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HILLS BANCORPORATION - Quarter Report: 2020 September (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
FORM 10-Q
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2020

OR
☐
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.
Iowa42-1208067
131 MAIN STREET, HILLS, Iowa 52235

Telephone number: (319) 679-2291

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

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APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date.
 SHARES OUTSTANDING
CLASSOctober 31, 2020
  
Common StockNo par value9,341,944

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HILLS BANCORPORATION
Index to Form 10-Q

Part I
FINANCIAL INFORMATION
 
  Page
 Number
   
Item 1.Financial Statements 
   
 
 
 
 
 
 
   
Item 2.
   
Item 3.
   
Item 4.
   
 Part II 
 OTHER INFORMATION 
   
Item 1.
   
Item 1A.
   
Item 2.
   
Item 3.
   
Item 4.
   
Item 5.
   
Item 6.
   
   
Page 3
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HILLS BANCORPORATION CONSOLIDATED BALANCE SHEETS (Amounts In Thousands, Except Share Amounts) 
September 30, 2020December 31, 2019
ASSETS(Unaudited)
Cash and cash equivalents$560,738 $241,965 
Investment securities available for sale at fair value (amortized cost September 30, 2020 $362,811; December 31, 2019 $351,069)
375,255 355,303 
Stock of Federal Home Loan Bank11,373 11,065 
Loans held for sale27,980 8,400 
Loans, net of allowance for loan losses (September 30, 2020 $37,060; December 31, 2019 $33,760)
2,731,030 2,606,277 
Property and equipment, net35,548 37,146 
Tax credit real estate investment7,160 8,280 
Accrued interest receivable13,731 12,442 
Deferred income taxes, net7,015 8,018 
Goodwill2,500 2,500 
Other assets8,121 9,491 
Total Assets$3,780,451 $3,300,887 
LIABILITIES AND STOCKHOLDERS' EQUITY  
Liabilities  
Noninterest-bearing deposits$500,272 $387,612 
Interest-bearing deposits2,614,279 2,273,752 
Total deposits$3,114,551 $2,661,364 
Other borrowings43 — 
Federal Home Loan Bank borrowings185,000 185,000 
Accrued interest payable2,198 2,474 
Other liabilities24,505 25,012 
Total Liabilities$3,326,297 $2,873,850 
Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)$46,895 $51,826 
STOCKHOLDERS' EQUITY  
Common stock, no par value; authorized 20,000,000 shares; issued September 30, 2020 10,328,875 shares; December 31, 2019 10,327,656 shares
$— $— 
Paid in capital59,972 55,943 
Retained earnings431,401 409,509 
Accumulated other comprehensive income7,031 1,415 
Treasury stock at cost (September 30, 2020 982,827 shares; December 31, 2019 975,962 shares)
(44,250)(39,830)
Total Stockholders' Equity$454,154 $427,037 
Less maximum cash obligation related to ESOP shares46,895 51,826 
Total Stockholders' Equity Less Maximum Cash Obligation Related to ESOP Shares$407,259 $375,211 
Total Liabilities & Stockholders' Equity$3,780,451 $3,300,887 

See Notes to Consolidated Financial Statements.
Page 4
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HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(Amounts In Thousands, Except Per Share Amounts)
 Three Months Ended
September 30,		Nine Months Ended
September 30,
 2020201920202019
Interest income:
Loans, including fees$29,750 $30,857 $89,975 $90,825 
Investment securities:
Taxable889 825 2,656 2,375 
Nontaxable933 918 2,941 2,898 
Federal funds sold103 1,369 801 2,954 
Total interest income$31,675 $33,969 $96,373 $99,052 
Interest expense:
Deposits$5,077 $7,662 $16,854 $21,418 
FHLB borrowings1,388 1,612 4,118 4,778 
Total interest expense$6,465 $9,274 $20,972 $26,196 
Net interest income$25,210 $24,695 $75,401 $72,856 
Provision for loan losses(157)144 4,500 (1,642)
Net interest income after provision for loan losses$25,367 $24,551 $70,901 $74,498 
Noninterest income:
Net gain on sale of loans$2,303 $1,197 $4,859 $2,060 
Trust fees2,494 2,427 7,450 7,107 
Service charges and fees2,636 2,695 7,427 7,618 
Other noninterest income77 295 462 982 
Gain (loss) on sale of investment securities— 24 10 (28)
 $7,510 $6,638 $20,208 $17,739 
Noninterest expenses:
Salaries and employee benefits$10,108 $9,258 $29,818 $27,310 
Occupancy1,067 986 3,248 3,274 
Furniture and equipment2,028 1,699 5,778 5,036 
Office supplies and postage425 469 1,333 1,370 
Advertising and business development340 607 1,479 1,800 
Outside services2,818 2,729 8,020 7,824 
FDIC insurance assessment223 208 617 612 
Other noninterest expense1,046 648 1,861 1,787 
 $18,055 $16,604 $52,154 $49,013 
Income before income taxes$14,822 $14,585 $38,955 $43,224 
Income taxes3,392 3,303 8,739 9,519 
Net income$11,430 $11,282 $30,216 $33,705 
Earnings per share:
Basic$1.22 $1.21 $3.22 $3.61 
Diluted$1.22 $1.21 $3.22 $3.61 
 
See Notes to Consolidated Financial Statements.
Page 5

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

 Three Months Ended September 30,Nine Months Ended
September 30,
 2020201920202019
Net income$11,430 $11,282 $30,216 $33,705 
Other comprehensive income  
Securities:  
Net change in unrealized (loss) income on securities available for sale$(84)$495 $8,220 $7,046 
Reclassification adjustment for net loss (gains) realized in net income— (24)(10)28 
Income taxes21 (118)(2,049)(1,765)
Other comprehensive (loss) income on securities available for sale$(63)$353 $6,161 $5,309 
Derivatives used in cash flow hedging relationships:  
Net change in unrealized gain (loss) on derivatives$364 $(103)$(726)$(1,081)
Income taxes(91)26 181 270 
Other comprehensive income (loss) on cash flow hedges$273 $(77)$(545)$(811)
Other comprehensive income, net of tax$210 $276 $5,616 $4,498 
Comprehensive income$11,640 $11,558 $35,832 $38,203 
 
See Notes to Consolidated Financial Statements.
Page 6


HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited) (Amounts In Thousands, Except Share Amounts)
Three Months Ended September 30, 2020 and 2019
Paid In CapitalRetained EarningsAccumulated Other Comprehensive Income (Loss)Treasury StockMaximum Cash Obligation Related To ESOP SharesTotal
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 compensation165 — — — — 165 
Forfeiture of 134 shares of common stock
(8)— — — — (8)
Share-based compensation6 — — — — 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 
Balance, June 30, 2020$60,043 $419,971 $6,821 $(42,787)$(45,329)$398,719 
Issuance of 13,120 shares of common stock
458 — — 351 — 809 
Issuance of 1,861 shares of common stock under the employee stock purchase plan
104 — — — — 104 
Unearned restricted stock compensation(474)— — — — (474)
Forfeiture of 3,188 shares of common stock
(166)— — — — (166)
Share-based compensation7 — — — — 7 
Change related to ESOP shares— — — — (1,566)(1,566)
Net income— 11,430 — — — 11,430 
Purchase of 29,807 shares of common stock
— — — (1,814)— (1,814)
Other comprehensive income— — 210 — — 210 
Balance, September 30, 2020$59,972 $431,401 $7,031 $(44,250)$(46,895)$407,259 

Page 7

Nine Months Ended September 30, 2020 and 2019
 Paid In CapitalRetained EarningsAccumulated Other
Comprehensive
Income (Loss)		Treasury StockMaximum Cash
Obligation Related
To ESOP Shares		Total
Balance, December 31, 201852,122 371,848 (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 compensation572 — — — — 572 
Forfeiture of 5,255 shares of common stock
(262)— — — — (262)
Share-based compensation7 — — — — 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 
Balance, December 31, 2019$55,943 $409,509 $1,415 $(39,830)$(51,826)$375,211 
Issuance of 105,542 shares of common stock
4,005 — — 2,810 — 6,815 
Issuance of 5,430 shares of common stock under the employee stock purchase plan
304 — — — — 304 
Unearned restricted stock compensation(81)— — — — (81)
Forfeiture of 4,211 shares of common stock
(218)— — — — (218)
Share-based compensation19 — — — — 19 
Change related to ESOP shares— — — — 4,931 4,931 
Net income— 30,216 — — — 30,216 
Cash dividends ($0.89 per share)
— (8,324)— — — (8,324)
Purchase of 112,407 shares of common stock
— — — (7,230)— (7,230)
Other comprehensive income— — 5,616 — — 5,616 
Balance, September 30, 2020$59,972 $431,401 $7,031 $(44,250)$(46,895)$407,259 
 

See Notes to Consolidated Financial Statements.
Page 8

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

 Nine Months Ended
September 30,
 20202019
Cash Flows from Operating Activities
Net income$30,216 $33,705 
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:  
Depreciation2,623 2,542 
Provision for loan losses4,500 (1,642)
Net (gain) loss on sale of investment securities available for sale(10)28 
Forfeiture of common stock(218)(262)
Share-based compensation19 7 
Compensation expensed through issuance of common stock971 348 
Provision for deferred income taxes(865)484 
Net gain on sale of other real estate owned and other repossessed assets— (11)
Increase in accrued interest receivable(1,289)(1,718)
Amortization of premium on investment securities, net555 303 
Decrease (increase) in other assets1,320 (1,763)
Amortization of operating lease right-of-use assets91 265 
Decrease in accrued interest payable and other liabilities(1,590)(40)
Loans originated for sale(359,531)(201,514)
Proceeds on sales of loans344,810 180,701 
Net gain on sales of loans(4,859)(2,060)
Net cash and cash equivalents provided by operating activities$16,743 $9,373 
Cash Flows from Investing Activities  
Proceeds from maturities of investment securities available for sale$64,096 $51,275 
Proceeds from sales of investment securities available for sale313 12,467 
Purchases of investment securities available for sale(77,004)(61,544)
Loans made to customers, net of collections(129,294)(11,296)
Proceeds on sale of other real estate owned and other repossessed assets— 63 
Purchases of property and equipment(1,025)(1,637)
Net changes from tax credit real estate investment1,120 777 
Net cash and cash equivalents used in investing activities$(141,794)$(9,895)
Cash Flows from Financing Activities  
Net increase in deposits$453,187 $279,834 
Net increase in short-term borrowings43 — 
Issuance of common stock, net of costs5,844 5,026 
Purchase of treasury stock(7,230)(5,177)
Proceeds from the issuance of common stock through the employee stock purchase plan304 325 
Dividends paid(8,324)(7,657)
Net cash and cash equivalents provided by financing activities$443,824 $272,351 
 
(Continued)

Page 9

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)
 Nine Months Ended
September 30,
 20202019
Increase in cash and cash equivalents$318,773 $271,829 
Cash and cash equivalents:  
Beginning of period241,965 43,305 
End of period$560,738 $315,134 
Supplemental Disclosures  
Cash payments for:  
Interest paid to depositors$17,130 $20,639 
Interest paid on other obligations4,118 4,778 
Income taxes paid7,329 8,044 
Noncash activities:  
(Decrease)/increase in maximum cash obligation related to ESOP shares$(4,931)$2,432 
Transfers to other real estate owned— 712 
Right-of-use assets obtained in exchange for operating lease obligations— 3,581 
 
See Notes to Consolidated Financial Statements.


Page 10

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, 2020 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2020.  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, 2019 filed with the Securities Exchange Commission on March 6, 2020.  The consolidated balance sheet as of December 31, 2019, 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. 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, 2020, 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
Page 11
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
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, 2020.


