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HILLS BANCORPORATION - Quarter Report: 2022 September (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2022

OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from  ___________ to ___________
Commission file number:  0-12668
Hills Bancorporation

(State or other jurisdiction of incorporation or organization)
I.R.S. Employer Identification No.
Iowa42-1208067

131 MAIN STREET, HILLS, Iowa 52235

Telephone number: (319) 679-2291

Securities registered pursuant to Section 12(b) of the Act:
Title of each classTrading Symbol(s)Name of each exchange on which registered
Indicate by checkmark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   No

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

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

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

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


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APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date.
 SHARES OUTSTANDING
CLASSOctober 31, 2022
  
Common StockNo par value9,261,346



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HILLS BANCORPORATION
Index to Form 10-Q

Part I
FINANCIAL INFORMATION
 
  Page
 Number
   
Item 1.Financial Statements 
   
 
 
 
 
 
 
   
Item 2.
   
Item 3.
   
Item 4.
   
 Part II 
 OTHER INFORMATION 
   
Item 1.
   
Item 1A.
   
Item 2.
   
Item 3.
   
Item 4.
   
Item 5.
   
Item 6.
   
   

Page 3

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HILLS BANCORPORATION CONSOLIDATED BALANCE SHEETS (Amounts In Thousands, Except Share Amounts) 
September 30, 2022December 31, 2021
ASSETS(Unaudited)
Cash and cash equivalents$242,121 $781,918 
Investment securities available for sale at fair value (amortized cost September 30, 2022 $814,817; December 31, 2021 $549,386)
747,553 551,354 
Stock of Federal Home Loan Bank4,862 4,546 
Loans held for sale2,664 5,716 
Loans, net of allowance for credit losses September 30, 2022 $38,980; December 31, 2021 $35,470
2,907,415 2,625,062 
Property and equipment, net33,703 34,290 
Tax credit real estate investment9,292 9,815 
Accrued interest receivable14,520 11,437 
Deferred income taxes, net26,866 9,125 
Goodwill2,500 2,500 
Other assets8,882 8,799 
Total Assets$4,000,378 $4,044,562 
LIABILITIES AND STOCKHOLDERS' EQUITY  
Liabilities  
Noninterest-bearing deposits$696,137 $633,101 
Interest-bearing deposits2,819,624 2,900,893 
Total deposits$3,515,761 $3,533,994 
Other borrowings 249 
Accrued interest payable1,056 1,165 
Allowance for credit losses on off-balance sheet credit exposures4,120 3,850 
Other liabilities19,367 16,841 
Total Liabilities$3,540,304 $3,556,099 
Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)$51,011 $50,013 
STOCKHOLDERS' EQUITY  
Common stock, no par value; authorized 20,000,000 shares; issued September 30, 2022 10,348,675 shares; December 31, 2021 10,329,493 shares
$ $— 
Paid in capital63,115 60,938 
Retained earnings500,806 474,392 
Accumulated other comprehensive (loss) income (50,959)1,477 
Treasury stock at cost (September 30, 2022 1,088,891 shares; December 31, 2021 1,029,853 shares)
(52,888)(48,344)
Total Stockholders' Equity$460,074 $488,463 
Less maximum cash obligation related to ESOP shares51,011 50,013 
Total Stockholders' Equity Less Maximum Cash Obligation Related to ESOP Shares$409,063 $438,450 
Total Liabilities & Stockholders' Equity$4,000,378 $4,044,562 

See Notes to Consolidated Financial Statements.
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HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(Amounts In Thousands, Except Per Share Amounts)
 Three Months Ended September 30,Nine Months Ended
September 30,
 2022202120222021
Interest income:
Loans, including fees$29,474 $29,004 $82,781 $86,956 
Investment securities:  
Taxable2,543 940 6,120 2,629 
Nontaxable1,036 963 3,036 2,880 
Federal funds sold1,366 289 2,502 652 
Total interest income$34,419 $31,196 $94,439 $93,117 
Interest expense:  
Deposits$4,104 $3,414 $10,254 $11,416 
FHLB borrowings 758  2,248 
Total interest expense$4,104 $4,172 $10,254 $13,664 
Net interest income$30,315 $27,024 $84,185 $79,453 
Credit loss (benefit) expense(336)82 3,270 (4,561)
Net interest income after credit loss (benefit) expense $30,651 $26,942 $80,915 $84,014 
Noninterest income:  
Net gain on sale of loans$240 $1,512 $1,377 $6,243 
Trust fees2,859 3,568 9,338 9,645 
Service charges and fees3,282 3,075 9,444 8,729 
Other noninterest income164 89 814 647 
 $6,545 $8,244 $20,973 $25,264 
Noninterest expenses:  
Salaries and employee benefits$10,818 $10,281 $31,990 $31,484 
Occupancy1,024 955 3,265 3,135 
Furniture and equipment1,770 1,652 5,150 5,523 
Office supplies and postage425 428 1,377 1,268 
Advertising and business development586 496 1,874 1,480 
Outside services3,491 3,496 9,407 9,781 
FDIC insurance assessment267 267 815 777 
Other noninterest expense650 623 1,802 1,668 
 $19,031 $18,198 $55,680 $55,116 
Income before income taxes$18,165 $16,988 $46,208 $54,162 
Income taxes4,425 3,863 10,490 12,230 
Net income$13,740 $13,125 $35,718 $41,932 
Earnings per share:  
Basic$1.48 $1.41 $3.85 $4.50 
Diluted$1.48 $1.41 $3.85 $4.50 
 
