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

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q



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

For the quarterly period ended March 31, 2020



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

For the transition period from ___________ to ___________

Commission file number: 0-12668

Hills Bancorporation



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

131 MAIN STREET, HILLS, Iowa 52235

Telephone number: (319) 679-2291

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



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

Indicate by checkmark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☑ Yes ☐ No

Indicate by checkmark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit such files). ☑ Yes ☐ No

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



Large accelerated filer	☐	Accelerated Filer	☑
Non-accelerated filer	☐	Small Reporting Company	☐
Emerging Growth Company	☐

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

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

Index

APPLICABLE ONLY TO CORPORATE ISSUERS:

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



		SHARES OUTSTANDING
CLASS		April 30, 2020

Common Stock	No par value	9,371,390

Index

HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION



		Page
		Number

Item 1.	Financial Statements

	Consolidated balance sheets, March 31, 2020 (unaudited) and December 31, 2019	4
	Consolidated statements of income (unaudited) for three months ended March 31, 2020 and 2019	5
	Consolidated statements of comprehensive income (unaudited) for three months ended March 31, 2020 and 2019	6
	Consolidated statements of stockholders' equity (unaudited) for three months ended March 31, 2020 and 2019	7
	Consolidated statements of cash flows (unaudited) for three months ended March 31, 2020 and 2019	8
	Notes to consolidated financial statements (condensed)	10

Item 2.	Management Discussion and Analysis of Financial Condition and Results of Operations	40

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	54

Item 4.	Controls and Procedures	55

	Part II
	OTHER INFORMATION

Item 1.	Legal proceedings	55

Item 1A.	Risk factors	55

Item 2.	Unregistered sales of equity securities and use of proceeds	58

Item 3.	Defaults upon senior securities	58

Item 4.	Mine safety disclosures	58

Item 5.	Other information	58

Item 6.	Exhibits	59

	Signatures	60

	Exhibits Index	61

Page 3

Index

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



	March 31, 2020			December 31, 2019
ASSETS	(Unaudited)			December 31, 2019
Cash and cash equivalents	$	268,293		$	241,965
Investment securities available for sale at fair value (amortized cost March 31, 2020 $367,051; December 31, 2019 $351,069)	371,839			355,303
Stock of Federal Home Loan Bank	11,374			11,065
Loans held for sale	11,592			8,400
Loans, net of allowance for loan losses (March 31, 2020 $38,340; December 31, 2019 $33,760)	2,626,399			2,606,277
Property and equipment, net	36,767			37,146
Tax credit real estate investment	7,945			8,280
Accrued interest receivable	13,691			12,442
Deferred income taxes, net	9,091			8,018
Goodwill	2,500			2,500
Other assets	6,747			9,491
Total Assets	$	3,366,238		$	3,300,887

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities
Noninterest-bearing deposits	$	381,171		$	387,612
Interest-bearing deposits	2,350,543			2,273,752
Total deposits	$	2,731,714		$	2,661,364
Federal Home Loan Bank borrowings	185,000			185,000
Accrued interest payable	2,352			2,474
Other liabilities	20,112			25,012
Total Liabilities	$	2,939,178		$	2,873,850

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	50,249		$	51,826

STOCKHOLDERS' EQUITY
Common stock, no par value; authorized 20,000,000 shares; issued March 31, 2020 10,328,925 shares; December 31, 2019 10,327,656 shares	$	—		$	—
Paid in capital	59,733			55,943
Retained earnings	408,260			409,509
Accumulated other comprehensive income	1,006			1,415
Treasury stock at cost (March 31, 2020 953,569 shares; December 31, 2019 975,962 shares)	(41,939		)	(39,830		)
Total Stockholders' Equity	$	427,060		$	427,037
Less maximum cash obligation related to ESOP shares	50,249			51,826
Total Stockholders' Equity Less Maximum Cash Obligation Related to ESOP Shares	$	376,811		$	375,211
Total Liabilities & Stockholders' Equity	$	3,366,238		$	3,300,887

See Notes to Consolidated Financial Statements.

Page 4

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Amounts In Thousands, Except Per Share Amounts)



	Three Months Ended March 31,
	2020		2019
Interest income:
Loans, including fees	$	29,893	$	29,573
Investment securities:
Taxable	884		758
Nontaxable	1,037		1,025
Federal funds sold	638		491
Total interest income	$	32,452	$	31,847
Interest expense:
Deposits	$	6,492	$	6,499
FHLB borrowings	1,370		1,575
Total interest expense	$	7,862	$	8,074
Net interest income	$	24,590	$	23,773
Provision for loan losses	4,649		(1,246		)
Net interest income after provision for loan losses	$	19,941	$	25,019
Noninterest income:
Net gain on sale of loans	$	658	$	286
Trust fees	2,570		2,252
Service charges and fees	2,529		2,275
Other noninterest income	400		437
Gain on sale of investment securities	10		—
	$	6,167	$	5,250

Noninterest expenses:
Salaries and employee benefits	$	9,584	$	8,722
Occupancy	1,152		1,186
Furniture and equipment	1,781		1,673
Office supplies and postage	503		459
Advertising and business development	759		638
Outside services	2,685		2,572
FDIC insurance assessment	180		209
Other noninterest expense	583		590
	$	17,227	$	16,049
Income before income taxes	$	8,881	$	14,220
Income taxes	1,806		3,017
Net income	$	7,075	$	11,203

Earnings per share:
Basic	$	0.75	$	1.20
Diluted	$	0.75	$	1.20

See Notes to Consolidated Financial Statements.

Page 5

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited) (Amounts In Thousands)



	Three Months Ended March 31,
	2020			2019
Net income	$	7,075		$	11,203

Other comprehensive (loss) income
Securities:
Net change in unrealized income on securities available for sale	$	564		$	3,293
Reclassification adjustment for net gains realized in net income	(10		)	—
Income taxes	(139		)	(821		)
Other comprehensive income on securities available for sale	$	415		$	2,472
Derivatives used in cash flow hedging relationships:
Net change in unrealized loss on derivatives	$	(1,098	)	$	(298	)
Income taxes	274			75
Other comprehensive loss on cash flow hedges	$	(824	)	$	(223	)

Other comprehensive (loss) income, net of tax	$	(409	)	$	2,249

Comprehensive income	$	6,666		$	13,452

See Notes to Consolidated Financial Statements.