Effect of New Financial Accounting Standards:

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 June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments (CECL). The ASU changes the way entities recognize impairment of financial assets by requiring immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the "incurred loss" model required under current GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance. For public companies, ASU 2016-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019, early adoption is permitted for the fiscal year beginning after December 15, 2018. With the passage of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), the option to delay CECL was provided until the earlier of the national health emergency being declared over or December 31, 2020. The Company elected to delay implementing CECL and continued to use the incurred loss method to calculate the allowance for loan losses as of and for the period ending September 30, 2020.

The Company has implemented a software solution provided by a third party vendor to assist in the determination of the CECL estimate. The CECL model has been finalized and we completed the validation process for the CECL model using an independent outside party in January 2020. 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 obtain estimated life-time credit losses using the conceptual components described above.
Page 12
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Upon the expiration of the CECL delay provided by the CARES Act, the adjustment upon adoption at January 1, 2020 will be an overall increase in our Allowance for Credit Losses (ACL) for loans of $3.5 million. We will also record an unfunded commitments liability of $1.45 million upon adoption. The future effects of CECL on our ACL will depend on the size and composition of our portfolio, the portfolio’s credit quality and economic conditions, as well as any refinements to our model, methodology and other key assumptions. We will recognize a one-time cumulative-effect adjustment to our allowance for loan losses upon adoption of the new standard. The increase in the ACL will result in a decrease to our regulatory capital amounts and ratios. Once finalized, we estimate the ACL as of September 30, 2020 to be approximately $41 million to $44 million and the unfunded commitments liability to be approximately $4 million to $5 million.

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 Company adopted ASU No. 2017-04 for the period ending March 31, 2020. There was no material impact on the financial statements.

In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities. This ASU requires companies to change the recognition and presentation of the effects of hedge accounting by eliminating the requirement to separately measure and report hedge ineffectiveness and requiring companies to present all of the elements of hedge accounting that affect earnings in the same income statement line as the hedged item. Furthermore, the standard eases the requirements for effectiveness testing, hedge documentation and applying the critical terms match method and introduces new alternatives that will permit companies to reduce the risk of material error corrections if they misapply the shortcut method. For public companies, ASU 2017-12 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018. The Company adopted ASU No. 2017-12 for the period ending March 31, 2019. There was no material impact on the financial statements.

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
Page 13
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
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 Company adopted ASU 2018-13 for the period ending March 31, 2020. There was no material impact on the financial statements.

In August 2018, the FASB issued ASU No. 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40), Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangements That Is a Service Contract. The amendments in this ASU align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). ASU 2018-15 is effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption of the amendments in this ASU is permitted, including adoption in any interim period, for all entities. The amendments in this ASU should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. The Company adopted ASU 2018-15 for the period ending March 31, 2020. There was no material impact on the financial statements.

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

In November 2019, the FASB issued ASU No. 2019-08, Compensation - Stock Compensation (Topic 718) and Revenue from Contracts with Customers (Topic 606), Codification Improvements - Share-Based Consideration Payable to a Customer. The amendments in this ASU require that an entity measure and classify share-based payment awards granted to a customer by applying the guidance in Topic 718. The amount recorded as a reduction of the transaction price is required to be measured on the basis of the grant-date fair value of the share-based payment award in accordance with Topic 718. The grant date is the date at which a grantor (supplier) and a grantee (customer) reach a mutual understanding of the key terms and conditions of a share-based payment award. The classification and subsequent measurement of the award are subject to the guidance in Topic 718 unless the share-based payment award is subsequently modified and the grantee is no longer a customer. The Company adopted ASU 2019-08 for the period ending December 31, 2019. There was no material impact on the financial statements.

In November 2019, the FASB issued ASU No. 2019-11, Codification Improvements to Topic 326, Financial Instruments - Credit Losses. The amendments in this ASU clarify or address stakeholders' specific issues about certain aspects of the amendments in ASU 2016-13 in the following areas: expected recoveries for purchased financial assets with credit deterioration, transition relief for troubled debt restructurings, disclosures related to accrued interest receivables and financial assets secured by collateral maintenance provisions. For public companies, ASU 2019-11 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 and will be adopted concurrently with ASU 2016-13. As noted above, we have elected to delay the adoption of ASU 2016-13 as permitted by the CARES Act.

Page 14
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740), Simplifying the Accounting for Income Taxes. The amendments in this ASU simplify the accounting for income taxes by removing specific exceptions included in Topic 740, introducing other simplifications and making technical corrections. For public business entities, the amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption is permitted. The Company is currently evaluating the impact the adoption of this ASU will have on the financial statements.


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,
 2020201920202019
Common shares outstanding at the beginning of the period9,364,062 9,346,449 9,351,694 9,336,441 
Weighted average number of net shares issued (redeemed)(7,765)(160)28,137 21,712 
Weighted average shares outstanding (basic)9,356,297 9,346,289 9,379,831 9,358,153 
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method3,592 4,284 3,673 4,146 
Weighted average number of shares (diluted)9,359,889 9,350,573 9,383,504 9,362,299 
Net income (In thousands)$11,430 $11,282 $30,216 $33,705 
Earnings per share:    
Basic$1.22 $1.21 $3.22 $3.61 
Diluted$1.22 $1.21 $3.22 $3.61 
Page 15
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Note 3.Other Comprehensive Income

The following table summarizes the balances of each component of accumulated other comprehensive income (AOCI), included in stockholders’ equity, at September 30, 2020 and December 31, 2019:

 September 30,
2020		December 31, 2019
 (amounts in thousands)
Net unrealized income on available-for-sale securities$12,444 $4,234 
Net unrealized loss on derivatives used for cash flow hedges(3,075)(2,349)
Tax effect$(2,338)$(470)
Net-of-tax amount$7,031 $1,415 
 
Note 4.Securities

The carrying values of investment securities at September 30, 2020 and December 31, 2019 are summarized in the following table (dollars in thousands):

 September 30, 2020December 31, 2019
 AmountPercentAmountPercent
Securities available for sale
U.S. Treasury$151,835 40.46 %$128,585 36.19 %
Other securities (FHLB, FHLMC and FNMA)25,209 6.72 15,229 4.29 
State and political subdivisions198,211 52.82 211,489 59.52 
Total securities available for sale$375,255 100.00 %$355,303 100.00 %

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, 2020 or December 31, 2019. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of September 30, 2020 and December 31, 2019 (in thousands):

 Amortized CostGross
Unrealized
Gains		Gross
Unrealized
(Losses)		Estimated Fair
Value
September 30, 2020:
U.S. Treasury$145,999 $5,836 $— $151,835 
Other securities (FHLB, FHLMC and FNMA)25,203 37 (31)25,209 
State and political subdivisions191,609 6,659 (57)198,211 
Total$362,811 $12,532 $(88)$375,255 
December 31, 2019:    
U.S. Treasury$127,096 $1,626 $(137)$128,585 
Other securities (FHLB, FHLMC and FNMA)15,287 — (58)15,229 
State and political subdivisions208,686 2,938 (135)211,489 
Total$351,069 $4,564 $(330)$355,303 


Page 16
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at September 30, 2020, were as follows (in thousands):
 
 Amortized
Cost		Fair Value
Due in one year or less$46,608 $46,887 
Due after one year through five years219,240 226,723 
Due after five years through ten years77,290 81,722 
Due over ten years19,673 19,923 
Total$362,811 $375,255 

As of September 30, 2020 investment securities with a carrying value of $13.75 million were pledged to collateralize derivative financial instruments and other borrowings.

Sales proceeds and gross realized gains and losses on available-for-sale securities for the nine months ended September 30, 2020 and 2019 were as follows (in thousands):

 September 30, 2020September 30, 2019
Sales proceeds$313 $12,467 
Gross realized gains10 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, 2020 and December 31, 2019 (in thousands):

 Less than 12 months12 months or moreTotal
September 30, 2020
Description of Securities		#Fair ValueUnrealized
Loss		%#Fair ValueUnrealized
Loss		%#Fair ValueUnrealized
Loss		%
U.S. Treasury— $— $— — %— $— $— — %— $— $— — %
Other securities (FHLB, FHLMC and FNMA)5 12,540 (31)0.25 — — — — 5 12,540 (31)0.25 
State and political subdivisions19 5,552 (50)0.90 5 621 (7)1.13 24 6,173 (57)0.92 
Total temporarily impaired securities24 $18,092 $(81)0.45 %5 $621 $(7)1.13 %29 $18,713 $(88)0.47 %
Page 17
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
 Less than 12 months12 months or moreTotal
December 31, 2019
Description of Securities		#Fair ValueUnrealized
Loss		%#Fair ValueUnrealized
Loss		%#Fair ValueUnrealized
Loss		%
U.S. Treasury11 $27,932 $(136)0.49 %1 $2,495 $(1)0.04 %12 $30,427 $(137)0.45 %
Other securities (FHLB, FHLMC and FNMA)— — — — 6 15,229 (58)0.38 6 15,229 (58)0.38 
State and political subdivisions66 17,881 (119)0.67 20 3,825 (16)0.42 86 21,706 (135)0.62 
Total temporarily impaired securities77 $45,813 $(255)0.56 %27 $21,549 $(75)0.35 %104 $67,362 $(330)0.49 %

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,
2020		December 31,
2019
 (Amounts In Thousands)
Agricultural$96,321 $91,317 
Commercial and financial335,463 221,323 
Real estate:
Construction, 1 to 4 family residential70,527 80,209 
Construction, land development and commercial114,270 108,410 
Mortgage, farmland243,689 242,730 
Mortgage, 1 to 4 family first liens900,224 910,742 
Mortgage, 1 to 4 family junior liens131,477 149,227 
Mortgage, multi-family371,167 350,761 
Mortgage, commercial417,042 402,181 
Loans to individuals30,521 32,308 
Obligations of state and political subdivisions56,424 49,896 
 $2,767,125 $2,639,104 
Net unamortized fees and costs965 933 
 $2,768,090 $2,640,037 
Less allowance for loan losses37,060 33,760 
 $2,731,030 $2,606,277 

As of September 30, 2020, the Company has provided $127.10 million of Paycheck Protection Program (PPP) loans recorded with commercial and financial loans above and has $3.77 million of deferred PPP loan fees recorded net of commercial and financial loans. For the nine months ended September 30, 2020, the Company has recognized $1.26 million of fees in interest income.
Page 18
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the three and nine months ended September 30, 2020 were as follows:

Three Months Ended September 30, 2020
AgriculturalCommercial and FinancialReal Estate: Construction and land developmentReal Estate: Mortgage, farmlandReal Estate: Mortgage, 1 to 4 familyReal Estate: Mortgage, multi- family and commercialOtherTotal
(Amounts In Thousands)
Allowance for loan losses:
Beginning balance$2,547 $5,777 $2,433 $4,089 $12,282 $9,173 $1,319 $37,620 
Charge-offs(8)(478)— — (115)(210)(63)(874)
Recoveries26 165 27 — 201 10 42 471 
Provision30 (119)(167)(41)(210)320 30 (157)
Ending balance$2,595 $5,345 $2,293 $4,048 $12,158 $9,293 $1,328 $37,060 