See Notes to Consolidated Financial Statements.
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HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited) (Amounts In Thousands)

 Three Months Ended September 30,Nine Months Ended
September 30,
 2022202120222021
Net income$13,740 $13,125 $35,718 $41,932 
Other comprehensive loss  
Securities:  
Net change in unrealized loss on securities available for sale$(25,983)$(1,510)$(69,232)$(6,017)
Income taxes6,005 377 16,796 1,502 
Other comprehensive loss on securities available for sale$(19,978)$(1,133)$(52,436)$(4,515)
Other comprehensive loss, net of tax$(19,978)$(1,133)$(52,436)$(4,515)
Comprehensive (loss) income$(6,238)$11,992 $(16,718)$37,417 
 
See Notes to Consolidated Financial Statements.



































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HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Unaudited) (Amounts In Thousands, Except Share Amounts)
Three Months Ended September 30, 2022 and 2021
Paid in CapitalRetained EarningsAccumulated Other Comprehensive Income (Loss)Treasury StockMaximum Cash Obligation Related to ESOP SharesTotal
Balance, June 30, 2021$60,776 $455,114 $5,400 $(47,187)$(48,726)$425,377 
Issuance of 1,204 shares of common stock
48   32  80 
Issuance of 1,725 shares of common stock under the employee stock purchase plan
100     100 
Unearned restricted stock compensation273     273 
Forfeiture of 2,114 shares of common stock
(125)    (125)
Share-based compensation6     6 
Change related to ESOP shares    (105)(105)
Net income 13,125    13,125 
Purchase of 19,556 shares of common stock
   (1,294) (1,294)
Other comprehensive loss  (1,133)  (1,133)
Balance, September 30, 2021$61,078 $468,239 $4,267 $(48,449)$(48,831)$436,304 
Balance, June 30, 2022$62,969 $487,066 $(30,981)$(52,472)$(49,932)$416,650 
Issuance of 4,475 shares of common stock
195   123  318 
Issuance of 1,529 shares of common stock under the employee stock purchase plan
98     98 
Unearned restricted stock compensation239     239 
Forfeiture of 6,089 shares of common stock
(392)    (392)
Share-based compensation6     6 
Change related to ESOP shares    (1,079)(1,079)
Net income 13,740    13,740 
Purchase of 7,541 shares of common stock
   (539) (539)
Other comprehensive loss  (19,978)  (19,978)
Balance, September 30, 2022$63,115 $500,806 $(50,959)$(52,888)$(51,011)$409,063 
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HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited) (Amounts In Thousands, Except Share Amounts)
Nine Months Ended September 30, 2022 and 2021
Paid in CapitalRetained EarningsAccumulated Other Comprehensive Income (Loss)Treasury StockMaximum Cash Obligation Related to ESOP SharesTotal
Balance, December 31, 2020$60,233 $439,831 $8,782 $(45,441)$(47,329)$416,076 
Cumulative change in accounting principle (Note 1) (4,751)   (4,751)
Balance, January 1, 2021 (as adjusted for change in accounting principle)60,233 435,080 8,782 (45,441)(47,329)411,325 
Issuance of 5,957 shares of common stock
225   159  384 
Issuance of 5,564 shares of common stock under the employee stock purchase plan
320     320 
Unearned restricted stock compensation603     603 
Forfeiture of 5,869 shares of common stock
(321)    (321)
Share-based compensation18     18 
Change related to ESOP shares    (1,502)(1,502)
Net income 41,932    41,932 
Cash dividends ($0.94 per share)
 (8,773)   (8,773)
Purchase of 49,136 shares of common stock
   (3,167) (3,167)
Other comprehensive loss  (4,515)  (4,515)
Balance, September 30, 2021$61,078 $468,239 $4,267 $(48,449)$(48,831)$436,304 
Balance, December 31, 2021$60,938 $474,392 $1,477 $(48,344)$(50,013)$438,450 
Issuance of 34,409 shares of common stock
1,897   267  2,164 
Issuance of 4,963 shares of common stock under the employee stock purchase plan
310     310 
Unearned restricted stock compensation594     594 
Forfeiture of 10,501 shares of common stock
(642)    (642)
Share-based compensation18     18 
Change related to ESOP shares    (998)(998)
Net income 35,718    35,718 
Cash dividends ($1.00 per share)
 (9,304)   (9,304)
Purchase of 68,727 shares of common stock
   (4,811) (4,811)
Other comprehensive loss  (52,436)  (52,436)
Balance, September 30, 2022$63,115 $500,806 $(50,959)$(52,888)$(51,011)$409,063 

 See Notes to Consolidated Financial Statements.
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HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Amounts In Thousands)