Page 6

Index

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



Three Months Ended March 31, 2020 and 2019
	Paid In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Treasury Stock			Maximum Cash Obligation Related To ESOP Shares			Total
Balance, December 31, 2018	$	52,122		$	371,848		$	(3,250	)	$	(36,968	)	$	(48,870	)	$	334,882
Issuance of 84,164 shares of common stock	2,932			—			—			2,202			—			5,134
Issuance of 1,929 shares of common stock under the employee stock purchase plan	105			—			—			—			—			105
Unearned restricted stock compensation	170			—			—			—			—			170
Forfeiture of 703 shares of common stock	(34		)	—			—			—			—			(34		)
Change related to ESOP shares	—			—			—			—			(981		)	(981		)
Net income	—			11,203			—			—			—			11,203
Cash dividends ($0.82 per share)	—			(7,657		)	—			—			—			(7,657		)
Purchase of 69,771 shares of common stock	—			—			—			(4,291		)	—			(4,291		)
Other comprehensive income	—			—			2,249			—			—			2,249
Balance, March 31, 2019	$	55,295		$	375,394		$	(1,001	)	$	(39,057	)	$	(49,851	)	$	340,780

Balance, December 31, 2019	55,943			409,509			1,415			(39,830		)	(51,826		)	375,211
Issuance of 91,274 shares of common stock	3,504			—			—			2,429			—			5,933
Issuance of 1,712 shares of common stock under the employee stock purchase plan	101			—			—			—			—			101
Unearned restricted stock compensation	202			—			—			—			—			202
Forfeiture of 443 shares of common stock	(23		)	—			—			—			—			(23		)
Share-based compensation	6			—			—			—			—			6
Change related to ESOP shares	—			—			—			—			1,577			1,577
Net income	—			7,075			—			—			—			7,075
Cash dividends ($0.89 per share)	—			(8,324		)	—			—			—			(8,324		)
Purchase of 68,881 shares of common stock	—			—			—			(4,538		)	—			(4,538		)
Other comprehensive income	—			—			(409		)	—			—			(409		)
Balance, March 31, 2020	$	59,733		$	408,260		$	1,006		$	(41,939	)	$	(50,249	)	$	376,811

See Notes to Consolidated Financial Statements.

Page 7

Index

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



	Three Months Ended March 31,
	2020			2019
Cash Flows from Operating Activities
Net income	$	7,075		$	11,203
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation	874			847
Provision for loan losses	4,649			(1,246		)
Net gain on sale of investment securities available for sale	(10		)	—
Forfeiture of common stock	(23		)	(34		)
Share-based compensation	6			—
Compensation expensed through issuance of common stock	89			108
Provision for deferred income taxes	(938		)	454
Net gain on sale of other real estate owned and other repossessed assets	—			(11		)
Increase in accrued interest receivable	(1,249		)	(2,186		)
Amortization of premium on investment securities, net	157			100
Decrease in other assets	2,649			426
Amortization of operating lease right-of-use assets	95			—
Decrease in accrued interest payable and other liabilities	(5,918		)	(955		)
Loans originated for sale	(55,609		)	(29,847		)
Proceeds on sales of loans	53,075			26,850
Net gain on sales of loans	(658		)	(286		)
Net cash and cash equivalents provided by operating activities	$	4,264		$	5,423

Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	9,076		$	10,251
Proceeds from sales of investment securities available for sale	313			—
Purchases of investment securities available for sale	(25,827		)	(12,143		)
Loans made to customers, net of collections	(24,771		)	(15,208		)
Proceeds on sale of other real estate owned and other repossessed assets	—			62
Purchases of property and equipment	(495		)	(427		)
Net changes from tax credit real estate investment	335			262
Net cash and cash equivalents used in investing activities	$	(41,369	)	$	(17,203	)

Cash Flows from Financing Activities
Net increase in deposits	$	70,350		$	175,768
Issuance of common stock, net of costs	5,844			5,026
Purchase of treasury stock	(4,538		)	(4,291		)
Proceeds from the issuance of common stock through the employee stock purchase plan	101			105
Dividends paid	(8,324		)	(7,657		)
Net cash and cash equivalents provided by financing activities	$	63,433		$	168,951

(Continued)

Page 8

Index

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

	Three Months Ended March 31,
	2020			2019
Increase in cash and cash equivalents	$	26,328		$	157,171
Cash and cash equivalents:
Beginning of period	241,965			43,305
End of period	$	268,293		$	200,476

Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	6,614		$	6,260
Interest paid on other obligations	1,370			1,575

Noncash activities:
(Decrease)/increase in maximum cash obligation related to ESOP shares	$	(1,577	)	$	981
Transfers to other real estate owned	—			51
Right-of-use assets obtained in exchange for operating lease obligations	—			3,581

See Notes to Consolidated Financial Statements.

Page 9

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


Note 1.	Summary of Significant Accounting Policies

Basis of Presentation:

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

Operating results for the three month period ended March 31, 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 as these activities are not subject to the requirements of ASC 606. Interest income on loans and investment securities is recognized on the accrual method in accordance with written contracts.

Descriptions of the Company’s revenue-generating activities that are within the scope of ASC 606 are the following: Service charges and fees on deposit accounts represent general service fees for monthly account maintenance and activity- or transaction-based fees and consist of transaction-based revenue which includes interchange income, time-based revenue (service period), item-based revenue or some other individual attribute-based revenue. Revenue is recognized when the Company’s performance obligation is completed which is generally monthly for account maintenance services or when a transaction has been completed (such as a wire transfer). Payment for such performance obligations are generally received at the time the performance obligations are satisfied. Trust income represents monthly fees due from wealth management customers as consideration for managing the customers' assets. Wealth management and trust services include custody of assets, investment management, fees for trust services and similar fiduciary activities. Revenue is recognized when our performance obligation is completed each month, which is generally the time that payment is received.

A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity's obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. As of March 31, 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 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 March 31, 2020.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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 March 31, 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.

Upon adoption on January 1, 2020, we estimate an overall increase in our Allowance for Credit Losses (ACL) for loans of approximately $3 million to $4 million. We also anticipate an unfunded commitments liability of approximately $1.0 million to $2.0 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.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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 March 31, 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 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.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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.

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.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 2.	Earnings Per Share

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

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



	Three Months Ended March 31,
	2020		2019
Common shares outstanding at the beginning of the period	9,351,694		9,336,441
Weighted average number of net shares issued	46,232		30,816
Weighted average shares outstanding (basic)	9,397,926		9,367,257
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method	3,754		4,008
Weighted average number of shares (diluted)	9,401,680		9,371,265
Net income (In thousands)	$	7,075	$	11,203
Earnings per share:
Basic	$	0.75	$	1.20
Diluted	$	0.75	$	1.20

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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 March 31, 2020 and December 31, 2019:



	March 31, 2020			December 31, 2019
	(amounts in thousands)
Net unrealized income on available-for-sale securities	$	4,788		$	4,234
Net unrealized loss on derivatives used for cash flow hedges	(3,447		)	(2,349		)
Tax effect	$	(335	)	$	(470	)
Net-of-tax amount	$	1,006		$	1,415


Note 4.	Securities

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



	March 31, 2020				December 31, 2019
	Amount		Percent		Amount		Percent
Securities available for sale
U.S. Treasury	$	148,740	40.00	%	$	128,585	36.19	%
Other securities (FHLB, FHLMC and FNMA)	12,826		3.45		15,229		4.29
State and political subdivisions	210,273		56.55		211,489		59.52
Total securities available for sale	$	371,839	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 March 31, 2020 or December 31, 2019. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of March 31, 2020 and December 31, 2019 (in thousands):



	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Estimated Fair Value
March 31, 2020:
U.S. Treasury	$	142,669	$	6,071	$	—		$	148,740
Other securities (FHLB, FHLMC and FNMA)	12,775		51		—			12,826
State and political subdivisions	211,607		1,135		(2,469		)	210,273
Total	$	367,051	$	7,257	$	(2,469	)	$	371,839
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 subdivisions	208,686		2,938		(135		)	211,489
Total	$	351,069	$	4,564	$	(330	)	$	355,303

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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 March 31, 2020, were as follows (in thousands):



	Amortized Cost		Fair Value
Due in one year or less	$	65,163	$	65,416
Due after one year through five years	206,921		212,657
Due after five years through ten years	82,468		81,957
Due over ten years	12,499		11,809
Total	$	367,051	$	371,839

As of March 31, 2020 investment securities with a carrying value of $13.51 million were pledged to collateralize derivative financial instruments and other borrowings.