Nine Months Ended September 30, 2020
 AgriculturalCommercial 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		OtherTotal
 (Amounts In Thousands)
Allowance for loan losses:
Beginning balance$2,400 $4,988 $2,599 $3,950 $10,638 $7,859 $1,326 $33,760 
Charge-offs(43)(1,253)(43)(1)(576)(290)(276)(2,482)
Recoveries44 374 81 — 636 33 114 1,282 
Provision194 1,236 (344)99 1,460 1,691 164 4,500 
Ending balance$2,595 $5,345 $2,293 $4,048 $12,158 $9,293 $1,328 $37,060 
Ending balance, individually evaluated for impairment$80 $477 $87 $1 $86 $— $14 $745 
Ending balance, collectively evaluated for impairment$2,515 $4,868 $2,206 $4,047 $12,072 $9,293 $1,314 $36,315 
Loans:
Ending balance$96,321 $335,463 $184,797 $243,689 $1,031,701 $788,209 $86,945 $2,767,125 
Ending balance, individually evaluated for impairment$1,742 $5,949 $7,933 $2,440 $6,980 $3,614 $14 $28,672 
Ending balance, collectively evaluated for impairment$94,579 $329,514 $176,864 $241,249 $1,024,721 $784,595 $86,931 $2,738,453 
Page 19
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Changes in the allowance for loan losses for the three and nine months ended September 30, 2019 were as follows:

Three Months Ended September 30, 2019
AgriculturalCommercial and FinancialReal Estate: Construction and land developmentReal Estate: Mortgage, farmlandReal Estate: Mortgage, 1 to 4 familyReal Estate: Mortgage, multi- family and commercialOtherTotal
(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)
Recoveries18 128 2 — 317 12 35 512 
Provision288 (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
 AgriculturalCommercial 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		OtherTotal
 (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)
Recoveries87 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 
Page 20
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
The following table presents the credit quality indicators by type of loans in each category as of September 30, 2020 and December 31, 2019, respectively (amounts in thousands):

AgriculturalCommercial and
Financial		Real Estate:
Construction, 1 to 4
family residential		Real Estate:
Construction, land
development and
commercial
September 30, 2020
Grade:
Excellent$3,174 $15,023 $1 $231 
Good11,212 62,843 13,969 16,492 
Satisfactory44,687 181,807 38,486 61,231 
Monitor28,217 61,300 16,441 28,008 
Special Mention6,624 9,147 1,315 7,595 
Substandard2,407 5,343 315 713 
Total$96,321 $335,463 $70,527 $114,270 

 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, 2020
Grade:
Excellent$5,968 $2,395 $268 $17,824 
Good42,037 43,348 3,284 56,624 
Satisfactory130,185 710,236 118,885 203,078 
Monitor55,917 114,949 5,575 59,787 
Special Mention6,100 13,424 1,635 15,439 
Substandard3,482 15,872 1,830 18,415 
Total$243,689 $900,224 $131,477 $371,167 

 Real Estate:
Mortgage,
commercial		Loans to
individuals		Obligations of state and
political subdivisions		Total
September 30, 2020
Grade:
Excellent$28,533 $— $6,970 $80,387 
Good94,886 160 13,923 358,778 
Satisfactory191,744 29,685 25,561 1,735,585 
Monitor78,640 436 9,822 459,092 
Special Mention19,103 164 148 80,694 
Substandard4,136 76 — 52,589 
Total$417,042 $30,521 $56,424 $2,767,125 
 
Page 21
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
 AgriculturalCommercial and
Financial		Real Estate:
Construction, 1 to 4
family residential		Real Estate:
Construction, land
development and
commercial
December 31, 2019
Grade:
Excellent$3,594 $3,461 $260 $190 
Good12,380 47,843 8,868 23,217 
Satisfactory43,308 117,114 51,093 47,987 
Monitor24,857 44,543 17,505 29,009 
Special Mention3,110 5,157 2,483 7,428 
Substandard4,068 3,205 — 579 
Total$91,317 $221,323 $80,209 $108,410 

 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, 2019
Grade:
Excellent$3,630 $3,209 $261 $18,955 
Good40,118 32,474 4,233 47,871 
Satisfactory134,738 751,215 136,079 189,391 
Monitor53,147 96,353 5,473 60,965 
Special Mention3,033 11,167 1,469 27,559 
Substandard8,064 16,324 1,712 6,020 
Total$242,730 $910,742 $149,227 $350,761 

 Real Estate:
Mortgage,
commercial		Loans to
individuals		Obligations of state and
political subdivisions		Total
December 31, 2019
Grade:
Excellent$27,017 $— $7,444 $68,021 
Good79,467 221 14,465 311,157 
Satisfactory206,196 31,385 20,274 1,728,780 
Monitor81,381 437 7,323 420,993 
Special Mention4,802 212 390 66,810 
Substandard3,318 53 — 43,343 
Total$402,181 $32,308 $49,896 $2,639,104 
Page 22
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
The below are descriptions of the credit quality indicators:

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

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

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

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

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

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




Page 23
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Past due loans as of September 30, 2020 and December 31, 2019 were as follows:

 30 - 59 Days
Past Due		60 - 89 Days
Past Due		90 Days
or More
Past Due		Total Past
Due		CurrentTotal
Loans
Receivable		Accruing Loans
Past Due 90
Days or More
 (Amounts In Thousands)
September 30, 2020
Agricultural$783 $6 $556 $1,345 $94,976 $96,321 $14 
Commercial and financial1,140 490 2,451 4,081 331,382 335,463 2,288 
Real estate:
Construction, 1 to 4 family residential630 668 — 1,298 69,229 70,527 — 
Construction, land development and commercial928 47 7,000 7,975 106,295 114,270 7,000 
Mortgage, farmland— 315 645 960 242,729 243,689 35 
Mortgage, 1 to 4 family first liens670 1,195 2,724 4,589 895,635 900,224 — 
Mortgage, 1 to 4 family junior liens65 260 109 434 131,043 131,477 — 
Mortgage, multi-family4,008 1,799 — 5,807 365,360 371,167 — 
Mortgage, commercial731 — 311 1,042 416,000 417,042 — 
Loans to individuals108 27 4 139 30,382 30,521 — 
Obligations of state and political subdivisions— — — — 56,424 56,424 — 
 $9,063 $4,807 $13,800 $27,670 $2,739,455 $2,767,125 $9,337 
December 31, 2019       
Agricultural$163 $275 $122 $560 $90,757 $91,317 $48 
Commercial and financial1,076 229 101 1,406 219,917 221,323 65 
Real estate:   
Construction, 1 to 4 family residential635 — — 635 79,574 80,209 — 
Construction, land development and commercial215 101 — 316 108,094 108,410 — 
Mortgage, farmland736 — 610 1,346 241,384 242,730 — 
Mortgage, 1 to 4 family first liens5,026 3,100 4,149 12,275 898,467 910,742 354 
Mortgage, 1 to 4 family junior liens813 126 233 1,172 148,055 149,227 139 
Mortgage, multi-family— 97 — 97 350,664 350,761 — 
Mortgage, commercial321 489 — 810 401,371 402,181 — 
Loans to individuals226 55 15 296 32,012 32,308 — 
Obligations of state and political subdivisions— — — — 49,896 49,896 — 
 $9,211 $4,472 $5,230 $18,913 $2,620,191 $2,639,104 $606 
 
Page 24
Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
The Company does not have a material amount of loans that are past due less than 90 days where there are serious doubts as to the ability of the borrowers to comply with the loan repayment terms.

Certain impaired loan information by loan type at September 30, 2020 and December 31, 2019, was as follows:

 September 30, 2020December 31, 2019
 Non-accrual
loans (1)		Accruing loans
past due 90 days
or more		TDR loansNon-
accrual
loans (1)		Accruing loans
past due 90 days
or more		TDR loans
 (Amounts In Thousands)(Amounts In Thousands)
Agricultural$1,537 $14 $111 $1,192 $48 $404 
Commercial and financial804 2,288 1,059 679 65 1,934 
Real estate:      
Construction, 1 to 4 family residential315 — — — — — 
Construction, land development and commercial206 7,000 315 — — 320 
Mortgage, farmland1,117 35 1,288 1,369 — 2,712 
Mortgage, 1 to 4 family first liens5,292 — 1,590 6,558 354 1,626 
Mortgage, 1 to 4 family junior liens195 — — 94 139 — 
Mortgage, multi-family82 — 1,704 97 — 1,719 
Mortgage, commercial1,328 — 1,833 779 — 593 
 $10,876 $9,337 $7,900 $10,768 $606 $9,308 

(1)There were $4.20 million and $4.34 million of TDR loans included within nonaccrual loans as of September 30, 2020 and December 31, 2019, respectively.

Loans 90 days or more past due that are still accruing interest increased $8.73 million from December 31, 2019 to September 30, 2020 primarily due to one relationship accounting for $9 million of the accruing loans past due 90 days or more as of September 30, 2020. As of September 30, 2020 there were 6 accruing loans past due 90 days or more. The average accruing loans past due as of September 30, 2020 was $1.56 million. There were 8 accruing loans past due 90 days or more as of December 31, 2019 and the average loan balance was $0.08 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 significant relationship past due 90 days or more also has significant guarantor strength therefore the Company expects to collect all outstanding amounts due.
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
Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Below is a summary of information for TDR loans as of September 30, 2020 and December 31, 2019:

 September 30, 2020December 31, 2019
Number
of
contracts		Recorded
investment		Commitments
outstanding		Number
of
contracts		Recorded
investment		Commitments
outstanding
 (Amounts In Thousands)(Amounts In Thousands)
Agricultural7 $1,309 $10 9 $1,552 $3 
Commercial and financial16 1,677 85 16 2,641 95 
Real estate:
Construction, 1 to 4 family residential— — — — — — 
Construction, land development and commercial2 315 4 2 320 — 
Mortgage, farmland7 2,352 — 8 4,021 — 
Mortgage, 1 to 4 family first liens18 1,901 — 16 2,083 — 
Mortgage, 1 to 4 family junior liens— — — — — — 
Mortgage, multi-family2 1,704 — 2 1,719 — 
Mortgage, commercial9 2,850 — 7 1,373 — 
Loans to individuals— — — — — — 
 61 $12,108 $99 60 $13,709 $98 

The following is a summary of TDR loans that were modified during the three and nine months ended September 30, 2020:
 Three Months Ended September 30, 2020Nine Months Ended September 30, 2020
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— $— $— 2 $93 $93 
Commercial and financial1 90 90 3 308 308 
Real estate:     
Construction, 1 to 4 family residential— — — — — — 
Construction, land development and commercial— — — — — — 
Mortgage, farmland— — — — — — 
Mortgage, 1 to 4 family first lien— — — 5 104 104 
Mortgage, 1 to 4 family junior liens— — — — — — 
Mortgage, multi-family— — — — — — 
Mortgage, commercial2 1,333 1,333 3 1,846 1,846 
 3 $1,423 $1,423 13 $2,351 $2,351 
Page 26
Index
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, 2020.  The Company had commitments to lend $0.10 million in additional borrowings to restructured loan customers as of December 31, 2019.  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, 2020 and one totaling $0.065 million modified during the year ended December 31, 2019.