 Nine Months Ended
September 30,
 20222021
Cash Flows from Operating Activities
Net income$35,718 $41,932 
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:  
Depreciation2,089 2,325 
Credit loss expense (benefit)3,270 (4,561)
Forfeiture of common stock(642)(321)
Share-based compensation18 18 
Compensation expensed through issuance of common stock683 384 
Provision for deferred income taxes(944)738 
Net gain on sale of other real estate owned and other repossessed assets(57)(25)
Increase in accrued interest receivable(3,083)(255)
Amortization of premium on investment securities, net724 872 
Increase in other assets(86)(683)
Amortization of operating lease right-of-use assets105 298 
Increase in accrued interest payable and other liabilities3,011 5,072 
Loans originated for sale(100,362)(356,975)
Proceeds on sales of loans104,791 396,427 
Net gain on sales of loans(1,377)(6,243)
Net cash and cash equivalents provided by operating activities$43,858 $79,003 
Cash Flows from Investing Activities  
Proceeds from maturities of investment securities available for sale$97,891 $76,242 
Purchases of investment securities available for sale(364,047)(176,023)
Purchases of stock of Federal Home Loan Bank(316)(574)
Loans made to customers, net of collections(285,559)56,533 
Proceeds on sale of other real estate owned and other repossessed assets161 70 
Purchases of property and equipment(1,502)(1,187)
Investment in tax credit real estate  (4,183)
Net changes from tax credit real estate investment523 836 
Net cash and cash equivalents used in investing activities$(552,849)$(48,286)
Cash Flows from Financing Activities  
Net (decrease) increase in deposits$(18,233)$275,691 
Net decrease in short-term borrowings(249)— 
Issuance of common stock, net of costs1,243 — 
Stock options exercised238  
Purchase of common stock(4,811)(3,167)
Proceeds from the issuance of common stock through the employee stock purchase plan310 320 
Dividends paid(9,304)(8,773)
Net cash and cash equivalents (used in) provided by financing activities$(30,806)$264,071 
 
(Continued)

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HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)
 Nine Months Ended
September 30,
 20222021
(Decrease) increase in cash and cash equivalents$(539,797)$294,788 
Cash and cash equivalents:  
Beginning of period781,918 574,310 
End of period$242,121 $869,098 
Supplemental Disclosures  
Cash payments for:  
Interest paid to depositors$10,363 $11,894 
Interest paid on other obligations 2,248 
Income taxes paid9,178 6,073 
Noncash activities:  
Increase in maximum cash obligation related to ESOP shares$998 $1,502 
 
See Notes to Consolidated Financial Statements.

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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1.Summary of Significant Accounting Policies

Basis of Presentation:

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

Operating results for the nine month period ended September 30, 2022 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2022.  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, 2021 filed with the Securities Exchange Commission on March 4, 2022.  The consolidated balance sheet as of December 31, 2021, 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.

Accounting Estimates:

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

Certain Significant Estimates:

The allowance for credit losses, fair values of securities and other financial instruments, and share-based compensation expense involve certain significant estimates made by management. These estimates are reviewed by management routinely and it is reasonably possible that circumstances that exist at September 30, 2022 may change in the near-term and the effect could be material to the consolidated financial statements. Actual amounts and values as of the balance sheet dates may be materially different than the amounts and values reported due to the inherent uncertainty in the estimation process.

Revenue Recognition:

Accounting Standards Codification ("ASC") 606, Revenue from Contracts with Customers ("ASC 606"), establishes principles for reporting information about the nature, amount, timing and uncertainty of revenue and cash flows arising from the Company’s contracts to provide goods or services to customers. The core principle requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it expects to be entitled to receive in exchange for those goods or services recognized as performance obligations are satisfied.

The majority of the Company’s revenue-generating transactions are not subject to ASC 606, including revenue generated from financial instruments, such as loans, letters of credit and investment securities. Interest income on loans and investment securities is recognized on the accrual method in accordance with written contracts.

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

A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity's obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. As of September 30, 2022, the Company did not have any significant contract balances.

An entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered. The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission). The Company utilizes the practical expedient which allows entities to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less. The Company has not incurred or capitalized any contract acquisition costs as of September 30, 2022.

Tax Credit Real Estate:

Tax credit real estate represents three multi-family rental properties, three assisted living rental properties, a multi-tenant rental property for persons with disabilities, and a multi-family senior living rental property, all of which are affordable housing projects as of September 30, 2022. The Bank has a 99% or greater limited partnership interest in each limited partnership. The investment in each was completed after the projects had been developed by the general partner. On a regular basis, the Company evaluates recoverability of the carrying value of the tax credit real estate investments to determine if an allowance for credit losses is necessary. The allowance for credit losses is measured by a comparison of the carrying amount of the investments to the future undiscounted cash flows expected to be generated by the investment properties, including the low-income housing tax credits and any estimated proceeds from eventual disposition. If there is an indication of impairment, the allowance for credit losses would be established with a charge to credit loss expense. There were no indications of impairment based on management's evaluation and therefore no allowance for credit losses was determined necessary as of September 30, 2022. Depreciation expense is provided on a straight-line basis over the estimated useful life of the assets. Expenditures for normal repairs and maintenance are charged to expense as incurred.

The investments in tax credit real estate are recorded for all years presented using the equity method of accounting, with the exception of the investment in the affordable housing project described below. The operations of the properties are not expected to contribute significantly to the Company’s income before income taxes. However, the properties do contribute in the form of income tax credits, which lowers the Company’s effective tax rate. Once established, the credits on each property last for ten years and are passed through from the limited partnerships to the Bank and reduces the consolidated federal tax liability of the Company.

In February 2021, the Company provided construction financing and contributed capital of $4.18 million to Del Ray Ridge LP, as limited partner, which owns and operates an affordable housing property in Iowa City, Iowa. The Company accounts for the investment in this tax credit real estate using the proportional amortization method as provided for under Accounting Standards Codification (ASC) 323-740. The investment qualifies for the proportional amortization method as it meets all of the criteria under ASC 323-740-25-1. Substantially all of the projected benefits are from tax credits and other tax benefits due to the minimum buyout clause included in the partnership agreement.