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



	March 31, 2020		March 31, 2019
Sales proceeds	$	313	$	—
Gross realized gains	10		—
Gross realized losses	—		—

The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2020 and December 31, 2019 (in thousands):



	Less than 12 months								12 months or more								Total
March 31, 2020 Description of Securities	#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
U.S. Treasury	—	$	—	$	—		—	%	—	$	—	$	—		—	%	—	$	—	$	—		—	%

Other securities (FHLB, FHLMC and FNMA)	—	—		—			—		—	—		—			—		—	—		—			—

State and political subdivisions	381	101,743		(2,460		)	2.42		9	1,086		(9		)	0.83		390	102,829		(2,469		)	2.40

Total temporarily impaired securities	381	$	101,743	$	(2,460	)	2.42	%	9	$	1,086	$	(9	)	0.83	%	390	$	102,829	$	(2,469	)	2.40	%

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)



	Less than 12 months								12 months or more								Total
December 31, 2019 Description of Securities	#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
U.S. Treasury	11	$	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 subdivisions	66	17,881		(119		)	0.67		20	3,825		(16		)	0.42		86	21,706		(135		)	0.62

Total temporarily impaired securities	77	$	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:



	March 31, 2020		December 31, 2019
	(Amounts In Thousands)
Agricultural	$	96,811	$	91,317
Commercial and financial	228,074		221,323
Real estate:
Construction, 1 to 4 family residential	83,445		80,209
Construction, land development and commercial	102,820		108,410
Mortgage, farmland	246,203		242,730
Mortgage, 1 to 4 family first liens	905,951		910,742
Mortgage, 1 to 4 family junior liens	148,444		149,227
Mortgage, multi-family	357,194		350,761
Mortgage, commercial	410,200		402,181
Loans to individuals	31,749		32,308
Obligations of state and political subdivisions	52,917		49,896
	$	2,663,808	$	2,639,104
Net unamortized fees and costs	931		933
	$	2,664,739	$	2,640,037
Less allowance for loan losses	38,340		33,760
	$	2,626,399	$	2,606,277

Page 17

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the three months ended March 31, 2020 were as follows:



	Three Months Ended March 31, 2020
	Agricultural			Commercial and Financial			Real Estate: Construction and land development		Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,400		$	4,988		$	2,599	$	3,950	$	10,638		$	7,859		$	1,326		$	33,760
Charge-offs	(4		)	(15		)	—		—		(229		)	(2		)	(190		)	(440		)
Recoveries	10			108			2		—		187			14			50			371
Provision	354			1,599			20		146		1,156			1,192			182			4,649

Ending balance	$	2,760		$	6,680		$	2,621	$	4,096	$	11,752		$	9,063		$	1,368		$	38,340

Ending balance, individually evaluated for impairment	$	217		$	1,534		$	—	$	3	$	176		$	—		$	2		$	1,932

Ending balance, collectively evaluated for impairment	$	2,543		$	5,146		$	2,621	$	4,093	$	11,576		$	9,063		$	1,366		$	36,408

Loans:

Ending balance	$	96,811		$	228,074		$	186,265	$	246,203	$	1,054,395		$	767,394		$	84,666		$	2,663,808

Ending balance, individually evaluated for impairment	$	1,884		$	3,853		$	418	$	4,130	$	8,773		$	3,669		$	2		$	22,729

Ending balance, collectively evaluated for impairment	$	94,927		$	224,221		$	185,847	$	242,073	$	1,045,622		$	763,725		$	84,664		$	2,641,079

Page 18

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Changes in the allowance for loan losses for the three months ended March 31, 2019 were as follows:



	Three Months Ended March 31, 2019
	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,789		$	5,826		$	3,292		$	3,972		$	12,516		$	8,165		$	1,250		$	37,810
Charge-offs	—			(180		)	(8		)	—			(177		)	(4		)	(108		)	(477		)
Recoveries	10			184			2			5			110			85			37			433
Provision	(258		)	174			(358		)	(106		)	(819		)	(23		)	144			(1,246		)

Ending balance	$	2,541		$	6,004		$	2,928		$	3,871		$	11,630		$	8,223		$	1,323		$	36,520

Ending balance, individually evaluated for impairment	$	258		$	1,375		$	—		$	—		$	74		$	483		$	59		$	2,249

Ending balance, collectively evaluated for impairment	$	2,283		$	4,629		$	2,928		$	3,871		$	11,556		$	7,740		$	1,264		$	34,271

Loans:

Ending balance	$	93,573		$	227,403		$	179,334		$	238,109		$	1,068,591		$	753,163		$	82,892		$	2,643,065

Ending balance, individually evaluated for impairment	$	2,740		$	4,039		$	832		$	4,189		$	6,879		$	4,333		$	59		$	23,071

Ending balance, collectively evaluated for impairment	$	90,833		$	223,364		$	178,502		$	233,920		$	1,061,712		$	748,830		$	82,833		$	2,619,994

Page 19

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The following table presents the credit quality indicators by type of loans in each category as of March 31, 2020 and December 31, 2019, respectively (amounts in thousands):



	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
March 31, 2020
Grade:
Excellent	$	3,710	$	3,517	$	—	$	241
Good	14,405		46,648		9,646		15,969
Satisfactory	45,924		122,917		53,520		48,413
Monitor	26,066		44,584		18,506		30,190
Special Mention	3,606		6,438		747		7,218
Substandard	3,100		3,970		1,026		789
Total	$	96,811	$	228,074	$	83,445	$	102,820



	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family
March 31, 2020
Grade:
Excellent	$	6,837	$	2,732	$	262	$	18,974
Good	37,941		32,019		4,086		51,338
Satisfactory	136,433		742,836		135,444		191,849
Monitor	53,050		101,037		5,494		61,677
Special Mention	3,971		10,534		1,341		27,361
Substandard	7,971		16,793		1,817		5,995
Total	$	246,203	$	905,951	$	148,444	$	357,194



	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
March 31, 2020
Grade:
Excellent	$	26,494	$	—	$	7,313	$	70,080
Good	81,334		199		14,266		307,851
Satisfactory	214,053		30,871		23,158		1,745,418
Monitor	80,061		387		7,795		428,847
Special Mention	4,967		235		385		66,803
Substandard	3,291		57		—		44,809
Total	$	410,200	$	31,749	$	52,917	$	2,663,808

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)



	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
December 31, 2019
Grade:
Excellent	$	3,594	$	3,461	$	260	$	190
Good	12,380		47,843		8,868		23,217
Satisfactory	43,308		117,114		51,093		47,987
Monitor	24,857		44,543		17,505		29,009
Special Mention	3,110		5,157		2,483		7,428
Substandard	4,068		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
Good	40,118		32,474		4,233		47,871
Satisfactory	134,738		751,215		136,079		189,391
Monitor	53,147		96,353		5,473		60,965
Special Mention	3,033		11,167		1,469		27,559
Substandard	8,064		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
Good	79,467		221		14,465		311,157
Satisfactory	206,196		31,385		20,274		1,728,780
Monitor	81,381		437		7,323		420,993
Special Mention	4,802		212		390		66,810
Substandard	3,318		53		—		43,343
Total	$	402,181	$	32,308	$	49,896	$	2,639,104