Page 27
Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Information regarding impaired loans as of and for the three and nine months ended September 30, 2020 is as follows:
 September 30, 2020Three Months Ended
September 30, 2020		Nine Months Ended September 30, 2020
 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$1,648 $2,308 $— $1,859 $6 $1,822 $18 
Commercial and financial2,974 4,708 — 3,788 38 3,641 110 
Real estate:      
Construction, 1 to 4 family residential412 480 — 700 — 575 — 
Construction, land development and commercial521 540 — 528 4 526 13 
Mortgage, farmland2,405 2,936 — 3,420 32 3,242 90 
Mortgage, 1 to 4 family first liens6,135 7,939 — 6,585 18 6,422 51 
Mortgage, 1 to 4 family junior liens108 353 — 161 — 135 — 
Mortgage, multi-family1,786 1,908 — 1,807 21 1,801 61 
Mortgage, commercial1,761 2,592 — 2,019 5 1,917 15 
Loans to individuals— 14 — — — — — 
 $17,750 $23,778 $— $20,867 $124 $20,081 $358 
With an allowance recorded:       
Agricultural$94 $94 $80 $109 $2 $102 $6 
Commercial and financial2,975 3,028 477 3,071 33 3,060 99 
Real estate: 
Construction, 1 to 4 family residential— — — — — — — 
Construction, land development and commercial7,000 7,000 87 7,000 80 7,000 236 
Mortgage, farmland35 35 1 37 1 37 1 
Mortgage, 1 to 4 family first liens650 701 49 668 3 666 10 
Mortgage, 1 to 4 family junior liens87 92 37 91 — 90 — 
Mortgage, multi-family— — — — — — — 
Mortgage, commercial67 67 — 69 1 69 3 
Loans to individuals14 14 14 14 — 14 1 
 $10,922 $11,031 $745 $11,059 $120 $11,038 $356 
Total:       
Agricultural$1,742 $2,402 $80 $1,968 $8 $1,924 $24 
Commercial and financial5,949 7,736 477 6,859 71 6,701 209 
Real estate:       
Construction, 1 to 4 family residential412 480 — 700 — 575 — 
Construction, land development and commercial7,521 7,540 87 7,528 84 7,526 249 
Mortgage, farmland2,440 2,971 1 3,457 33 3,279 91 
Mortgage, 1 to 4 family first liens6,785 8,640 49 7,253 21 7,088 61 
Mortgage, 1 to 4 family junior liens195 445 37 252 — 225 — 
Mortgage, multi-family1,786 1,908 — 1,807 21 1,801 61 
Mortgage, commercial1,828 2,659 — 2,088 6 1,986 18 
Loans to individuals14 28 14 14 — 14 1 
 $28,672 $34,809 $745 $31,926 $244 $31,119 $714 
Page 28
Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Information regarding impaired loans as of December 31, 2019 is as follows:

 Recorded
Investment		Unpaid Principal
Balance		Related
Allowance
With no related allowance recorded:(Amounts In Thousands)
Agricultural$1,596 $2,157 $— 
Commercial and financial1,340 2,220 — 
Real estate:   
Construction, 1 to 4 family residential101 144 — 
Construction, land development and commercial320 336 — 
Mortgage, farmland4,081 4,613 — 
Mortgage, 1 to 4 family first liens7,157 9,015 — 
Mortgage, 1 to 4 family junior liens— 246 — 
Mortgage, multi-family1,816 1,930 — 
Mortgage, commercial1,302 1,852 — 
Loans to individuals— 14 — 
 $17,713 $22,527 $— 
With an allowance recorded:   
Agricultural$134 $134 $87 
Commercial and financial1,402 1,539 792 
Real estate:   
Construction, 1 to 4 family residential— — — 
Construction, land development and commercial— — — 
Mortgage, farmland— — — 
Mortgage, 1 to 4 family first liens1,280 1,501 64 
Mortgage, 1 to 4 family junior liens233 233 47 
Mortgage, multi-family— — — 
Mortgage, commercial70 70 1 
Loans to individuals93 93 93 
 $3,212 $3,570 $1,084 
Total:   
Agricultural$1,730 $2,291 $87 
Commercial and financial2,742 3,759 792 
Real estate:   
Construction, 1 to 4 family residential101 144 — 
Construction, land development and commercial320 336 — 
Mortgage, farmland4,081 4,613 — 
Mortgage, 1 to 4 family first liens8,437 10,516 64 
Mortgage, 1 to 4 family junior liens233 479 47 
Mortgage, multi-family1,816 1,930 — 
Mortgage, commercial1,372 1,922 1 
Loans to individuals93 107 93 
 $20,925 $26,097 $1,084 
Page 29
Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Impaired loans increased $7.75 million from December 31, 2019 to September 30, 2020.  Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans.  Impaired loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement.  Impaired loans were 1.05% of loans held for investment as of September 30, 2020 and 0.79% as of December 31, 2019.  The increase in impaired loans is due to an increase of $0.46 million in loans with a specific reserve, an increase in nonaccrual loans of $0.11 million and an increase in 90 days or more accruing loans of $8.73 million and is offset by a decrease in TDR loans of $1.41 million from December 31, 2019 to September 30, 2020.

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 15 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, 2020 and 2019, total operating lease expense was $0.42 million and $0.47 million, respectively, and is included in occupancy expenses in the consolidated statements of income. Included in this for the nine months ended September 30, 2020 and 2019 were $0.35 million and $0.40 million of operating lease costs, respectively, $0.03 million and $0.02 million of short term lease costs, respectively, and $0.04 million and $0.05 million of variable lease costs, respectively.
For the nine months ended September 30, 2020 and 2019, cash paid for amounts included in the measurement of operating lease liabilities was $0.35 million and $0.40 million, respectively, and right-of-use assets obtained in exchange for lease obligations was $0.00 million and $3.58 million, respectively.

Page 30
Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)


As of September 30, 2020 and December 31, 2019, operating lease right-of-use assets included in other assets was $2.91 million and $3.20 million, respectively. Operating lease liabilities were $2.96 million and $3.23 million as of September 30, 2020 and December 31, 2019. As of September 30, 2020 and December 31, 2019, the weighted average remaining lease term for operating leases was 11.25 years and 10.86 years, respectively, and the weighted average discount rate for operating leases was 3.48% and 3.46%, respectively. Discount rates used were determined from FHLB borrowing rates for comparable terms.
As of September 30, 2020, maturities of lease liabilities were as follows:
Year ending December 31:(Amounts In Thousands)
2020$117 
2021456 
2022447 
2023301 
2024250 
Thereafter2,009 
Total lease payments3,580 
Less imputed interest(625)
Total operating lease liabilities$2,955 




Page 31
Index
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, 2020 are as follows:
 September 30, 2020
 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$560,738 $560,738 $560,738 $— $— 
Investment securities386,628 386,628 151,835 234,793 — 
Loans held for sale27,980 27,980 — 27,980 — 
Loans     
Agricultural93,726 94,086 — — 94,086 
Commercial and financial330,118 330,164 — — 330,164 
Real estate:    
Construction, 1 to 4 family residential69,639 69,819 — — 69,819 
Construction, land development and commercial112,865 112,610 — — 112,610 
Mortgage, farmland239,641 238,974 — — 238,974 
Mortgage, 1 to 4 family first liens890,560 896,881 — — 896,881 
Mortgage, 1 to 4 family junior liens129,948 127,667 — — 127,667 
Mortgage, multi-family366,800 367,834 — — 367,834 
Mortgage, commercial412,116 413,699 — — 413,699 
Loans to individuals29,832 30,070 — — 30,070 
Obligations of state and political subdivisions55,785 56,945 — — 56,945 
Accrued interest receivable13,731 13,731 — 13,731 — 
Total financial instrument assets$3,720,107 $3,727,826 $712,573 $276,504 $2,738,749 
Financial instrument liabilities     
Deposits     
Noninterest-bearing deposits$500,272 $500,272 $— $500,272 $— 
Interest-bearing deposits2,614,279 2,630,803 — 2,630,803 — 
Other borrowings43 43 — 43 — 
Federal Home Loan Bank borrowings185,000 185,869 — 185,869 — 
Interest rate swaps3,075 3,075 — 3,075 — 
Accrued interest payable2,198 2,198 — 2,198 — 
Total financial instrument liabilities$3,304,867 $3,322,260 $— $3,322,260 $— 
 Face Amount    
Financial instrument with off-balance sheet risk:     
Loan commitments$476,859 $— $— $— $— 
Letters of credit8,300 — — — — 
Total financial instrument liabilities with off-balance-sheet risk$485,159 $— $— $— $— 
(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.
Page 32
Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
(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, 2019 are as follows:

 December 31, 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$241,965 $241,965 $241,965 $— $— 
Investment securities366,368 366,368 128,585 237,783 — 
Loans held for sale8,400 8,400 — 8,400 — 
Loans     
Agricultural88,917 90,118 — — 90,118 
Commercial and financial216,335 217,640 — — 217,640 
Real estate:     
Construction, 1 to 4 family residential79,096 79,954 — — 79,954 
Construction, land development and commercial106,924 107,276 — — 107,276 
Mortgage, farmland238,780 239,521 — — 239,521 
Mortgage, 1 to 4 family first liens902,630 896,676 — — 896,676 
Mortgage, 1 to 4 family junior liens147,634 143,261 — — 143,261 
Mortgage, multi-family346,938 349,663 — — 349,663 
Mortgage, commercial398,145 395,838 — — 395,838 
Loans to individuals31,455 32,722 — — 32,722 
Obligations of state and political subdivisions49,423 50,564 — — 50,564 
Accrued interest receivable12,442 12,442 — 12,442 — 
Total financial instrument assets$3,235,452 $3,232,408 $370,550 $258,625 $2,603,233 
Financial instrument liabilities:     
Deposits     
Noninterest-bearing deposits$387,612 $387,612 $— $387,612 $— 
Interest-bearing deposits2,273,752 2,292,332 — 2,292,332 — 
Federal Home Loan Bank borrowings185,000 186,091 — 186,091 — 
Interest rate swaps2,349 2,349 2,349 
Accrued interest payable2,474 2,474 — 2,474 — 
Total financial instrument liabilities$2,851,187 $2,870,858 $— $2,870,858 $— 
 Face Amount    
Financial instrument with off-balance sheet risk:     
Loan commitments$424,165 $— $— $— $— 
Letters of credit8,569 — — — — 
Total financial instrument liabilities with off-balance-sheet risk$432,734 $— $— $— $— 
 
(1)Considered Level 1 under ASC 820.
Page 33
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
(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 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 1Quoted prices in active markets for identical assets or liabilities.
Level 2Observable 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 3Unobservable 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, 2020.   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. 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.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Fair value has been estimated in accordance with ASC 820, Fair Value Measurements and Disclosures, and is intended to represent the price that would be received in an orderly transaction between market participants as of the measurement date. In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, at least one significant assumption not observable in the market was utilized. These unobservable assumptions reflect estimates that market participants would use in pricing the asset or liability. Inputs to these valuation techniques are subjective in nature, involve uncertainties and require significant judgment and therefore cannot be determined with precision. Accordingly, the fair value estimates presented are not necessarily indicative of the amounts to be realized in a current market exchange. Loans are classified as Level 3.
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, 2020
 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$151,835 $— $— $151,835 
State and political subdivisions— 198,211 — 198,211 
Other securities (FHLB, FHLMC and FNMA)— 25,209 — 25,209 
Derivative Financial Instruments
Interest rate swaps$— (3,075)$— (3,075)
Total$151,835 $220,345 $— $372,180 

 December 31, 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$128,585 $— $— $128,585 
State and political subdivisions— 211,489 — 211,489 
Other securities (FHLB, FHLMC and FNMA)— 15,229 — 15,229 
Derivative Financial Instruments
Interest rate swaps— (2,349)— (2,349)
Total$128,585 $224,369 $— $352,954 
 
(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, 2020 and the year ended December 31, 2019.