Adoption of Financial Accounting Standard Codification 326 (ASC 326 (CECL)):

On January 1, 2021, the Company adopted ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires the recognition of the allowance for credit losses be estimated using the current expected credit loss (CECL) methodology. The Company adopted ASC 326 using the modified retrospective method for all financial assets measured at amortized cost and off-balance sheet (OBS) credit exposures. Results for reporting periods beginning January 1, 2021 are presented under ASC 326. The Company recorded a net decrease to retained earnings of $4.75 million as of January 1, 2021 for the cumulative effect of adopting ASC 326, which includes deferred taxes of $1.58 million. The transition adjustment includes a $2.75 million increase to the Allowance for Credit Losses On Loans and the recording of a $3.58 million Allowance for Credit Losses on OBS Credit Exposures.
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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

The following table illustrates the impact of ASC 326 (amounts in thousands).

January 1, 2021
As Reported Under ASC 326Pre-ASC 326 AdoptionImpact of ASC 326 Adoption
Assets:
Loans
Allowance for credit losses on loans$39,816 $37,070 $2,746 
Liabilities:
Allowance for credit losses on off-balance sheet credit exposures$3,584 $— $3,584 

Available-for-sale debt securities and the allowance for credit losses on available-for-sale debt securities: Available-for-sale ("AFS") securities consist of debt securities not classified as trading or held to maturity.  Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity.  There were no trading or held to maturity securities as of September 30, 2022 or 2021. Fair value measurement is based upon quoted market prices in active markets, if available. If quoted prices in active markets are not available, fair value is measured using pricing models or other model-based valuation techniques such as present value of future cash flows, which consider prepayment assumptions and other factors such as credit losses and market liquidity. Unrealized gains and losses are excluded from earnings and reported, net of tax, in other comprehensive income ("OCI"). Premiums on debt securities are amortized to the earliest call date and discounts on debt securities are accreted over the period to maturity of those securities. The method of amortization results in a constant effective yield on those securities (the interest method). Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

AFS debt securities in unrealized loss positions are evaluated for impairment related to credit losses at least quarterly. For AFS debt securities, a decline in fair value due to credit loss results in recording an allowance for credit losses to the extent the fair value is less than the amortized cost basis. Declines in fair value that have not been recorded through an allowance for credit losses, such as declines due to changes in market interest rates, are recorded through other comprehensive income, net of applicable taxes.

Impairment may result from credit deterioration of the issuer or collateral underlying the security. In performing an assessment of whether any decline in fair value is due to a credit loss, all relevant information is considered at the individual security level. For asset-backed securities performance indicators considered related to the underlying assets include default rates, delinquency rates, percentage of nonperforming assets, debt-to-collateral ratios, third-party guarantees, current levels of subordination, vintage, geographic concentration, analyst reports and forecasts, credit ratings and other market data. In assessing whether a credit loss exists, we compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis for the security, a credit loss exists and an allowance for credit losses is recorded, limited to the amount the fair value is less than amortized cost basis.

If we intend to sell a debt security or more likely than not we will be required to sell the security before recovery of its amortized cost basis, the debt security is written down to its fair value and the write down is charged against the allowance for credit losses with any incremental impairment reported in earnings.

Accrued interest receivable on AFS debt securities totaled $3.31 million at September 30, 2022 and is excluded from the estimate of credit losses.

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

Loans held for investment: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at amortized cost net of the allowance for credit losses ("ACL"). Amortized cost is the principal balance outstanding, net of deferred loan fees and costs. Accrued interest receivable on loans held for investment totaled $11.21 million at September 30, 2022 and is excluded from the estimate of credit losses. Interest income is accrued on the unpaid principal balance. Nonrefundable loan fees and origination costs are deferred and recognized as a yield adjustment over the life of the related loan.

The accrual of interest income on loans is discontinued when, in the opinion of management, there is reasonable doubt as to the
borrower's ability to meet payments of interest or principal when they become due, which is generally when a loan is 90 days or
more past due unless the loan is well secured and in the process of collection. When a loan is placed on nonaccrual status, all previously accrued and unpaid interest is reversed against interest income. Loans are returned to an accrual status when all of the principal and interest amounts contractually due are brought current and repayment of the remaining contractual principal and interest is expected. A loan may also return to accrual status if additional collateral is received from the borrower and, in the opinion of management, the financial position of the borrower indicates that there is no longer any reasonable doubt as to the collection of the amount contractually due. Payment received on nonaccrual loans are applied first to principal. Once principal is recovered, any remaining payments received are applied to interest income.

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

Allowance for credit losses for loans held for investment: The allowance for credit losses is an estimate of the expected losses over the remaining life of the Company's existing loans held for investment portfolio. The allowance for credit losses for loans held for investment, as reported in our consolidated balance sheet, is adjusted by a credit loss expense, which is reported in earnings, and reduced by the charge-off of loan amounts, net of recoveries.

The loan loss estimation process involves procedures to appropriately consider the unique characteristics of loan portfolio segments which consist of agricultural, 1 to 4 family first and junior liens, commercial, and consumer lending. These segments are further disaggregated into loan classes, the level at which credit risk is monitored. For each of these pools, the Company generates cash flow projections at the instrument level wherein payment expectations are adjusted for estimated prepayment speed, curtailments, time to recovery, probability of default, and loss given default. The modeling of expected prepayment speeds, curtailment rates, and time to recovery are based on historical internal data. The following provides the credit quality indicators and risk elements that are most relevant and most carefully considered and monitored for each loan portfolio segment.