Page 21

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The below are descriptions of the credit quality indicators:

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

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

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

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

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

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Past due loans as of March 31, 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		Current		Total Loans Receivable		Accruing Loans Past Due 90 Days or More
	(Amounts In Thousands)
March 31, 2020
Agricultural	$	1,655	$	463	$	316	$	2,434	$	94,377	$	96,811	$	20
Commercial and financial	2,296		459		256		3,011		225,063		228,074		176
Real estate:
Construction, 1 to 4 family residential	3,555		190		—		3,745		79,700		83,445		—
Construction, land development and commercial	1,464		240		—		1,704		101,116		102,820		—
Mortgage, farmland	3,992		112		953		5,057		241,146		246,203		161
Mortgage, 1 to 4 family first liens	9,148		250		4,479		13,877		892,074		905,951		528
Mortgage, 1 to 4 family junior liens	855		101		149		1,105		147,339		148,444		—
Mortgage, multi-family	—		95		—		95		357,099		357,194		—
Mortgage, commercial	1,162		855		—		2,017		408,183		410,200		—
Loans to individuals	226		90		16		332		31,417		31,749		—
Obligations of state and political subdivisions	—		—		—		—		52,917		52,917		—
	$	24,353	$	2,855	$	6,169	$	33,377	$	2,630,431	$	2,663,808	$	885

December 31, 2019
Agricultural	$	163	$	275	$	122	$	560	$	90,757	$	91,317	$	48
Commercial and financial	1,076		229		101		1,406		219,917		221,323		65
Real estate:
Construction, 1 to 4 family residential	635		—		—		635		79,574		80,209		—
Construction, land development and commercial	215		101		—		316		108,094		108,410		—
Mortgage, farmland	736		—		610		1,346		241,384		242,730		—
Mortgage, 1 to 4 family first liens	5,026		3,100		4,149		12,275		898,467		910,742		354
Mortgage, 1 to 4 family junior liens	813		126		233		1,172		148,055		149,227		139
Mortgage, multi-family	—		97		—		97		350,664		350,761		—
Mortgage, commercial	321		489		—		810		401,371		402,181		—
Loans to individuals	226		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

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

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



	March 31, 2020						December 31, 2019
	Non-accrual loans (1)		Accruing loans past due 90 days or more		TDR loans		Non- accrual loans (1)		Accruing loans past due 90 days or more		TDR loans
	(Amounts In Thousands)						(Amounts In Thousands)
Agricultural	$	1,356	$	20	$	425	$	1,192	$	48	$	404
Commercial and financial	1,295		176		1,859		679		65		1,934
Real estate:
Construction, 1 to 4 family residential	—		—		—		—		—		—
Construction, land development and commercial	—		—		319		—		—		320
Mortgage, farmland	1,288		161		2,681		1,369		—		2,712
Mortgage, 1 to 4 family first liens	6,489		528		1,615		6,558		354		1,626
Mortgage, 1 to 4 family junior liens	240		—		—		94		139		—
Mortgage, multi-family	95		—		1,709		97		—		1,719
Mortgage, commercial	1,286		—		579		779		—		593
	$	12,049	$	885	$	9,187	$	10,768	$	606	$	9,308


(1)	There were $4.99 million and $4.34 million of TDR loans included within nonaccrual loans as of March 31, 2020 and December 31, 2019, respectively.

Loans 90 days or more past due that are still accruing interest increased $0.28 million from December 31, 2019 to March 31, 2020 due to an increase in the number of accruing loans past due 90 days or more. As of March 31, 2020 there were 15 accruing loans past due 90 days or more. The average accruing loans past due as of March 31, 2020 are $0.06 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 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 24

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Below is a summary of information for TDR loans as of March 31, 2020 and December 31, 2019:



	March 31, 2020					December 31, 2019
	Number of contracts	Recorded investment		Commitments outstanding		Number of contracts	Recorded investment		Commitments outstanding
		(Amounts In Thousands)					(Amounts In Thousands)
Agricultural	11	$	1,559	$	—	9	$	1,552	$	3
Commercial and financial	17	2,685		85		16	2,641		95
Real estate:
Construction, 1 to 4 family residential	—	—		—		—	—		—
Construction, land development and commercial	2	319		—		2	320		—
Mortgage, farmland	8	3,969		—		8	4,021		—
Mortgage, 1 to 4 family first liens	16	2,067		—		16	2,083		—
Mortgage, 1 to 4 family junior liens	—	—		—		—	—		—
Mortgage, multi-family	2	1,709		—		2	1,719		—
Mortgage, commercial	8	1,865		—		7	1,373		—
Loans to individuals	—	—		—		—	—		—
	64	$	14,173	$	85	60	$	13,709	$	98

The following is a summary of TDR loans that were modified during the three months ended March 31, 2020:



	Three Months Ended March 31, 2020
	Number of contracts	Pre-modification recorded investment		Post-modification recorded investment

Agricultural	2	$	93	$	93
Commercial and financial	1	199		199
Real estate:
Construction, 1 to 4 family residential	—	—		—
Construction, land development and commercial	—	—		—
Mortgage, farmland	—	—		—
Mortgage, 1 to 4 family first lien	—	—		—
Mortgage, 1 to 4 family junior liens	—	—		—
Mortgage, multi-family	—	—		—
Mortgage, commercial	1	513		513
	4	$	805	$	805

Page 25

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The Company had commitments to lend $0.09 million in additional borrowings to restructured loan customers as of March 31, 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 March 31, 2020 and one totaling $0.065 million modified during the year ended December 31, 2019.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Information regarding impaired loans as of and for the three months ended March 31, 2020 is as follows:



	March 31, 2020						Three Months Ended March 31, 2020
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	1,584	$	2,251	$	—	$	1,688	$	6
Commercial and financial	1,303		2,177		—		1,371		12
Real estate:
Construction, 1 to 4 family residential	99		144		—		100		—
Construction, land development and commercial	319		334		—		320		4
Mortgage, farmland	3,969		4,496		—		3,995		39
Mortgage, 1 to 4 family first liens	6,838		8,630		—		6,896		18
Mortgage, 1 to 4 family junior liens	95		339		—		94		—
Mortgage, multi-family	1,804		1,921		—		1,810		20
Mortgage, commercial	1,865		2,415		—		1,876		7
Loans to individuals	—		14		—		—		—
	$	17,876	$	22,721	$	—	$	18,150	$	106

With an allowance recorded:
Agricultural	$	300	$	300	$	217	$	300	$	1
Commercial and financial	2,550		2,718		1,534		2,421		23
Real estate:
Construction, 1 to 4 family residential	—		—		—		—		—
Construction, land development and commercial	—		—		—		—		—
Mortgage, farmland	161		161		3		161		3
Mortgage, 1 to 4 family first liens	1,695		1,962		126		1,730		9
Mortgage, 1 to 4 family junior liens	145		146		50		147		—
Mortgage, multi-family	—		—		—		—		—
Mortgage, commercial	—		—		—		—		—
Loans to individuals	2		2		2		2		—
	$	4,853	$	5,289	$	1,932	$	4,761	$	36

