.



	Three Months Ended September 30,
	2019		2018		$ Change			% Change
	(Amounts in thousands)
Net gain on sale of loans	$	1,197	$	453	$	744		164.24	%
Trust fees	2,427		2,105		322			15.30
Service charges and fees	2,695		2,839		(144		)	(5.07	)
Other noninterest income	295		1,271		(976		)	(76.79	)
Gain on sale of investment securities	24		—		24			—
	$	6,638	$	6,668	$	(30	)	(0.45	)

In the three months ended September 30, 2019 and 2018, the net gain on sale of loans was $1.20 million and $0.45 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.

Other noninterest income decreased $0.98 million in the three months ended September 30, 2019 compared to September 30, 2018 primarily due to the sale of the insurance department in August 2018 for a gain of $885,000.

Other noninterest income categories experienced marginal period-to-period fluctuations for the three months ended September 30, 2019.

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HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2019 and 2018

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended September 30, 2019 and 2018.



	Three Months Ended September 30,
	2019		2018		$ Change			% Change
	(Amounts in thousands)
Salaries and employee benefits	$	9,258	$	8,611	$	647		7.51	%
Occupancy	986		1,208		(222		)	(18.38	)
Furniture and equipment	1,699		1,693		6			0.35
Office supplies and postage	469		432		37			8.56
Advertising and business development	607		584		23			3.94
Outside services	2,729		2,767		(38		)	(1.37	)
FDIC insurance assessment	208		226		(18		)	(7.96	)
Other noninterest expense	648		434		214			49.31
	$	16,604	$	15,955	$	649		4.07

In the three months ended September 30, 2019 and 2018, salaries and employee benefits expense increased $0.65 million. The increase is primarily the result of annual salary adjustments and hiring of additional employees to staff branch growth.

Other noninterest expense categories experienced marginal period-to-period fluctuations for the three months ended September 30, 2019.

Income Taxes

Federal and state income tax expenses were $3.30 million and $2.59 million for the three months ended September 30, 2019 and 2018, respectively. Income taxes as a percentage of income before taxes were 22.65% in 2019 and 20.49% in 2018. 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 quarter ended March 31, 2019 was the first with all comparable periods on a Post-Tax Act basis, therefore the Company expects income taxes as a percentage of income before taxes to be more comparable in current and future periods than it was over the previous fiscal year.

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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 9.63% of the Company’s total assets at September 30, 2019 compared to 10.48% at December 31, 2018.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position. As of September 30, 2019, 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 $693.89 million at September 30, 2019.

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 $472.91 million. The borrowings under these credit lines would be secured by the Bank’s investment securities. The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at September 30, 2019.

As of September 30, 2019, investment securities with a carrying value of $12.92 million were pledged to collateralize public and trust deposits, derivative financial instruments, and other borrowings. As of December 31, 2018, investment securities with a carrying value of $9.78 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, 2018.



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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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, 2018.



Item 4.	Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission. There have been no changes in the Company’s internal controls over financial reporting during the nine months ended September 30, 2019 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

In the normal course of business, the Company and its subsidiaries are subject to pending and threatened legal actions, some of which seek substantial relief or damages. While the ultimate outcome of such legal proceedings cannot be predicted with certainty, after reviewing pending and threatened litigation with counsel, management believes at this time that the outcome of such litigation will not have a material adverse effect on the Company’s business, financial conditions, or results of operations.



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, 2018.

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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 September 30, 2019:



Period	Total number of shares purchased	Average price paid per share		Total number of shares purchased as part of publicly announced plans or programs	Maximum number of shares that may yet be purchased under the plans or programs (1)
July 1 to July 31	55	$	63.50	55	297,669
August 1 to August 31	1,430	64.49		1,430	296,239
September 1 to September 30	6,724	64.50		6,724	289,515
Total	8,209	$	64.49	8,209	289,515

(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, 2020. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.



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 of Hills Bancorporation, incorporated by reference to Exhibit 3.2 to the Company's Form 10-Q Filed with the Commission on May 6, 2019.
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), (2)
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.


(2)	The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document.

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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:	November 4 2019	By: /s/ Dwight O. Seegmiller
		Dwight O. Seegmiller, Director, President and Chief Executive Officer

Date:	November 4 2019	By: /s/ Shari DeMaris
		Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer

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QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED SEPTEMBER 30, 2019



Exhibit Number	Description	Page Number In The Sequential Numbering System September 30, 2019 Form 10-Q

31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	63-64

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	65

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