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

Mortgage loans secured by farmland are made to individuals and businesses within the Company's trade area. The primary source of repayment is the cash flow generated by the collateral underlying the loan. The secondary repayment source would be the liquidation of the collateral. Terms for real estate loans secured by farmland range from one to ten years with an amortization period of 25 years or less. Generally, interest rates are fixed for mortgage loans secured by farmland. Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate and the Iowa real gross domestic product (GDP).

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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
1 to 4 Family First and Junior Liens - The 1 to 4 family first and junior liens portfolio segment is comprised of the single family and home equity loan classes, which are underwritten after evaluating a borrower's capacity to repay, credit, and collateral. Several factors are considered when assessing a borrower's capacity, including the borrower's employment, income, current debt, assets, and level of equity in the property. Credit refers to how well a borrower manages their current and prior debts as documented by a credit report that provides credit scores and the borrower's current and past information about their credit history. Collateral refers to the type and use of property, occupancy, and market value. Property appraisals are obtained to assist in evaluating collateral. Loan-to-property value and debt-to-income ratios, loan amount, and lien position are also considered in assessing whether to originate a loan. These borrowers are particularly susceptible to downturns in economic trends such as conditions that negatively affect housing prices and demand and levels of unemployment. Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate and the all-transactions house price index for Iowa.

Commercial - The commercial loan portfolio segment is comprised of the commercial real estate mortgage including obligations of states and political subdivisions, multifamily residential mortgage, construction/land development and commercial and financial loan classes, whose underwriting standards consider the factors described for single family and home equity loan classes as well as others when assessing the borrower's and associated guarantors or other related party's financial position. These other factors include assessing liquidity, the level and composition of net worth, leverage, considering all other lender amounts and position, an analysis of cash expected to flow through the obligors including the outflow to other lenders, vacancies and prior experience with the borrower. This information is used to assess adequate financial capacity, profitability, and experience. Ultimate repayment of these loans is sensitive to interest rate changes, general economic conditions, liquidity, and availability of long-term financing. Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate, the all-transactions house price index for Iowa and the Iowa real GDP.

Consumer Lending - The Bank offers consumer loans to individuals including personal loans and automobile loans. These consumer loans typically have shorter terms, lower balances, higher yields and higher risks of default than real estate-related loans. Consumer loans collections are dependent on the borrower's continuing financial stability and are more likely to be affected by adverse personal circumstances. Collateral for these loans generally includes automobiles, boats, recreational vehicles and real estate. However, depending on the overall financial condition of the borrower, some loans are made on an unsecured basis. The collateral securing these loans may depreciate over time, may be difficult to recover and may fluctuate in value based on condition. Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate and the Iowa real GDP.

The allowance level is influenced by loan volumes, loan credit quality indicator migration or delinquency status, historic loss experience and other conditions influencing loss expectations, such as reasonable and supportable forecasts of economic conditions. The methodology for estimating the amount of expected credit losses reported in the allowance for credit losses has two basic components: first, a pooled component for estimated expected credit losses for pools of loans that share similar risk characteristics; and second, an asset-specific component involving individual loans that do not share risk characteristics with other loans and the measurement of expected credit losses for such individual loans. Depending on the nature of the pool of financial assets with similar risk characteristics, the Company uses a discounted cash flow method or remaining life method to estimate expected credit losses.

Discounted cash flow method: In estimating the component of the allowance for credit losses for loans that share similar risk characteristics with other loans, such loans are segregated into loan classes. Loans are designated into loan classes based on loans pooled by product types and similar risk characteristics or areas of risk concentration. In determining the allowance for credit losses, we derive an estimated credit loss assumption from a model that categorizes loan pools based on loan type and purpose. This model calculates an expected loss percentage for each loan class by considering the probability of default, using life-of-loan analysis periods for all loan segments, and the historical severity of loss, based on the aggregate net lifetime losses incurred per loan class. The default and severity factors used to calculate the allowance for credit losses for loans that share similar risk characteristics with other loans are adjusted for differences between the historical period used to calculate historical default and loss severity rates and expected conditions over the remaining lives of the loans in the portfolio related to: (1) lending policies and procedures; (2) international, national, regional and local economic business conditions and developments that affect the collectability of the portfolio; (3) the nature and volume of the loan portfolio including the terms of the loans; (4) the experience, ability, and depth of the lending management and other relevant staff; (5) the volume and severity of past due and adversely classified or graded loans and the volume of nonaccrual loans; (6) the quality of our loan review system and (7) the value of underlying collateral for collateralized loans. Additional factors include the existence and effect of any
Page 15

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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
concentrations of credit, and changes in the level of such concentrations and the effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio. Such factors are used to adjust the historical probabilities of default and severity of loss so that they reflect management expectation of future conditions based on a reasonable and supportable forecast. The Company uses regression analysis of historical internal and peer data to determine which variables are best suited to be economic variables utilized when modeling lifetime probability of default and loss given default. This analysis also determines how expected probability of default and loss given default will react to forecasted levels of the economic variables.

For all DCF models, management has determined that four quarters represents a reasonable and supportable forecast period and reverts back to a historical loss rate over twelve quarters on a straight-line basis. Other internal and external indicators of economic forecasts are also considered by management when developing the forecast metrics.