Total:
Agricultural	$	1,884	$	2,551	$	217	$	1,988	$	7
Commercial and financial	3,853		4,895		1,534		3,792		35
Real estate:
Construction, 1 to 4 family residential	99		144		—		100		—
Construction, land development and commercial	319		334		—		320		4
Mortgage, farmland	4,130		4,657		3		4,156		42
Mortgage, 1 to 4 family first liens	8,533		10,592		126		8,626		27
Mortgage, 1 to 4 family junior liens	240		485		50		241		—
Mortgage, multi-family	1,804		1,921		—		1,810		20
Mortgage, commercial	1,865		2,415		—		1,876		7
Loans to individuals	2		16		2		2		—
	$	22,729	$	28,010	$	1,932	$	22,911	$	142

Page 27

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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 financial	1,340		2,220		—
Real estate:
Construction, 1 to 4 family residential	101		144		—
Construction, land development and commercial	320		336		—
Mortgage, farmland	4,081		4,613		—
Mortgage, 1 to 4 family first liens	7,157		9,015		—
Mortgage, 1 to 4 family junior liens	—		246		—
Mortgage, multi-family	1,816		1,930		—
Mortgage, commercial	1,302		1,852		—
Loans to individuals	—		14		—
	$	17,713	$	22,527	$	—

With an allowance recorded:
Agricultural	$	134	$	134	$	87
Commercial and financial	1,402		1,539		792
Real estate:
Construction, 1 to 4 family residential	—		—		—
Construction, land development and commercial	—		—		—
Mortgage, farmland	—		—		—
Mortgage, 1 to 4 family first liens	1,280		1,501		64
Mortgage, 1 to 4 family junior liens	233		233		47
Mortgage, multi-family	—		—		—
Mortgage, commercial	70		70		1
Loans to individuals	93		93		93
	$	3,212	$	3,570	$	1,084

Total:
Agricultural	$	1,730	$	2,291	$	87
Commercial and financial	2,742		3,759		792
Real estate:
Construction, 1 to 4 family residential	101		144		—
Construction, land development and commercial	320		336		—
Mortgage, farmland	4,081		4,613		—
Mortgage, 1 to 4 family first liens	8,437		10,516		64
Mortgage, 1 to 4 family junior liens	233		479		47
Mortgage, multi-family	1,816		1,930		—
Mortgage, commercial	1,372		1,922		1
Loans to individuals	93		107		93
	$	20,925	$	26,097	$	1,084

Page 28

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Impaired loans increased $1.80 million from December 31, 2019 to March 31, 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 0.85% of loans held for investment as of March 31, 2020 and 0.79% as of December 31, 2019. The increase in impaired loans is due to an increase of $0.43 million in loans with a specific reserve, an increase in nonaccrual loans of $1.28 million and an increase in 90 days or more accruing loans of $0.28 million and is offset by a decrease in TDR loans of $0.12 million from December 31, 2019 to March 31, 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 16 years, some of which include options to extend the leases for up to 10 years, and some of which include options to terminate the leases within 1 year. As the options are reasonably certain to be exercised, they are recognized as part of the right-of-use assets and lease liabilities.

For the three months ended March 31, 2020 and 2019, total operating lease expense was $0.14 million and $0.17 million, respectively, and is included in occupancy expenses in the consolidated statements of income. Included in this for the three months ended March 31, 2020 and 2019 were $0.11 million and $0.14 million, respectively, of operating lease costs, $0.01 million and $0.01 million, respectively, of short term lease costs, and $0.02 million and $0.02 million, respectively, of variable lease costs.

For the three months ended March 31, 2020 and 2019, cash paid for amounts included in the measurement of operating lease liabilities was $0.12 million and $0.14 million, respectively, and right-of-use assets obtained in exchange for lease obligations was $0.00 million and $3.58 million, respectively.

Page 29

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

As of March 31, 2020 and December 31, 2019, operating lease right-of-use assets included in other assets was $3.11 million and $3.20 million, respectively. Operating lease liabilities were $3.14 million and $3.23 million as of March 31, 2020 and December 31, 2019. As of March 31, 2020 and December 31, 2019, the weighted average remaining lease term for operating leases was 10.98 years and 10.86 years years, respectively, and the weighted average discount rate for operating leases was 3.46% and 3.46%, respectively. Discount rates used were determined from FHLB borrowing rates for comparable terms.

As of March 31, 2020, maturities of lease liabilities were as follows:



Year ending December 31:	(Amounts In Thousands)
2020	$	352
2021	456
2022	448
2023	301
2024	250
Thereafter	2,009
Total lease payments	3,816
Less imputed interest	(679		)
Total operating lease liabilities	$	3,137

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 7.	Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments as of March 31, 2020 are as follows:



	March 31, 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	$	268,293	$	268,293	$	268,293	$	—	$	—
Investment securities	383,213		383,213		148,740		234,473		—
Loans held for sale	11,592		11,592		—		11,592		—
Loans
Agricultural	94,051		94,325		—		—		94,325
Commercial and financial	221,394		222,339		—		—		222,339
Real estate:
Construction, 1 to 4 family residential	82,255		82,626		—		—		82,626
Construction, land development and commercial	101,389		100,695		—		—		100,695
Mortgage, farmland	242,107		240,554		—		—		240,554
Mortgage, 1 to 4 family first liens	896,775		887,278		—		—		887,278
Mortgage, 1 to 4 family junior liens	146,799		142,083		—		—		142,083
Mortgage, multi-family	352,986		353,963		—		—		353,963
Mortgage, commercial	405,345		402,564		—		—		402,564
Loans to individuals	30,984		32,244		—		—		32,244
Obligations of state and political subdivisions	52,314		52,850		—		—		52,850
Accrued interest receivable	13,691		13,691		—		13,691		—
Total financial instrument assets	$	3,303,188	$	3,288,310	$	417,033	$	259,756	$	2,611,521
Financial instrument liabilities
Deposits
Noninterest-bearing deposits	$	381,171	$	381,171	$	—	$	381,171	$	—
Interest-bearing deposits	2,350,543		2,370,184		—		2,370,184		—
Federal Home Loan Bank borrowings	185,000		186,018		—		186,018		—
Interest rate swaps	3,447		3,447		—		3,447		—
Accrued interest payable	2,352		2,352		—		2,352		—
Total financial instrument liabilities	$	2,922,513	$	2,943,172	$	—	$	2,943,172	$	—

	Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	479,581	$	—	$	—	$	—	$	—
Letters of credit	8,447		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	488,028	$	—	$	—	$	—	$	—


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


(2)	Considered Level 2 under ASC 820.


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

Page 31

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The carrying value and estimated fair values of the Company's financial instruments as of December 31, 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 securities	366,368		366,368		128,585		237,783		—
Loans held for sale	8,400		8,400		—		8,400		—
Loans
Agricultural	88,917		90,118		—		—		90,118
Commercial and financial	216,335		217,640		—		—		217,640
Real estate:
Construction, 1 to 4 family residential	79,096		79,954		—		—		79,954
Construction, land development and commercial	106,924		107,276		—		—		107,276
Mortgage, farmland	238,780		239,521		—		—		239,521
Mortgage, 1 to 4 family first liens	902,630		896,676		—		—		896,676
Mortgage, 1 to 4 family junior liens	147,634		143,261		—		—		143,261
Mortgage, multi-family	346,938		349,663		—		—		349,663
Mortgage, commercial	398,145		395,838		—		—		395,838
Loans to individuals	31,455		32,722		—		—		32,722
Obligations of state and political subdivisions	49,423		50,564		—		—		50,564
Accrued interest receivable	12,442		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 deposits	2,273,752		2,292,332		—		2,292,332		—
Federal Home Loan Bank borrowings	185,000		186,091		—		186,091		—
Interest rate swaps	2,349		2,349				2,349
Accrued interest payable	2,474		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 credit	8,569		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	432,734	$	—	$	—	$	—	$	—


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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

Page 32

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

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



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



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



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

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

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

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 three months ended March 31, 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.