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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, 2020Three Months Ended September 30, 2020Nine Months Ended September 30, 2020
 Readily
Available
Market
Prices(1)		Observable
Market
Prices(2)		Company
Determined
Market
Prices(3)		Total at
Fair
Value		Total LossesTotal Losses
 (Amounts in Thousands)
Loans (4)
Agricultural$— $— $1,376 $1,376 $— $— 
Commercial and financial— — 1,843 1,843 — 385 
Real Estate:— 
Construction, 1 to 4 family residential— — 419 419 — — 
Construction, land development and commercial— — 315 315 — — 
Mortgage, farmland— — 2,062 2,062 — — 
Mortgage, 1 to 4 family first liens— — 6,702 6,702 20 176 
Mortgage, 1 to 4 family junior liens— — 158 158 — — 
Mortgage, multi-family— — 1,786 1,786 — — 
Mortgage, commercial— — 3,094 3,094 175 250 
Loans to individuals— — — — — — 
Foreclosed assets (5)— — — — — — 
Total$— $— $17,755 $17,755 $195 $811 
 
(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, 2019Year Ended December 31, 2019
 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$— $— $1,272 $1,272 $36 
Commercial and financial— — 1,803 1,803 499 
Real Estate:
Construction, 1 to 4 family residential— — — — — 
Construction, land development and commercial— — 215 215 8 
Mortgage, farmland— — 3,576 3,576 — 
Mortgage, 1 to 4 family first liens— — 7,986 7,986 370 
Mortgage, 1 to 4 family junior liens— — 49 49 — 
Mortgage, multi-family— — 1,816 1,816 — 
Mortgage, commercial— — 1,237 1,237 125 
Loans to individuals— — — — — 
Foreclosed assets (5)— — — — — 
Total$— $— $17,954 $17,954 $1,038 
(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, 2021.  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 1,328,410 shares of its common stock in privately negotiated transactions from August 1, 2005 through September 30, 2020.  Of these 1,328,410 shares, 29,807 shares were purchased during the quarter ended September 30, 2020, at an average price per share of $60.86.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(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 $81.42 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.

As initially reported in the Company’s quarterly report filed with the SEC on November 4, 2019, Hills Bank was sued in a class action lawsuit in the Iowa District Court for Johnson County on April 10, 2019. The lawsuit sought 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. The Plaintiff subsequently amended the petition to assert additional claims involving overdraft charges and NSF fees. The parties have negotiated a class-wide settlement, which was preliminarily approved by the Court on October 9, 2020. While the Bank disputes the merits of the claim, management determined that settlement avoids added expenses, distractions to Bank management and personnel, and the attendant risks related to litigating the claims. The Bank’s Management believes that the settlement will have no material impact on the Company's financial condition and results of operation when taken as a whole. The final hearing to address the fairness of the proposed settlement has been scheduled for June 25, 2021.

The outbreak of Coronavirus Disease 2019 (“COVID-19”) has and will continue to adversely impact a broad range of industries in which the Company’s customers operate and impair their ability to fulfill their financial obligations to the Company.  The World Health Organization has declared COVID-19 to be a global pandemic indicating that almost all public commerce and related business activities must be, to varying degrees, curtailed with the goal of decreasing the rate of new infections.

The spread of the outbreak has caused significant disruptions in the U.S. economy and is highly likely to disrupt banking and other financial activity in the areas in which the Company operates and could also potentially create widespread business continuity issues for the Company.  The Company’s business is dependent upon the willingness and ability of its employees and customers to conduct banking and other financial transactions.  If the global response to contain COVID-19 escalates or is unsuccessful, the Company could experience a material adverse effect on its business, financial condition, results of operations and cash flows.

On August 10, 2020, a derecho impacted Eastern Iowa, primarily Cedar Rapids, Iowa and the surrounding areas. The derecho caused widespread high winds up to 140 mph, the equivalent of a Category 4 hurricane, torrential rain, large hail and low-class tornadoes. The damage from the derecho was significant across the east central Iowa area, including wide-scale utility disruptions, residential and commercial property damage, severe damage to corn and soybeans crops.

A substantial number of the Bank's branches in Cedar Rapids and surrounding communities were without power and closed in the immediate aftermath of the derecho, though most were able to reopen within a week of the derecho. The Bank responded to the derecho by providing employees time away from the office to help them recover from the derecho and to assist with neighborhood clean-up efforts, as well as supporting city and county employees, utility workers and area non-profits with food and monetary donations to help with basic needs. The Bank assisted customers impacted by the derecho by providing short-term loan modifications of two to six months to defer principal payments on loans totaling $15.38 million, primarily for 1 to 4 family non-owner occupied, multifamily and commercial real estate loans. The Bank anticipates that the majority of costs incurred to repair damages to the Bank branches will be covered by insurance.

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
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, 2020 and December 31, 2019 is as follows:
 September 30, 2020December 31, 2019
 (Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans$70,765 $65,203 
Credit cards60,661 57,421 
Commercial, real estate and home construction112,534 94,490 
Commercial lines and real estate purchase loans232,899 207,051 
Outstanding letters of credit8,300 8,569 
 
Note 10.Income Taxes

Federal income tax expense for the nine months ended September 30, 2020 and 2019 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, 2019, 2018 and 2017 remain subject to examination by the Internal Revenue Service.  For state tax purposes, the tax years ended December 31, 2019, 2018 and 2017 remain open for examination.  There were no material unrecognized tax benefits at September 30, 2020  and December 31, 2019 and therefore no interest or penalties on unrecognized tax benefits has been recorded.  As of September 30, 2020, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending September 30, 2021. Income taxes as a percentage of income before taxes were 22.43% for the nine months ended September 30, 2020 and 22.02% for the same period in 2019. 

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 $3.08 million of collateral as of September 30, 2020.

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,
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
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, 2020 and December 31, 2019:

 Notional
Amount		Fair
Value		Balance
Sheet
Category		Maturity
 (Amounts in Thousands)
September 30, 2020     
Interest rate swap$25,000 $(170)Other Liabilities11/9/2020
Interest rate swap25,000 (2,905)Other Liabilities11/7/2023
December 31, 2019       
Interest rate swap$25,000 $(279)Other Liabilities11/9/2020
Interest rate swap25,000 (2,070)Other Liabilities11/7/2023

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, 2020 and year ended December 31, 2019:

 
 Recognized
in OCI		Reclassified from AOCI into
Income		Recognized in Income on
Derivatives
 Amount of
Gain (Loss)		CategoryAmount
of Gain
(Loss)		CategoryAmount
of Gain
(Loss)
 (Amounts in Thousands)
September 30, 2020  
Interest rate swap$81 Interest Expense$— Other Income$— 
Interest rate swap(626)Interest Expense— Other Income— 
December 31, 2019     
Interest rate swap$(119)Interest Expense$— Other Income$— 
Interest rate swap(446)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,”
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“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.

•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, diseases and/or pandemics, 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.
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•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, 2020 and December 31, 2019 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.

With the passage of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), the option to delay CECL was provided until the earlier of the national health emergency being declared over or December 31, 2020. The Company elected to delay implementing CECL and continued to use the incurred loss method to calculate the allowance for loan losses as of and for the period ending September 30, 2020.

COVID-19: What the Company knows and what steps we have taken.

The outbreak of Coronavirus Disease 2019 (“COVID-19”) has and will continue to adversely impact a broad range of industries in which the Company’s customers operate and impair their ability to fulfill their financial obligations to the Company.  The World Health Organization has declared COVID-19 to be a global pandemic indicating that almost all public commerce and related business activities must be, to varying degrees, curtailed with the goal of decreasing the rate of new infections.

The spread of the outbreak has caused significant disruptions in the U.S. economy and is highly likely to disrupt banking and other financial activity in the areas in which the Company operates and could also potentially create widespread business continuity issues for the Company.  The Company’s business is dependent upon the willingness and ability of its employees and customers to conduct banking and other financial transactions.  If the global response to contain COVID-19 escalates or is unsuccessful, the Company could experience a material adverse effect on its business, financial condition, results of operations and cash flows.
Shareholders
Dividend declaration
The Company expects to continue to maintain the payment of its annual dividend consistent with its past practices. 
Communities

Offices

With the health of our employees and customers being our top concern, as of March 17, 2020, the Bank temporarily suspended branch lobby hours to the public for walk-in transactions. The Bank has since reopened all branch lobbies with the following changes:
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• Plexiglass windows on our teller stations and reception areas
•A limit on the number of people who can be in the lobbies at one time
•Transaction areas and reusable items will be frequently wiped down
•Hand sanitizing stations located at each entrance
•Floor stickers to guide social distancing while waiting in line
•Require all customers and non-customers entering lobbies to wear face masks.

Drive-thru services remain available as well as all ATM’s to complete needed transactions. Customers are also able to directly contact our bankers through the HERE by Hills Bank app and Hills Bank Online is available 24/7.
Consumers
Home Loans
With the Federal Reserve rate drops of 150 basis points in March (100 basis points of which was directly related to the effects of the virus on the economy), a surge in home loan activity has occurred, a significant portion of which is refinance related. The Bank sells most of its home loans into the secondary market and has seen a significant increase in the net gain on the sale of these loans.
The Bank is working with customers who request forbearance agreements, though this has not been a significant number or dollar amount of agreements as of September 30, 2020. The Bank has also provided short-term modifications for customers primarily through deferrals of principal only payments for three or four months. Commercial related modifications including commercial and financial and multifamily and commercial real estate mortgages were provided for 512 loans totaling $318.79 million. 1 to 4 family and consumer related modifications were provided for 626 loans totaling $74.27 million and agricultural related modifications were provided for 12 loans totaling $3.30 million. As these short-term deferrals have now expired, a minimal number of customers have requested additional modifications related to the pandemic. These modifications totaled $3.35 million for 54 loans, the majority of which were 43 1 to 4 family loans totaling $3.01 million through October 26, 2020.
The Bank continues to assist our customers through this difficult time in the best manner possible by providing $127.10 million of Paycheck Protection Program (PPP) loans as of September 30, 2020.
Employees
The Bank continues to promote social distancing by encouraging employees who can work remotely to do so and in other cases, departments have been dispersed to keep the team separated. 
Financial - Exposures
Given the timing of the outbreak in the United States of the COVID-19 pandemic, the Company’s first quarter performance was not significantly impacted with the exception of the provision for loan losses. In the second quarter, the Company provided a significant number of PPP loans to customers as well as short-term loan modifications deferring principal and interest or principal only for three to four months. As discussed above, the initial short-term loan modifications have now expired and only a minimal number of customers have requested additional pandemic-related modifications described above. The COVID-19 pandemic represents an unprecedented challenge to the global economy in general and the financial services sector in particular.  However, there is still significant uncertainty regarding the overall length of the pandemic and the aggregate impact that it will have on global and regional economies, including uncertainties regarding the potential positive effects of governmental actions taken in response to the pandemic during 2020.  With so much uncertainty, it is impossible for the Bank to accurately predict the impact that the pandemic will have on the Company’s primary markets and the overall extent to which it will affect the Company’s financial condition and results of operations during the remainder of the current fiscal year.  At a minimum, the actions taken by the Company to assist its customers experiencing challenges from the pandemic will likely have a material impact on the Company’s performance in 2020.  Nonetheless, management believes that the Company’s current regulatory capital position is adequate to face the coming challenges.
To account for potential exposures resulting from the pandemic, the Bank has increased its allowance for loan losses for the nine months ended September 30, 2020 by approximately $3.3 million since December 31, 2019. The Bank is fully prepared to make additional provisions as warranted by the COVID-19 situation.

Our credit administration is closely monitoring and analyzing the higher risk segments within the loan portfolio, tracking loan payment deferrals, customer liquidity and providing timely reports to senior management and the board of directors. Based on
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the Company’s capital levels, prudent underwriting policies, loan concentration diversification and our geographic footprint, we currently expect to be able to manage the economic risks and uncertainties associated with the pandemic and remain adequately capitalized.   

Government Response

Congress, the FRB and the other U.S. state and federal financial regulatory agencies have taken actions to mitigate disruptions to economic activity and financial stability resulting from the COVID-19 pandemic. The federal banking agencies have encouraged financial institutions to prudently work with affected borrowers and passed measures to provide relief from reporting loan classifications due to modifications related to the COVID-19 outbreak. The descriptions below summarize additional significant government actions taken in response to the COVID-19 pandemic. The descriptions are qualified in their entirety by reference to the particular statutory or regulatory provisions or government programs summarized.