Remaining life method: Expected credit losses for credit cards and overdrafts are determined through use of the remaining life method. The remaining life method utilizes average annual charge-off rates and remaining life to estimate the allowance for credit losses. This is done by estimating the amount and timing of principal payments expected to be received as payment for the balance outstanding as of the reporting period and applying those principal payments against the balance outstanding as of the reporting period along with the average annual charge-off rate until the expected payments have been fully allocated.

Collateral dependent financial assets: For a loan that does not share risk characteristics with other loans, expected credit loss is measured based on net realizable value, that is, the difference between the discounted value of the expected future cash flows, based on the original effective interest rate, and the amortized cost basis of the loan. For these loans, we recognize expected credit loss equal to the amount by which the net realizable value of the loan is less than the amortized cost basis of the loan (which is net of previous charge- offs and deferred loan fees and costs), except when the loan is collateral dependent, that is, when the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the collateral. In these cases, expected credit loss is measured as the difference between the amortized cost basis of the loan and the fair value of the collateral. The fair value of the collateral is adjusted for the estimated cost to sell if repayment or satisfaction of a loan is dependent on the sale (rather than only on the operation) of the collateral.

The Company’s estimate of the ACL reflects losses expected over the contractual life of the assets, adjusted for estimated prepayments or curtailments. The contractual term does not consider extensions, renewals or modifications unless the Company has identified an expected troubled debt restructure (TDR). A loan that has been modified or renewed is considered a TDR when two conditions are met: 1) the borrower is experiencing financial difficulty and 2) concessions are made for the borrower's benefit that would not otherwise be considered for a borrower or transaction with similar credit risk characteristics. The Company’s ACL reflects all effects of a TDR when an individual asset is specifically identified as a reasonably expected TDR. The Company has determined that a TDR is reasonably expected no later than the point when the lender concludes that modification is the best course of action and it is at least reasonably possible that the troubled borrower will accept some form of concession from the lender to avoid a default. Reasonably expected TDRs and executed non-performing TDRs are evaluated individually to determine the required ACL. TDRs performing in accordance with their modified contractual terms for a reasonable period of time may be included in the Company’s existing pools based on the underlying risk characteristics of the loan to measure the ACL.

Allowance for credit losses on off-balance sheet credit exposures, including unfunded loan commitments: The Company maintains a separate allowance for credit losses from off-balance-sheet credit exposures, including unfunded loan commitments, which is disclosed on the balance sheet. Management estimates the amount of expected losses by calculating a commitment usage factor over the contractual period for exposures that are not unconditionally cancellable by the Company and applying the loss factors used in the ACL methodology to the results of the usage calculation to estimate the liability for credit losses related to unfunded commitments for each loan type. No credit loss estimate is reported for off-balance-sheet (OBS) credit exposures that are unconditionally cancellable by the Company, such as credit card receivables, or for undrawn amounts under such arrangements that may be drawn prior to the cancellation of the arrangement. The allowance for credit losses on OBS credit exposures is adjusted as credit loss expense. Categories of OBS credit exposures correspond to the loan portfolio segments described previously.

Troubled debt restructurings (“TDR loans”):  A loan is accounted for and reported as a troubled debt restructuring ("TDR") when, for economic or legal reasons, we grant a concession to a borrower experiencing financial difficulty that we would not otherwise consider. These concessions may include rate reductions, principal forgiveness, extension of maturity date and other actions intended to minimize potential losses to the Company. A restructuring that results in only an insignificant delay in
Page 16

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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
payment is not considered a concession. A delay may be considered insignificant if the payments subject to the delay are insignificant relative to the unpaid principal or collateral value and the contractual amount due, or the delay in timing of the restructured payment period is insignificant relative to the frequency of payments, the debt's original contractual maturity or original expected duration.

TDRs that are performing and on accrual status as of the date of the modification remain on accrual status. TDRs that are nonperforming as of the date of modification generally remain as nonaccrual until the prospect of future payments in accordance with the modified loan agreement is reasonably assured, generally demonstrated when the borrower maintains compliance with the restructured terms for a predetermined period, normally at least six months. TDRs with temporary below-market concessions remain designated as a TDR regardless of the accrual or performance status until the loan is paid off. However, if the TDR loan has been modified in a subsequent restructure with market terms and the borrower is not currently experiencing financial difficulty, then the loan is no longer classified as a TDR in the quarter following the modification. Management evaluates loans where there is a reasonable expectation at the reporting date that a troubled debt restructuring will be executed with an individual borrower for purposes of estimating the allowance for credit losses.

Section 4013 of the CARES Act, “Temporary Relief From Troubled Debt Restructurings,” allows financial institutions the option to temporarily suspend certain requirements under GAAP related to TDRs for a limited period of time during the COVID-19 pandemic. Under Section 4013 of the CARES Act, loan modifications that qualify for such suspension are those where the borrower was not more than 30 days past due as of December 31, 2019. In addition, the loan modification being made in response to the COVID-19 pandemic must include a deferral or delay in the payment of principal or interest, or change in the interest rate on the loan. Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time a modification program is implemented. The relief related to TDRs expired on January 1, 2022. See Note 5 for further discussion.