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

Page 33

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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:



	March 31, 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	$	148,740	$	—		$	—	$	148,740
State and political subdivisions	—		210,273			—		210,273
Other securities (FHLB, FHLMC and FNMA)	—		12,826			—		12,826
Derivative Financial Instruments
Interest rate swaps	$	—	(3,447		)	$	—	(3,447		)
Total	$	148,740	$	219,652		$	—	$	368,392



	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 three months ended March 31, 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.



	March 31, 2020								Three Months Ended March 31, 2020
	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	$	—	$	—	$	1,371	$	1,371	$	—
Commercial and financial	—		—		2,099		2,099		—
Real Estate:									—
Construction, 1 to 4 family residential	—		—		—		—		—
Construction, land development and commercial	—		—		215		215		—
Mortgage, farmland	—		—		3,464		3,464		—
Mortgage, 1 to 4 family first liens	—		—		7,850		7,850		93
Mortgage, 1 to 4 family junior liens	—		—		189		189		—
Mortgage, multi-family	—		—		1,804		1,804		—
Mortgage, commercial	—		—		1,732		1,732		—
Loans to individuals	—		—		—		—		—
Foreclosed assets (5)	—		—		—		—		—
Total	$	—	$	—	$	18,724	$	18,724	$	93


(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, 2019								Year 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, 2020. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors. The Company has purchased 1,284,884 shares of its common stock in privately negotiated transactions from August 1, 2005 through March 31, 2020. Of these 1,284,884 shares, 68,881 shares were purchased during the quarter ended March 31, 2020, at an average price per share of $65.88.

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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 $102.08 million. The concentrations of credit by type of loan are set forth in Note 5 to the Consolidated Financial Statements. Outstanding letters of credit were granted primarily to commercial borrowers. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the economic conditions in Johnson, Linn and Washington Counties, Iowa.

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

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

The outbreak of Coronavirus Disease 2019 (“COVID-19”) could 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 will likely cause 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.

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

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments at March 31, 2020 and December 31, 2019 is as follows:



	March 31, 2020		December 31, 2019
	(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	69,940	$	65,203
Credit cards	59,848		57,421
Commercial, real estate and home construction	114,387		94,490
Commercial lines and real estate purchase loans	235,406		207,051
Outstanding letters of credit	8,447		8,569

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 10.	Income Taxes

Federal income tax expense for the three months ended March 31, 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 March 31, 2020 and December 31, 2019 and therefore no interest or penalties on unrecognized tax benefits has been recorded. As of March 31, 2020, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending March 31, 2021. Income taxes as a percentage of income before taxes were 20.34% for the three months ended March 31, 2020 and 21.22% 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 $3.45 million of collateral as of March 31, 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, the Bank asserted that the underlying principal balance would remain outstanding throughout the hedge transaction making it probable that sufficient LIBOR-based interest payments would exist through the maturity date of the swaps.

The table below identifies the balance sheet category and fair values of the Bank’s derivative instruments designated as cash flow hedges as of March 31, 2020 and December 31, 2019:



	Notional Amount		Fair Value			Balance Sheet Category	Maturity
	(Amounts in Thousands)
March 31, 2020
Interest rate swap	$	25,000	$	(357	)	Other Liabilities	11/9/2020
Interest rate swap	25,000		(3,090		)	Other Liabilities	11/7/2023

December 31, 2019
Interest rate swap	$	25,000	$	(279	)	Other Liabilities	11/9/2020
Interest rate swap	25,000		(2,070		)	Other Liabilities	11/7/2023

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The table below identifies the gains and losses recognized on the Bank’s derivative instruments designated as cash flow hedges for the three months ended March 31, 2020 and year ended December 31, 2019:




	Recognized in OCI			Reclassified from AOCI into Income			Recognized in Income on Derivatives
	Amount of Gain (Loss)			Category	Amount of Gain (Loss)		Category	Amount of Gain (Loss)
	(Amounts in Thousands)
March 31, 2020
Interest rate swap	$	(58	)	Interest Expense	$	—	Other Income	$	—
Interest rate swap	(766		)	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,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.

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


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


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


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

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


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


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


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


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


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


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


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


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


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


•	The economic impact of natural disasters, 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.


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

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

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Critical Accounting Policies

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

economic conditions throughout the Midwest and the state of certain industries. Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position. Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations. Although management believes the levels of the allowance as of March 31, 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 March 31, 2020.

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

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. Appointments can be made at branches to complete all needed

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paperwork and transactions. Drive-thru services remain open 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. Given the nature of the programs, the results will mostly be recorded in the second quarter. The Bank sells most of its home loans into the secondary market.

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 April 30, 2020. The Bank expects to continue receiving requests for forbearance agreements and the significance of these agreements entered into will be more clear in the second quarter.

The Bank remains ready to assist our customers through this difficult time in the best manner possible, including helping a significant number of customers get Paycheck Protection Program loan applications processed and approved.

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, management does not believe that the Company’s first quarter performance was significantly impacted with the exception of the provision for loan losses. 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 the latter portion of the first quarter of 2020 and into April. 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 second quarter performance. 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 provision for loan losses in the current quarter by approximately $4.6 million. 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 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.

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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 March 31, 2020, the Bank has nineteen full-service locations.

Net income for the three month period ended March 31, 2020 was $7.08 million compared to $11.20 million for the same three months of 2019, a decrease of 36.85%. The $4.13 million decrease in net income was caused by a number of factors. The principal factors in the decrease in net income for the first three months of 2020 are an increase in the provision for loan losses of $5.90 million, primarily due to the uncertainty created by the COVID-19 pandemic, and an increase in noninterest expenses of $1.18 million. This change was offset by an increase in net interest income of $0.82 million, an increase in noninterest income of $0.92 million and a decrease in income tax expense of $1.21 million.

The Company achieved a return on average assets of 1.26% and a return on average equity of 11.49% for the twelve months ended March 31, 2020, compared to the twelve months ended March 31, 2019, which were 1.23% and 11.36%, 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 3.16% for the three months ended March 31, 2020 compared to 3.27% for the same three months of 2019. Average earning assets were $3.186 billion year to date in 2020 and $3.013 billion in 2019.

Highlights noted on the balance sheet as of March 31, 2020 for the Company included the following:


•	Total assets were $3.366 billion, an increase of $65.35 million since December 31, 2019.


•	Cash and cash equivalents were $268.29 million, an increase of $26.33 million since December 31, 2019. Cash and cash equivalents growth included approximately $83.56 million of temporary public funds.


•	Net loans were $2.638 billion, an increase of $23.31 million since December 31, 2019. Loans held for sale increased $3.19 million since December 31, 2019.


•	Deposits increased $70.35 million since December 31, 2019. Deposit growth included approximately $83.56 million in temporary public funds.

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 1 to 4 family residential construction, multi-family and commercial real estate loans.