The CARES Act

The Coronavirus Aid, Relief and Economic Security (CARES) Act was signed into law on March 27, 2020. Among other provisions, the CARES Act includes funding for the SBA to expand lending, relief from certain U.S. GAAP requirements to allow COVID-19-related loan modifications to not be categorized as troubled debt restructurings and a range of incentives to encourage deferment, forbearance or modification of consumer credit and mortgage contracts. One of the key CARES Act programs is the Paycheck Protection Program, which temporarily expanded the SBA’s business loan guarantee program to include forgivable loans used for permissible purposes, which were issued under the program through August 8, 2020. Paycheck Protection Program loans are available to a broader range of entities than ordinary SBA loans, and the loan may be forgiven in an amount equal to payroll costs and certain other expenses during either an eight-week or twenty-four week “covered period.” The Bank is participating in this program as described above.

The CARES Act contains additional protections for homeowners and renters of properties with federally-backed mortgages, including a 60-day moratorium on the initiation of foreclosure proceedings beginning on March 18, 2020 and a 120-day moratorium on initiating eviction proceedings effective March 27, 2020. These foreclosure and eviction moratoriums have been extended through year-end by the Federal Housing Administration. Borrowers of federally-backed mortgages have the right under the CARES Act to request up to 360 days of forbearance on their mortgage payments if they experience financial hardship directly or indirectly due to the coronavirus-related public health emergency.

Also pursuant to the CARES Act, the U.S. Treasury has the authority to provide loans, guarantees and other investments in support of eligible businesses, states and municipalities affected by the economic effects of COVID-19. Some of these funds have been used to support several FRB programs and facilities described below or additional programs or facilities that are established by its authority under Section 13(3) of the Federal Reserve Act and meeting certain criteria.

FRB Actions

The FRB has taken a range of actions to support the flow of credit to households and businesses. For example, on March 15, 2020, the FRB reduced the target range for the federal funds rate to 0 to 0.25% and announced that it would increase its holdings of U.S. Treasury securities and agency mortgage-backed securities and begin purchasing agency commercial mortgage-backed securities. The FRB has also encouraged depository institutions to borrow from the discount window and has lowered the primary credit rate for such borrowing by 150 basis points while extending the term of such loans up to 90 days. Reserve requirements have been reduced to zero as of March 26, 2020.

In addition, the FRB has established, or has taken steps to establish, a range of facilities and programs to support the U.S. economy and U.S. marketplace participants in response to economic disruptions associated with COVID-19. Through these facilities and programs, the FRB, relying on its authority under Section 13(3) of the Federal Reserve Act, has taken steps to directly or indirectly purchase assets from, or make loans to, U.S. companies, financial institutions, municipalities and other market participants.








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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, 2020, the Bank has nineteen full-service locations.

Net income for the nine month period ended September 30, 2020 was $30.22 million compared to $33.71 million for the same nine months of 2019, a decrease of 10.35%.  The $3.49 million decrease in net income was caused by a number of factors.  The principal factors in the decrease in net income for the first nine months of 2020 are an increase in the provision for loan losses of $6.14 million, primarily due to the uncertainty created by the COVID-19 pandemic, and an increase in noninterest expenses of $3.14 million. This change was offset by an increase in net interest income of $2.55 million, an increase in noninterest income of $2.47 million and a decrease in income tax expense of $0.78 million.

The Company achieved a return on average assets of 1.22% and a return on average equity of 11.00% for the twelve months ended September 30, 2020, compared to the twelve months ended September 30, 2019, which were 1.25% and 11.58%, respectively.  Dividends of $0.89 per share were paid in January 2020 to 2,644 shareholders.  The 2019 dividend was $0.82 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 3.05% for the nine months ended September 30, 2020 compared to 3.20% for the same nine months of 2019.  Average earning assets were $3.362 billion year to date in 2020 and $3.108 billion in 2019.

Highlights noted on the balance sheet as of September 30, 2020 for the Company included the following:

•Total assets were $3.780 billion, an increase of $479.56 million since December 31, 2019.
•Cash and cash equivalents were $560.74 million, an increase of $318.77 million since December 31, 2019. Cash and cash equivalents growth included approximately $115 million of temporary public funds. A portion of the increase can also be attributed to increased savings with the current negative economic environment due to the pandemic and equity investors fleeing volatile capital markets in an effort to preserve principal.
•Net loans were $2.759 billion, an increase of $144.33 million since December 31, 2019.  The increase was primarily due to PPP loans provided to customers totaling $127.10 million. Loans held for sale increased $19.58 million since December 31, 2019.
•Deposits increased $453.19 million since December 31, 2019. Deposit growth included approximately $115 million in temporary public funds. A portion of the increase can also be attributed to the current negative economic environment.

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.











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Financial Condition

As indicated in the table below, growth in the loan portfolio since year end was primarily in agricultural, commercial and financial, multi-family and commercial real estate loans. The significant increase in commercial and financial is due to PPP loans totaling $127.10 million being provided to customers. The Company anticipates most PPP loans will be forgiven in accordance with the SBA's requirements.

The COVID-19 pandemic has created significant uncertainty regarding projecting loan demand throughout the remainder of 2020 and into 2021. 

The following table sets forth the composition of the loan portfolio as of September 30, 2020 and December 31, 2019:

 September 30, 2020December 31, 2019
 AmountPercentAmountPercent
 (Amounts In Thousands)(Amounts In Thousands)
Agricultural$96,321 3.48 %$91,317 3.46 %
Commercial and financial335,463 12.12 221,323 8.39 
Real estate:  
Construction, 1 to 4 family residential70,527 2.55 80,209 3.04 
Construction, land development and commercial114,270 4.13 108,410 4.11 
Mortgage, farmland243,689 8.81 242,730 9.20 
Mortgage, 1 to 4 family first liens900,224 32.53 910,742 34.51 
Mortgage, 1 to 4 family junior liens131,477 4.75 149,227 5.65 
Mortgage, multi-family371,167 13.41 350,761 13.29 
Mortgage, commercial417,042 15.07 402,181 15.24 
Loans to individuals30,521 1.10 32,308 1.22 
Obligations of state and political subdivisions56,424 2.05 49,896 1.89 
 $2,767,125 100.00 %$2,639,104 100.00 %
Net unamortized fees and costs965  933  
 $2,768,090  $2,640,037  
Less allowance for loan losses37,060  33,760  
 $2,731,030  $2,606,277  
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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, 2020 and December 31, 2019:

 
 September 30, 2020December 31, 2019
 Amount% of Total
Allowance		% of Loans to
Total Loans		Amount% of Total
Allowance		% of Loans to
Total Loans
 (In Thousands)(In Thousands)
Agricultural$2,595 7.00 %3.48 %$2,400 7.11 %3.46 %
Commercial and financial5,345 14.42 12.12 4,988 14.77 8.39 
Real estate:   
Construction, 1 to 4 family residential888 2.40 2.55 1,113 3.30 3.04 
Construction, land development and commercial1,405 3.79 4.13 1,486 4.40 4.11 
Mortgage, farmland4,048 10.92 8.81 3,950 11.70 9.20 
Mortgage, 1 to 4 family first liens10,629 28.68 32.53 9,045 26.79 34.51 
Mortgage, 1 to 4 family junior liens1,529 4.13 4.75 1,593 4.72 5.65 
Mortgage, multi-family4,367 11.78 13.41 3,823 11.32 13.29 
Mortgage, commercial4,926 13.29 15.07 4,036 11.95 15.24 
Loans to individuals689 1.86 1.10 853 2.53 1.22 
Obligations of state and political subdivisions639 1.73 2.05 473 1.41 1.89 
 $37,060 100.00 %100.00 %$33,760 100.00 %100.00 %

The allowance for loan losses totaled $37.06 million at September 30, 2020 compared to $33.76 million at December 31, 2019.  The percentage of the allowance to outstanding loans was 1.34% and 1.28% at September 30, 2020 and December 31, 2019, respectively.  The allowance was based on management’s consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks and the overall amount of loans outstanding.  The increase in the allowance in 2020 is due to anticipated declines in the credit quality of the Bank's loan portfolio primarily due to the significant uncertainty created by the COVID-19 pandemic and increases in qualitative factors primarily in the areas of 1 to 4 family mortgages, commercial and financial, multi-family and commercial mortgages also primarily due to COVID-19.

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, 2020, 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 $19.95 million from December 31, 2019 to September 30, 2020.  The fair value of securities available for sale was $12.44 million more than the amortized cost of such securities as of September 30, 2020.  At December 31, 2019, the fair value of the securities available for sale was $4.23 million more than the amortized cost of such securities.

Deposits increased $453.19 million in the first nine months of 2020 primarily due to the disbursement of Paycheck Protection Program (PPP) funds to customers' accounts. A portion of the increase can also be attributed to the current negative economic environment creating volatility in the equity markets. 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 $72.27 million as of September 30, 2020 with an average rate of 0.34%.  Brokered deposits were $109.29 million as of December 31, 2019 with an average interest rate of 1.65%. As of September 30, 2020 and December 31, 2019, brokered deposits were 2.32% and 4.11% of total deposits, respectively.

Federal Home Loan Bank (FHLB) borrowings were $185 million as of September 30, 2020 and December 31, 2019. It is expected that the FHLB funding source will be considered in the future if loan growth were 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 2020, Hills Bancorporation paid a dividend of $8.32 million or $0.89 per share.  The dividend was $0.82 per share in January 2019.  After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of September 30, 2020 totaled $407.26 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. As of March 31, 2020, the Bank elected to use the Community Bank Leverage Ratio (CBLR) framework as provided for in the Economic Growth, Regulatory Relief and Consumer Protection Act. Under the CBLR framework, the Bank is required to maintain a CBLR of greater than 9%. The CARES Act reduced the minimum ratio to 8% beginning in the 2nd quarter of 2020 through December 31, 2020, increasing to 8.5% for 2021 and returning to 9% beginning January 1, 2022. As of September 30, 2020 and December 31, 2019, 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, 2020 and December 31, 2019 are presented below (amounts in thousands):

 ActualFor Capital Adequacy PurposesTo Be Well Capitalized Under Prompt Corrective Action Provisions
 AmountRatioRatioRatio
As of September 30, 2020:
Company:
Community Bank Leverage ratio$444,623 12.23 %8.000 11.000 
Bank:    
Community Bank Leverage ratio444,460 12.23 8.000 11.000 
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 ActualFor Capital Adequacy PurposesTo Be Well Capitalized Under Prompt Corrective Action Provisions
 AmountRatioRatioRatio
As of December 31, 2019
Company:
Total risk-based capital$454,452 18.15 %8.00 %10.00 %
Tier 1 risk-based capital423,122 16.90 6.00 8.00 
Tier 1 common equity423,122 16.90 4.50 6.50 
Leverage ratio423,122 12.77 4.00 5.00 
Bank:    
Total risk-based capital455,440 18.20 8.00 10.00 
Tier 1 risk-based capital424,127 16.95 6.00 8.00 
Tier 1 common equity424,127 16.95 4.50 6.50 
Leverage ratio424,127 12.81 4.00 5.00 


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Discussion of operations for the nine months ended September 30, 2020 and 2019

Net Income Overview

Net income decreased $3.49 million for the nine months ended September 30, 2020 compared to the first nine months of 2019.  Total net income was $30.22 million in 2020 and $33.71 million in the comparable period in 2019, a decrease of 10.35%.  The changes in net income in 2020 from the first nine months of 2019 were primarily the result of the following:

•Net interest income increased by $2.55 million, before provision expense.
•The provision for loan losses increased by $6.14 million.
•Noninterest income increased by $2.47 million.
•Noninterest expenses increased by $3.14 million.
•Income tax expense decreased by $0.78 million.
For the nine month period ended September 30, 2020 and September 30, 2019 basic earnings per share was $3.22 and $3.61, respectively. Diluted earnings per share was $3.22 for the nine months ended September 30, 2020 compared to $3.61 for the same period in 2019.