Effect of New Financial Accounting Standards:

In May 2021, the FASB issued ASU 2021-04, Earnings Per Share (Topic 260), Debt-Modifications and Extinguishments (Subtopic 470-50), Compensation-Stock Compensation (Topic 718), and Derivatives and Hedging-Contracts in Entity's Own Equity (Subtopic 815-40), Issuer's Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options. The amendments in this ASU affect entities that issue freestanding written call options that are classified in equity. Specifically, the amendments affect those entities when a freestanding equity-classified written call option is modified or exchanged and remains equity classified after the modification or exchange. An entity should recognize the effect of a modification or an exchange of a freestanding equity-classified written call option to compensate for goods or services in accordance with the guidance in Topic 718, Compensation-Stock Compensation. The amendments in this ASU are effective for all entities for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. An entity should apply the amendments prospectively to modifications or exchanges occurring on or after the effective date of the amendments. The adoption of the ASU by the Company on January 1, 2022 did not have a material impact on the financial statements.

In October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 815) Accounting for Contract Assets and Contract Liabilities from Contracts with Customers. The amendments in this Update require that an entity (acquirer) recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606. At the acquisition date, an acquirer should account for the related revenue contracts in accordance with Topic 606 as if it had originated the contracts. To achieve this, an acquirer may assess how the acquiree applied Topic 606 to determine what to record for the acquired revenue contracts. The amendments in this ASU are effective for all entities for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. An entity should apply the amendments prospectively to business combinations occurring on or after the effective date of the amendments. The Company is in the process of evaluating the impact of this ASU on the financial statements.

In March 2022, the FASB issued ASU 2022-02, Financial Instruments - Credit Losses (Topic 326) Troubled Debt Restructurings and Vintage Disclosures. The FASB issued these amendments to eliminate accounting guidance for TDRs by creditors in Subtopic 310-40, Receivables-Troubled Debt Restructurings by Creditors, while enhancing disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty, and to require that an entity disclose current-period gross writeoffs by year of origination for financing receivables and net investments in leases within the scope of Subtopic 326-20, Financial Instruments-Credit Losses-Measured at Amortized Cost. The amendments in this Update are effective for fiscal years beginning after December 15, 2022, including interim periods within
Page 17

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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
those fiscal years, and should be applied prospectively, except as provided in the next sentence. For the transition method related to the recognition and measurement of TDRs, an entity has the option to apply a modified retrospective transition method, resulting in a cumulative-effect adjustment to retained earnings in the period of adoption. Early adoption is permitted if an entity has adopted the amendments in Update 2016-03, including adoption in an interim period. The Company is in the process of evaluating the impact of this ASU on the financial statements.

Note 2.Earnings Per Share

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

The computation of basic and diluted earnings per share for the periods presented is as follows:
 Three Months Ended September 30,Nine Months Ended September 30,
 2022202120222021
Common shares outstanding at the beginning of the period9,267,410 9,306,252 9,299,640 9,330,995 
Weighted average number of net shares redeemed (3,569)(7,539)(24,256)(21,234)
Weighted average shares outstanding (basic)9,263,841 9,298,713 9,275,384 9,309,761 
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method676 3,731 1,935 3,605 
Weighted average number of shares (diluted)9,264,517 9,302,444 9,277,319 9,313,366 
Net income (In thousands)$13,740 $13,125 $35,718 $41,932 
Earnings per share:    
Basic$1.48 $1.41 $3.85 $4.50 
Diluted$1.48 $1.41 $3.85 $4.50 

Page 18

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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Note 3.Accumulated Other Comprehensive Income (Loss)

The following table summarizes the balances of each component of accumulated other comprehensive (loss) income (AOCI), included in stockholders’ equity, at September 30, 2022 and December 31, 2021:

 September 30, 2022December 31, 2021
 (amounts in thousands)
Net unrealized (loss) gain on available-for-sale securities$(67,264)$1,968 
Tax effect16,305 (491)
Net-of-tax amount$(50,959)$1,477 
 
Note 4.Securities

The carrying values of investment securities at September 30, 2022 and December 31, 2021 are summarized in the following table (dollars in thousands):

 September 30, 2022December 31, 2021
 AmountPercentAmountPercent
Securities available for sale
U.S. Treasury$449,393 60.12 %$243,925 44.24 %
Other securities (FHLB, FHLMC and FNMA)31,577 4.22 34,467 6.25 
State and political subdivisions216,489 28.96 263,516 47.80 
Mortgage-backed securities and collateralized mortgage obligations50,094 6.70 9,446 1.71 
Total securities available for sale$747,553 100.00 %$551,354 100.00 %

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.  Municipal bonds are comprised of general obligation bonds and revenue bonds issued by various municipal corporations. As of September 30, 2022 and December 31, 2021, all securities held were rated investment grade based upon external ratings where available and, where not available, based upon management knowledge of the local issuers and their financial situations. There were no trading or held to maturity securities as of September 30, 2022 or December 31, 2021.


