However, 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 March 31, 2020 and December 31, 2019:



	March 31, 2020				December 31, 2019
	Amount		Percent		Amount		Percent
	(Amounts In Thousands)				(Amounts In Thousands)
Agricultural	$	96,811	3.64	%	$	91,317	3.46	%
Commercial and financial	228,074		8.56		221,323		8.39
Real estate:
Construction, 1 to 4 family residential	83,445		3.13		80,209		3.04
Construction, land development and commercial	102,820		3.86		108,410		4.11
Mortgage, farmland	246,203		9.24		242,730		9.20
Mortgage, 1 to 4 family first liens	905,951		34.01		910,742		34.51
Mortgage, 1 to 4 family junior liens	148,444		5.57		149,227		5.65
Mortgage, multi-family	357,194		13.41		350,761		13.29
Mortgage, commercial	410,200		15.40		402,181		15.24
Loans to individuals	31,749		1.19		32,308		1.22
Obligations of state and political subdivisions	52,917		1.99		49,896		1.89
	$	2,663,808	100.00	%	$	2,639,104	100.00	%
Net unamortized fees and costs	931				933
	$	2,664,739			$	2,640,037
Less allowance for loan losses	38,340				33,760
	$	2,626,399			$	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 March 31, 2020 and December 31, 2019:



	March 31, 2020						December 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	$	2,760	7.20	%	3.64	%	$	2,400	7.11	%	3.46	%
Commercial and financial	6,680		17.42		8.56		4,988		14.77		8.39
Real estate:
Construction, 1 to 4 family residential	1,190		3.10		3.13		1,113		3.30		3.04
Construction, land development and commercial	1,431		3.73		3.86		1,486		4.40		4.11
Mortgage, farmland	4,096		10.68		9.24		3,950		11.70		9.20
Mortgage, 1 to 4 family first liens	10,107		26.37		34.01		9,045		26.79		34.51
Mortgage, 1 to 4 family junior liens	1,645		4.29		5.57		1,593		4.72		5.65
Mortgage, multi-family	4,208		10.98		13.41		3,823		11.32		13.29
Mortgage, commercial	4,855		12.66		15.40		4,036		11.95		15.24
Loans to individuals	765		2.00		1.19		853		2.53		1.22
Obligations of state and political subdivisions	603		1.57		1.99		473		1.41		1.89
	$	38,340	100.00	%	100.00	%	$	33,760	100.00	%	100.00	%

The allowance for loan losses totaled $38.34 million at March 31, 2020 compared to $33.76 million at December 31, 2019. The percentage of the allowance to outstanding loans was 1.44% and 1.28% at March 31, 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 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 first liens, 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 March 31, 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 $16.54 million from December 31, 2019 to March 31, 2020. The fair value of securities available for sale was $4.79 million more than the amortized cost of such securities as of March 31, 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 $70.35 million in the first three months of 2020 primarily due to temporary public funds of approximately $83.56 million. 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 $85.02 million as of March 31, 2020 with an average rate of 0.50%. Brokered deposits were $109.29 million as of December 31, 2019 with an average interest rate of 1.65%. As of March 31, 2020 and December 31, 2019, brokered deposits were 3.11% and 4.11% of total deposits, respectively.

Federal Home Loan Bank (FHLB) borrowings were $185 million as of March 31, 2020 and December 31, 2019. It is expected that the FHLB funding source will be considered in the future if loan growth continues to exceed core deposit increases and the interest rates on funds borrowed from the FHLB are favorable compared to other funding alternatives.

Dividends and Equity

In January 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 March 31, 2020 totaled $376.81 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 March 31, 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 March 31, 2020 and December 31, 2019 are presented below (amounts in thousands):

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	Actual		For Capital Adequacy Purposes	To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount	Ratio	Ratio	Ratio
As of March 31, 2020:
Company:
Community Bank Leverage ratio	423,554	12.86	8.000	11.000
Bank:
Community Bank Leverage ratio	423,623	12.87	8.000	11.000



	Actual				For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Ratio		Ratio
As of December 31, 2019
Company:
Total risk-based capital	$	454,452	18.15	%	8.00	%	10.00	%
Tier 1 risk-based capital	423,122		16.90		6.00		8.00
Tier 1 common equity	423,122		16.90		4.50		6.50
Leverage ratio	423,122		12.77		4.00		5.00
Bank:
Total risk-based capital	455,440		18.20		8.00		10.00
Tier 1 risk-based capital	424,127		16.95		6.00		8.00
Tier 1 common equity	424,127		16.95		4.50		6.50
Leverage ratio	424,127		12.81		4.00		5.00

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Discussion of operations for the three months ended March 31, 2020 and 2019

Net Income Overview

Net income decreased $4.13 million for the three months ended March 31, 2020 compared to the first three months of 2019. Total net income was $7.08 million in 2020 and $11.20 million in the comparable period in 2019, a decrease of 36.85%. The changes in net income in 2020 from the first three months of 2019 were primarily the result of the following:


•	Net interest income increased by $0.82 million, before provision expense.


•	The provision for loan losses increased by $5.90 million.


•	Noninterest income increased by $0.92 million.


•	Noninterest expenses increased by $1.18 million.


•	Income tax expense decreased by $1.21 million.

For the three month period ended March 31, 2020 and March 31, 2019 basic earnings per share was $0.75 and $1.20, respectively. Diluted earnings per share was $0.75 for the three months ended March 31, 2020 compared to $1.20 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 $2.638 billion at March 31, 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 $4.65 million in 2020 compared to a reduction of expense of $1.25 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 projected increases in the size of the Company’s loan portfolio 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 $24.59 million for the first three months of 2020 was derived from the Company’s $3.186 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.16%. Average earning assets in the three months ended March 31, 2019 were $3.013 billion and the tax-equivalent net interest margin was 3.27%. The importance of net interest margin is illustrated by the fact that an increase or decrease in the net interest margin of 10 basis points would have resulted approximately in a $0.80 million change in income before income taxes in the three month period ended March 31, 2020. Net interest income for the Company increased primarily as a result of growth in the volume of earning assets. The Company expects net interest compression to impact earnings for the foreseeable future with increased costs of funding in the short-term due to competition for deposits combined with the interest rate decreases by the Federal Reserve Board. The Company believes growth in net interest income will be contingent on the growth of the Company’s earnings assets.

The third important factor affecting the Company’s net income is income tax expense. Federal and state income tax expenses were $1.81 million and $3.02 million for the three months ended March 31, 2020 and 2019, respectively. Income taxes as a percentage of income before taxes were 20.34% in 2020 and 21.22% in 2019.