The Company’s net income is driven primarily by three important factors. The first important 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 $2.759 billion at September 30, 2020.  The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio.  The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more.  In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historically higher credit risk.  The provision for loan losses was an expense of $4.50 million in 2020 compared to a reduction of expense of $1.64 million in 2019.  The increase is primarily attributable to increases in qualitative factors due to the COVID-19 pandemic's economic impact. The Company believes that the provision for loan losses may increase for the foreseeable future resulting from and further deterioration in credit quality due to COVID-19.

The second 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 $75.40 million for the first nine months of 2020 was derived from the Company’s $3.362 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.05%.  Average earning assets in the nine months ended September 30, 2019 were $3.108 billion and the tax-equivalent net interest margin was 3.20%.  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 $2.52 million change in income before income taxes in the nine month period ended September 30, 2020.  Net interest income for the Company increased primarily as a result of growth in the volume of earning assets (offsetting reductions in interest income caused by declines in interest rates) and the continued low interest rates on interest bearing deposits resulting in decreased interest expense.  The Company expects net interest compression to impact earnings for the foreseeable future due to competition for loans and deposits combined with the 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. For the nine months ended September 30, 2020, a significant portion of the increase in the loan portfolio is attributable to PPP loans. The Company anticipates most PPP loans will be forgiven in accordance with the SBA's requirements.

The third important factor affecting the Company’s net income is net gain on the sale of loans. The net gain on the sale of loans was $4.86 million and $2.06 million for the nine months ended September 30, 2020 and 2019, respectively, an increase of 135.87% for the nine months ended September 30, 2020 compared to the same period in 2019. Loans originated for sale in the first nine months of 2020 totaled $359.53 million compared to $201.51 million in the same period in 2019, an increase of 78.41%. 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 and has been significantly impacted by the Federal Reserve Board's reduction of the federal funds rate to 0.25%, resulting in a significant amount of mortgage loan refinance activity.




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Discussion of operations for the nine months ended September 30, 2020 and 2019

Net Interest Income

Net interest income increased for the nine months ended September 30, 2020 compared to the comparable period in 2019.  The increase was as a result of growth in the average volume of earning assets and the continued low interest rates on interest bearing deposits resulting in decreased interest expense.  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 respective volumes of earning assets and liabilities for the period and the net interest margin. Net interest margin is the ratio of the Company's net interest income to the average volume of its earning assets.The net interest margin for the first nine months of 2020 was 3.05% compared to 3.20% in 2019 for the same period.  Interest expense decreased $5.22 million for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019 primarily due to decreasing 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 2020 compared to the comparable period in 2019 are shown in the following table:
 Increase (Decrease) in Net Interest Income
 Change in
Average Balance		Change in
Average Rate		Volume ChangesRate ChangesNet Change
 (Amounts in Thousands)
Interest income:
Loans, net$87,500 (0.21)%$4,802 $(5,645)$(843)
Taxable securities36,706 (0.26)685 (404)281 
Nontaxable securities6,881 (0.06)141 (86)55 
Federal funds sold123,017 (1.93)2,139 (4,292)(2,153)
 $254,104  $7,767 $(10,427)$(2,660)
Interest expense:     
Interest-bearing demand deposits$140,254 (0.33)%$(945)$2,128 $1,183 
Savings deposits(6,857)(0.61)731 3,230 3,961 
Time deposits42,647 (0.03)(729)149 (580)
FHLB borrowings(30,000)(0.01)652 8 660 
Interest-bearing other liabilities(2)(1.69)— — — 
 $146,042  $(291)$5,515 $5,224 
Change in net interest income  $7,476 $(4,912)$2,564 

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)20202019
Yield on average interest-earning assets3.88 %4.32 %
Rate on average interest-bearing liabilities1.08 1.44 
Net interest spread2.80 %2.88 %
Effect of noninterest-bearing funds0.25 0.32 
Net interest margin (tax equivalent interest income divided by average interest-earning assets)3.05 %3.20 %
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Discussion of operations for the nine months ended September 30, 2020 and 2019
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 seven times during the first nine months of 2020.  The target rate remained at 0.25% as of September 30, 2020.  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, 2020, the rate indexes for the one, three and five year indexes were 0.12%, 0.16% and 0.28%, respectively.  The one year index decreased 93.14% from 1.75% at September 30, 2019, the three year index decreased 89.74% and the five year index decreased 81.94%.  The three year index was 1.56% and the five year index was 1.55% at September 30, 2019.  The targeted federal funds rate was 0.25% and 2.00% at September 30, 2020 and 2019, respectively.  The Company anticipates short term and long term rates in the indexes to remain consistent for the remainder of 2020.

Provision for Loan Losses

The provision for loan losses was an expense of $4.50 million for the nine months ended September 30, 2020 compared to a reduction of expense of $1.64 million in 2019, an increase of expense of $6.14 million, which resulted in an overall increase to the allowance of $3.30 million since year end. In the first nine months of 2020, there was an increase of $3.41 million due to changes in average balances, composition of loans outstanding and changes in qualitative factors and a $0.11 million decrease in the amount allocated to the allowance due to changes in credit quality. 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 increase in expense in 2020 is primarily attributable to significant uncertainties with respect to the qualitative factors considered by management due to the COVID-19 pandemic's economic impact as compared to September 30, 2019.

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, 2020 and 2019, recoveries were $1.28 million and $1.36 million, respectively; and charge-offs were $2.48 million in 2020 and $1.96 million in 2019.  The allowance for loan losses totaled $37.06 million at September 30, 2020 compared to $33.76 million at December 31, 2019.  The allowance represented 1.34% and 1.28% of loans held for investment at September 30, 2020 and December 31, 2019.

Noninterest Income
The following table sets forth the various categories of noninterest income for the nine months ended September 30, 2020 and 2019.
 Nine Months Ended September 30,
 20202019$ Change% Change
 (Amounts in thousands)
Net gain on sale of loans$4,859 $2,060 $2,799 135.87 %
Trust fees7,450 7,107 343 4.83 
Service charges and fees7,427 7,618 (191)(2.51)
Other noninterest income462 982 (520)(52.95)
Gain (loss) on sale of investment securities10 (28)38 135.71 
 $20,208 $17,739 $2,469 13.92 
Loans originated for sale in the first nine months of 2020, which consist primarily of fixed rate residential mortgage loans, totaled $359.53 million compared to $201.51 million in the same period in 2019, an increase of 78.41%. In the nine months ended September 30, 2020 and 2019, the net gain on sale of loans was $4.86 million and $2.06 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 and has been significantly impacted by the Federal Reserve Board's reduction of the federal funds rate to 0.25%, resulting in a significant amount of mortgage loan refinance activity. 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. 
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HILLS BANCORPORATION

Discussion of operations for the nine months ended September 30, 2020 and 2019

Other noninterest income categories experienced marginal period-to-period fluctuations for the nine months ended September 30, 2020.

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the nine months ended September 30, 2020 and 2019.

 Nine Months Ended September 30,
 20202019$ Change% Change
 (Amounts in thousands)
Salaries and employee benefits$29,818 $27,310 $2,508 9.18 %
Occupancy3,248 3,274 (26)(0.79)
Furniture and equipment5,778 5,036 742 14.73 
Office supplies and postage1,333 1,370 (37)(2.70)
Advertising and business development1,479 1,800 (321)(17.83)
Outside services8,020 7,824 196 2.51 
FDIC insurance assessment617 612 5 0.82 
Other noninterest expense1,861 1,787 74 4.14 
 $52,154 $49,013 $3,141 6.41 

In the nine months ended September 30, 2020 and 2019, salaries and employee benefits expense increased $2.51 million. The increase is primarily the result of annual salary adjustments, hiring of additional employees to staff growth and increased variable compensation due to the increase in loans originated for sale described above.

Other noninterest expense categories experienced marginal period-to-period fluctuations for the nine months ended September 30, 2020.




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HILLS BANCORPORATION
Discussion of operations for the three months ended September 30, 2020 and 2019

Net Income Overview

Net income increased $0.15 million for the three months ended September 30, 2020 compared to the same period in 2019.  Total net income was $11.43 million in 2020 and $11.28 million in the comparable period in 2019, an increase of 1.31%.  For the three month period ended September 30, 2020 and September 30, 2019 basic earnings per share was $1.22 and $1.21, respectively. Diluted earnings per share was $1.22 for the three months ended September 30, 2020 compared to $1.21 for the same period in 2019.

Net Interest Income

Net interest income increased for the three months ended September 30, 2020 compared to the comparable period in 2019.  The increase was primarily the result of growth in the volume of earning assets and the continued low interest rates on interest bearing deposits resulting in decreased interest expense.  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 decreased $2.81 million for the three months ended September 30, 2020 compared to the three months ended September 30, 2019 primarily due to decreasing interest rates on deposits. The factors that have the greatest impact on net interest income are the average respective volumes of earning assets and liabilities and the net interest margin.  The net interest margin for the three months ended September 30, 2020 was 2.90% compared to 3.13% in 2019 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 2020 compared to the comparable period in 2019 are shown in the following table:
 Increase (Decrease) in Net Interest Income
 Change in
Average Balance		Change in
Average Rate		Volume ChangesRate ChangesNet Change
 (Amounts in Thousands)
Interest income:
Loans, net$125,487 (0.38)%$2,009 $(3,114)$(1,105)
Taxable securities42,481 (0.38)233 (169)64 
Nontaxable securities8,396 (0.08)57 (39)18 
Federal funds sold152,008 (2.09)832 (2,098)(1,266)
 $328,372  $3,131 $(5,420)$(2,289)
Interest expense:     
Interest-bearing demand deposits$163,620 (0.51)%$(377)$1,141 $764 
Savings deposits28,613 (0.69)198 1,288 1,486 
Time deposits15,355 (0.23)(88)423 335 
FHLB borrowings(30,000)0.01 224 — 224 
Interest-bearing other liabilities2 (2.41)— — — 
 $177,590 $(43)$2,852 $2,809 
Change in net interest income  $3,088 $(2,568)$520 

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.







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HILLS BANCORPORATION



Discussion of operations for the three months ended September 30, 2020 and 2019

A summary of the net interest spread and margin is as follows:
(Tax Equivalent Basis)20202019
Yield on average interest-earning assets3.62 %4.28 %
Rate on average interest-bearing liabilities0.96 1.47 
Net interest spread2.66 %2.81 %
Effect of noninterest-bearing funds0.24 0.32 
Net interest margin (tax equivalent interest income divided by average interest-earning assets)2.90 %3.13 %
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HILLS BANCORPORATION
Discussion of operations for the three months ended September 30, 2020 and 2019

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $0.16 million for the three months ended September 30, 2020 compared to an expense of $0.14 million in 2019, an expense decrease of $0.30 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 2020 is the result of changes in the composition and allocation of loans within credit quality ratings as compared to September 30, 2019 and a reduction in specific reserves as of September 30, 2020 as compared to September 30, 2019.
 
The allowance for loan losses decreased $0.56 million during the three months ended September 30, 2020 compared to June 30, 2020.  In the three months ended September 30, 2020, there was a $0.35 million decrease in the amount allocated to the allowance due to credit quality and a $0.21 decrease 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, 2020 and 2019, recoveries were $0.47 million and $0.51 million, respectively; and charge-offs were $0.87 million in 2020 and $0.74 million in 2019.  The allowance for loan losses totaled $37.06 million at September 30, 2020 compared to $33.76 million at December 31, 2019.  The allowance represented 1.34% and 1.28% of loans held for investment at September 30, 2020 and December 31, 2019, respectively.