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Discussion of operations for the three months ended March 31, 2020 and 2019

Net Interest Income

Net interest income increased for the three months ended March 31, 2020 compared to the comparable period in 2019. The increase was as a result of growth in the average volume of earning assets. Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the average volume of earning assets for the period and the net interest margin. The net interest margin for the first three months of 2020 was 3.16% compared to 3.27% in 2019 for the same period. Interest expense decreased $0.21 million for the three months ended March 31, 2020 compared to the three months ended March 31, 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 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 Changes			Rate Changes			Net Change
	(Amounts in Thousands)
Interest income:
Loans, net	$	18,909		(0.03	)%	$	687		$	(363	)	$	324
Taxable securities	27,780			(0.07	)	197			(71		)	126
Nontaxable securities	6,044			(0.05	)	41			(25		)	16
Federal funds sold	120,201			(1.14	)	736			(589		)	147
	$	172,934				$	1,661		$	(1,048	)	$	613

Interest expense:
Interest-bearing demand deposits	$	106,569		(0.08	)%	$	(238	)	$	145		$	(93	)
Savings deposits	(23,206		)	(0.37	)	180			640			820
Time deposits	70,221			0.19		(393		)	(327		)	(720		)
FHLB borrowings	(30,000		)	—		205			—			205
Interest-bearing other liabilities	(4		)	(1.21	)	—			—			—
	$	123,580				$	(246	)	$	458		$	212
Change in net interest income						$	1,415		$	(590	)	$	825

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)	2020		2019
Yield on average interest-earning assets	4.15	%	4.35	%
Rate on average interest-bearing liabilities	1.27		1.39
Net interest spread	2.88	%	2.96	%
Effect of noninterest-bearing funds	0.28		0.31
Net interest margin (tax equivalent interest income divided by average interest-earning assets)	3.16	%	3.27	%

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Discussion of operations for the three months ended March 31, 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 three times during the first three months of 2020. The target rate decreased to 0.25% as of March 31, 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 March 31, 2020, the rate indexes for the one, three and five year indexes were 0.17%, 0.29% and 0.37%, respectively. The one year index decreased 92.92% from 2.40% at March 31, 2019, the three year index decreased 86.88% and the five year index decreased 83.41%. The three year index was 2.21% and the five year index was 2.23% at March 31, 2019. The targeted federal funds rate was 0.25% and 2.50% at March 31, 2020 and 2019, respectively. The Company anticipates short term and long term rates in the indexes to remain consistent for 2020.

Provision for Loan Losses

The provision for loan losses was an expense of $4.65 million for the three months ended March 31, 2020 compared to a reduction of expense of $1.25 million in 2019, an increase of expense of $5.90 million, which resulted in an overall increase to the allowance of $4.58 million since year end. 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 increases in qualitative factors due to the COVID-19 pandemic's economic impact as compared to March 31, 2019.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the three months ended March 31, 2020 and 2019, recoveries were $0.37 million and $0.43 million, respectively; and charge-offs were $0.44 million in 2020 and $0.48 million in 2019. The allowance for loan losses totaled $38.34 million at March 31, 2020 compared to $33.76 million at December 31, 2019. The allowance represented 1.44% and 1.28% of loans held for investment at March 31, 2020 and December 31, 2019.

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended March 31, 2020 and 2019.



	Three Months Ended March 31,
	2020		2019		$ Change			% Change
	(Amounts in thousands)
Net gain on sale of loans	$	658	$	286	$	372		130.07	%
Trust fees	2,570		2,252		318			14.12
Service charges and fees	2,529		2,275		254			11.16
Other noninterest income	400		437		(37		)	(8.47	)
Gain on sale of investment securities	10		—		10			—
	$	6,167	$	5,250	$	917		17.47

Loans originated for sale in the first three months of 2020 totaled $55.61 million compared to $29.85 million in the same period in 2019, an increase of 86.30%. In the three months ended March 31, 2020 and 2019, the net gain on sale of loans was $0.66 million and $0.29 million, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can

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Discussion of operations for the three months ended March 31, 2020 and 2019

vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income.

Other noninterest income categories experienced marginal period-to-period fluctuations for the three months ended March 31, 2020.

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended March 31, 2020 and 2019.



	Three Months Ended March 31,
	2020		2019		$ Change			% Change
	(Amounts in thousands)
Salaries and employee benefits	$	9,584	$	8,722	$	862		9.88	%
Occupancy	1,152		1,186		(34		)	(2.87	)
Furniture and equipment	1,781		1,673		108			6.46
Office supplies and postage	503		459		44			9.59
Advertising and business development	759		638		121			18.97
Outside services	2,685		2,572		113			4.39
FDIC insurance assessment	180		209		(29		)	(13.88	)
Other noninterest expense	583		590		(7		)	(1.19	)
	$	17,227	$	16,049	$	1,178		7.34

In the three months ended March 31, 2020 and 2019, salaries and employee benefits expense increased $0.86 million. The increase is primarily the result of annual salary adjustments and hiring of additional employees to staff growth.

Other noninterest expense categories experienced marginal period-to-period fluctuations for the three months ended March 31, 2020.

Income Taxes

Federal and state income tax expenses were $1.81 million and $3.02 million for the three months ended March 31, 2020 and 2019, respectively. The decrease in income taxes compared to 2019 is a result of lower net income primarily attributable to the increase in the provision for loan losses for the three months ended March 31, 2020. Income taxes as a percentage of income before taxes were 20.34% in 2020 and 21.22% in 2019.

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Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs. Federal funds sold and investment securities available for sale are readily marketable assets. Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position. Investment securities available for sale comprised 11.05% of the Company’s total assets at March 31, 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 March 31, 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 $714.39 million at March 31, 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 $483.62 million. The borrowings under these credit lines would be secured by the Bank’s investment securities. The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at March 31, 2020.

As of March 31, 2020, investment securities with a carrying value of $13.51 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 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.



Item 4.	Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission. There have been no changes in the Company’s internal controls over financial reporting during the three months ended March 31, 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.



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.

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.

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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 have 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 22 million people have filed claims for unemployment, and stock markets have declined in value 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 is 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


•	Federal Deposit Insurance Corporation premiums may increase if the agency experiences additional resolution costs.

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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.

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

The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended March 31, 2020:



Period	Total number of shares purchased	Average price paid per share		Total number of shares purchased as part of publicly announced plans or programs	Maximum number of shares that may yet be purchased under the plans or programs (1)
January 1 to January 31	3,047	$	65.00	3,047	280,950
February 1 to February 29	6,077	65.12		6,077	274,873
March 1 to March 31	59,757	66.00		59,757	215,116
Total	68,881	$	65.88	68,881	215,116

(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.



Item 3.	Defaults upon Senior Securities

Hills Bancorporation has no senior securities.



Item 4.	Mine Safety Disclosure

Not applicable.



Item 5.	Other Information

None.

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Item 6.	Exhibits



3.1	Restated Articles of Incorporation, incorporated by reference to Exhibit 3.1 to the Company's Form 10-Q Filed with the Commission on May 6, 2015.
3.2	Amended and Restated Bylaws of Hills Bancorporation, incorporated by reference to Exhibit 3.2 to the Company's Form 10-Q Filed with the Commission on May 6, 2019.
4.1	Description of Registered Securities, incorporated by reference to Exhibit 4.1 to the Company's Form 10-K filed with the Commission on March 6, 2020.
10.1	2020 Stock Option and Incentive Plan.
31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
101.INS	XBRL Instance Document (1), (2)
101.SCH	XBRL Taxonomy Extension Schema Document (1)
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document (1)
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document (1)
101.LAB	XBRL Taxonomy Extension Label Linkbase Document (1)
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document (1)


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


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

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SIGNATURES

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



		HILLS BANCORPORATION

Date:	May 4 2020	By: /s/ Dwight O. Seegmiller
		Dwight O. Seegmiller, Director, President and Chief Executive Officer

Date:	May 4 2020	By: /s/ Shari DeMaris
		Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer

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HILLS BANCORPORATION

QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED MARCH 31, 2020



Exhibit Number	Description	Page Number In The Sequential Numbering System March 31, 2020 Form 10-Q

10.1	2020 Stock Option and Incentive Plan.	62-78

31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	79-80

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	81

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