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended September 30, 2020 and 2019.
 Three Months Ended September 30,
 20202019$ Change% Change
 (Amounts in thousands)
Net gain on sale of loans$2,303 $1,197 $1,106 92.40 %
Trust fees2,494 2,427 67 2.76 
Service charges and fees2,636 2,695 (59)(2.19)
Other noninterest income77 295 (218)(73.90)
Gain on sale of investment securities— 24 (24)— 
 $7,510 $6,638 $872 13.14 
In the three months ended September 30, 2020 and 2019, the net gain on sale of loans was $2.30 million and $1.20 million, respectively, which consist primarily of fixed rate residential mortgage loans.  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 and has been significantly impacted by the Federal Reserve Board's reduction of the federal funds rate to 0.25%, resulting in a significant amount of mortgage loan refinance activity.  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 categories experienced marginal period-to-period fluctuations for the three months ended September 30, 2020.
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HILLS BANCORPORATION

Discussion of operations for the three months ended September 30, 2020 and 2019

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended September 30, 2020 and 2019.
 Three Months Ended
September 30,
 20202019$ Change% Change
 (Amounts in thousands)
Salaries and employee benefits$10,108 $9,258 $850 9.18 %
Occupancy1,067 986 81 8.22 
Furniture and equipment2,028 1,699 329 19.36 
Office supplies and postage425 469 (44)(9.38)
Advertising and business development340 607 (267)(43.99)
Outside services2,818 2,729 89 3.26 
FDIC insurance assessment223 208 15 7.21 
Other noninterest expense1,046 648 398 61.42 
 $18,055 $16,604 $1,451 8.74 
In the three months ended September 30, 2020 and 2019, salaries and employee benefits expense increased $0.85 million. The increase is primarily the result of annual salary adjustments, hiring of additional employees to staff branch growth and increased variable compensation due to the increase in loans originated for sale described above.

Other noninterest expense categories experienced marginal period-to-period fluctuations for the three months ended September 30, 2020.


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HILLS BANCORPORATION
Income Taxes

Federal and state income tax expenses were $8.74 million and $9.52 million for the nine months ended September 30, 2020 and 2019, respectively. Income taxes as a percentage of income before taxes were 22.43% in 2020 and 22.02% in 2019.
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HILLS BANCORPORATION
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 9.93% of the Company’s total assets at September 30, 2020 compared to 10.76% at December 31, 2019.

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, 2020, the Company had borrowed $185.00 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 $683.83 million at September 30, 2020.

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 $504.46 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, 2020.

As of September 30, 2020, investment securities with a carrying value of $13.75 million were pledged to collateralize public and trust deposits, derivative financial instruments, and other borrowings.  As of December 31, 2019, investment securities with a carrying value of $12.93 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, 2019.
Item 3.Quantitative and Qualitative Disclosures about Market Risk
The Company's primary market risk exposure is to changes in interest rates.  Interest rate risk is the risk to current or anticipated earnings or capital arising from movements in interest rates.  Interest rate risk arises from repricing risk, basis risk, yield curve risk and options risk.  Repricing risk is the difference between the timing of rate changes and the timing of cash flows.  Basis risk is the difference from changing rate relationships among different yield curve affecting Bank activities.  Yield curve risk is the difference from changing rate relationships across the spectrum of maturities.  Option risk is the difference resulting from interest-related options imbedded in Bank products.  The Bank’s primary source of interest rate risk exposure arises from repricing risk.  To measure this risk the Bank uses a static gap measurement system that identifies the repricing gaps across the full maturity spectrum of the Bank’s assets and liabilities and an earnings simulation approach.  The gap schedule is known as the interest rate sensitivity report.  The report reflects the repricing characteristics of the Bank’s assets and liabilities.  The report details the calculation of the gap ratio.  This ratio indicates the amount of interest-earning assets repricing within a given period in comparison to the amount of interest-bearing liabilities repricing within the same period of time.  A gap ratio of 1.0 indicates a matched position, in which case the effect on net interest income due to interest rate movements will be minimal.  A gap ratio of less than 1.0 indicates that more liabilities than assets reprice within the time period, and a ratio greater than 1.0 indicates that more assets reprice than liabilities.

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

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

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

The Bank's cumulative gap ratio over the immediate 90 day horizon has increased from 2.2 at December 31, 2019 to 3.3 at September 30, 2020. As a consequence, the Bank's interest rate risk, as monitored by management, has increased from December 31, 2019 due to the significant Federal Reserve rate cuts in the first quarter of 2020 and the continued low interest rate environment.
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 Interim Principal Accounting 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 Interim Principal Accounting 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, 2020 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.

As initially reported in the Company’s quarterly report filed with the SEC on November 4, 2019, Hills Bank was sued in a class action lawsuit in the Iowa District Court for Johnson County on April 10, 2019. The lawsuit sought 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. The Plaintiff subsequently amended the petition to assert additional claims involving overdraft charges and NSF fees. The parties have negotiated a class-wide settlement, which was preliminarily approved by the Court on October 9, 2020. While the Bank disputes the merits of the claim, management determined that settlement avoids added expenses, distractions to Bank management and personnel, and the attendant risks related to litigating the claim. The aggregate amount of the settlement was significantly below the disclosure threshold under this item for legal claims, and the Bank’s Management believes that the settlement will have no material impact on the Company's financial condition and results of operation. The final hearing to address the fairness of the proposed settlement has been scheduled for June 25, 2021.

Item 1A.Risk Factors
 
Except as otherwise provided below, there have been no material changes from the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2019.

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The ongoing COVID-19 pandemic and measures intended to prevent its spread could have a material adverse effect on our business, results of operations and financial condition, and such effects will depend on future developments, which are highly uncertain and are difficult to predict.

In December 2019, a novel coronavirus (COVID-19) was reported in China, and, in March 2020, the World Health Organization declared it a pandemic. On March 12, 2020, the President of the United States declared the COVID-19 outbreak in the United States a national emergency. The COVID-19 pandemic has caused significant economic dislocation in the United States as many state and local governments ordered non-essential businesses to close and residents to shelter in place at home. This has resulted in an unprecedented slow-down in economic activity and a related increase in unemployment. Since the COVID-19 outbreak, more than 65 million people have filed claims for unemployment, and stock markets have experienced significant volatility and, in particular, bank stocks have significantly declined in value. In response to the COVID-19 outbreak, the Federal Reserve Board has reduced the benchmark fed funds rate to a target range of 0% to 0.25%, and the yields on 10 and 30-year treasury notes have declined to historic lows. The federal banking agencies have encouraged financial institutions to prudently work with affected borrowers and recently passed legislation to provide relief from reporting loan classifications due to modifications related to the COVID-19 outbreak.

Finally, the spread of the coronavirus has caused the Company to modify its business practices, including employee travel, employee work locations, and cancellation of physical participation in meetings, events and conferences. The Company may take further actions as may be required by government authorities or that it determines are in the best interests of employees, customers and business partners. There is no certainty that such measures will be sufficient to mitigate the risks posed by the virus or will otherwise be satisfactory to government authorities. In addition, the success of the Company’s operations substantially depends on the management skills of its executive officers and directors, many of whom have held officer and director positions with the Company for many years. The unanticipated loss or unavailability of key employees due to the outbreak could harm our ability to operate our business or execute our business strategy.

Given the ongoing and dynamic nature of the circumstances, it remains difficult to predict the full impact of the COVID-19 outbreak on our business. The United States government has taken steps to attempt to mitigate some of the more severe anticipated economic effects of the virus, including the passage of the CARES Act, but there can be no assurance that such steps will be effective or achieve their desired results in a timely fashion. The extent of such impact from the COVID-19 outbreak and related mitigation efforts will depend on future developments, which are highly uncertain, including but not limited to, the duration and spread of the outbreak, its severity, the actions to contain the virus or treat its impact, and how quickly and to what extent normal economic and operating conditions can resume. As the result, the Company could be subject to any of the following risks, any of which could have a material, adverse effect on our business, financial condition, liquidity, and results of operations:

•demand for our products and services may decline, making it difficult to grow assets and income;

•if the economy is unable to substantially reopen, and high levels of unemployment continue for an extended period of time, loan delinquencies, problem assets, and foreclosures may increase, resulting in increased charges and reduced income;

•collateral for loans, especially real estate, may decline in value, which could cause loan losses to increase;

•our allowance for loan losses may have to be increased if borrowers experience financial difficulties beyond forbearance periods, which will adversely affect our net income;

•the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us;

•as the result of the decline in the Federal Reserve Board’s target federal funds rate, the yield on our assets may decline to a greater extent than the decline in our cost of interest-bearing liabilities, reducing our net interest margin and spread and reducing net income;

•a material decrease in net income or a net loss over several quarters could result in a decrease in the rate of our quarterly cash dividend;

•we rely on third party vendors for certain services and the unavailability of a critical service due to the COVID-19 outbreak could have an adverse effect on us; and
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•Federal Deposit Insurance Corporation premiums may increase if the agency experiences additional resolution costs.
Any one or a combination of the factors identified above could negatively impact our business, financial condition and results of operations and prospects. Even after the COVID-19 outbreak has subsided, the Company may continue to experience materially adverse impacts to our business as a result of the virus’s global economic impact, including the availability of credit, adverse impacts on our liquidity and any recession that has occurred or may occur in the future.

The ongoing impact of the derecho storm could have a material adverse effect on our business, results of operations and financial condition, and such effects will depend on future developments, which are highly uncertain and are difficult to predict.

On August 10, 2020, a derecho impacted Eastern Iowa, primarily Cedar Rapids, Iowa and the surrounding areas. The derecho caused widespread high winds up to 140 mph, the equivalent of a Category 4 hurricane, torrential rain, large hail and low-class tornadoes. The damage from the derecho was significant across the east central Iowa area, including wide-scale utility disruptions, residential and commercial property damage and severe damage to corn and soybeans crops. The Bank has assisted customers impacted by the derecho by providing short-term loan modifications to defer principal payments on loans totaling $15.38 million, primarily for 1 to 4 family non-owner occupied, multifamily and commercial real estate loans. Further deterioration to the local economy caused by the derecho could have a materially negative impact on the Bank’s financial condition and results of operation in future periods.
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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 nine months ended September 30, 2020:

PeriodTotal 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 301,417 $59.98 1,417 199,980 
August 1 to August 3117,431 60.22 17,431 182,549 
September 1 to September 3010,959 62.00 10,959 171,590 
Total29,807 $60.86 29,807 171,590 
 
(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, 2021.  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. 
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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
3.2
4.1
31
32
101.INSXBRL Instance Document (1), (2)
101.SCHXBRL Taxonomy Extension Schema Document (1)
101.CALXBRL Taxonomy Extension Calculation Linkbase Document (1)
101.DEFXBRL Taxonomy Extension Definition Linkbase Document (1)
101.LABXBRL Taxonomy Extension Label Linkbase Document (1)
101.PREXBRL 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 5, 2020 By:  /s/ Dwight O. Seegmiller
  Dwight O. Seegmiller, Director, President and Chief Executive Officer
   
Date:November 5, 2020 By:  /s/ Jason S. Weeks
  Jason S. Weeks, Interim Treasurer and Interim Principal Accounting Officer
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HILLS BANCORPORATION
QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED SEPTEMBER 30, 2020
Exhibit
Number		DescriptionPage Number In The Sequential
Numbering System September 30, 2020 Form 10-Q
3171-72
   
3273 
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