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Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
The carrying amount of available-for-sale securities, fair values and allowance for credit losses were as follows as of September 30, 2022 and December 31, 2021 (in thousands):
 Amortized CostGross
Unrealized
Gains
Gross
Unrealized
(Losses)
Allowance for Credit LossesEstimated Fair
Value
September 30, 2022
U.S. Treasury$477,725 $— $(28,332)$— $449,393 
Other securities (FHLB, FHLMC and FNMA)35,279 — (3,702)— 31,577 
State and political subdivisions243,551 32 (27,094)— 216,489 
Mortgage-backed securities and collateralized mortgage obligations58,262 — (8,168)— $50,094 
Total$814,817 $32 $(67,296)$— $747,553 
December 31, 2021:    
U.S. Treasury$244,192 $2,011 $(2,278)$— $243,925 
Other securities (FHLB, FHLMC and FNMA)35,353 — (886)— 34,467 
State and political subdivisions260,266 4,420 (1,170)— 263,516 
Mortgage-backed securities and collateralized mortgage obligations9,575 — (129)— 9,446 
Total$549,386 $6,431 $(4,463)$— $551,354 

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at September 30, 2022, were as follows (in thousands) below. Expected maturities of MBS may differ from contractual maturities because the mortgages underlying the securities may be called or prepaid without any penalties. Therefore, these securities are not included in the maturity categories in the following summary.
 
 Amortized
Cost
Fair Value
Due in one year or less$70,189 $69,380 
Due after one year through five years534,977 500,740 
Due after five years through ten years106,929 93,201 
Due over ten years44,460 34,138 
$756,555 $697,459 
Mortgage-backed securities and collateralized mortgage obligations58,262 50,094 
$814,817 $747,553 

As of September 30, 2022, investment securities with a carrying value of $9.02 million were pledged to collateralize other borrowings. As of September 30, 2022, there were no holdings of securities of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of stockholders' equity.

There were no sales of available-for-sale securities for the nine months ended September 30, 2022 and 2021.










Page 20

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2022 and December 31, 2021 (in thousands):

 Less than 12 months12 months or moreTotal
September 30, 2022
Description of Securities
#Fair ValueUnrealized
Loss
%#Fair ValueUnrealized
Loss
%#Fair ValueUnrealized
Loss
%
U.S. Treasury108 $348,659 $(15,385)4.41 %45 $100,734 $(12,947)12.85 %153 $449,393 $(28,332)6.30 %
Other securities (FHLB, FHLMC and FNMA)— — — — 14 31,577 (3,702)11.72 14 31,577 (3,702)11.72 
State and political subdivisions627 157,266 (13,213)8.40 224 55,661 (13,881)24.94 851 212,927 (27,094)12.72 
Mortgage-backed securities and collateralized mortgage obligations14 42,947 (6,369)14.83 7,147 (1,799)25.17 18 50,094 (8,168)16.31 
Total temporarily impaired securities749 $548,872 $(34,967)6.37 %287 $195,119 $(32,329)16.57 %1,036 $743,991 $(67,296)9.05 %

 Less than 12 months12 months or moreTotal
December 31, 2021
Description of Securities
#Fair ValueUnrealized
Loss
%#Fair ValueUnrealized
Loss
%#Fair ValueUnrealized
Loss
%
U.S. Treasury55 $136,867 $(2,203)1.61 %$2,416 $(75)3.10 %56 $139,283 $(2,278)1.64 %
Other securities (FHLB, FHLMC and FNMA)12,484 (303)2.43 21,984 (583)2.65 14 34,468 (886)2.57 
State and political subdivisions231 70,542 (1,055)1.50 14 9,248 (115)1.24 245 79,790 (1,170)1.47 
Mortgage-backed securities and collateralized mortgage obligations9,446 (129)1.37 — — — — 9,446 (129)1.37 
Total temporarily impaired securities295 $229,339 $(3,690)1.61 %24 $33,648 $(773)2.30 %319 $262,987 $(4,463)1.70 %

The Company considered the following information in reaching the conclusion that the impairments disclosed in the table above are not attributable to credit losses.  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. The securities are of high credit quality (investment grade credit ratings) and principal and interest payments are made timely with no payments past due as of September 30, 2022. The fair value is expected to recover as the securities approach maturity. The U.S. Treasury and other securities are issued and guaranteed by U.S. government-sponsored entities and agencies. The mortgage-backed securities and collateralized mortgage obligations have implied U.S. government guarantees of the agency
Page 21

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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
securities. The Company evaluates if a credit loss exists by monitoring to ensure it has adequate credit support considering the nature of the investment, number and significance of investments in an unrealized loss position, collectability or delinquency issues, the underlying financial statements of the issuers, credit ratings and subsequent changes thereto, and other available relevant information. Considering the above factors, management has determined that no allowance for credit losses is necessary for the securities portfolio as of September 30, 2022.

Note 5.Loans

Classes of loans are as follows:

 September 30, 2022December 31,
2021
 (Amounts In Thousands)
Agricultural$98,555 $106,933 
Commercial and financial248,179 222,002 
Real estate:
Construction, 1 to 4 family residential89,379 80,486 
Construction, land development and commercial165,431 127,021 
Mortgage, farmland248,103 232,744 
Mortgage, 1 to 4 family first liens1,060,888 909,564 
Mortgage, 1 to 4 family junior liens118,326 114,342 
Mortgage, multi-family435,666 382,792 
Mortgage, commercial397,048 401,377 
Loans to individuals35,355 32,687 
Obligations of state and political subdivisions49,191 50,285 
 $2,946,121 $2,660,233 
Net unamortized fees and costs274 299 
 $2,946,395 $2,660,532 
Less allowance for credit losses38,980 35,470 
 $2,907,415 $2,625,062 

For the nine months ended September 30, 2022 and 2021, the Company recognized none and $5.48 million, respectively, of deferred Paycheck Protection Program (PPP) loan fees in interest income.

















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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Changes in the allowance for credit losses, the allowance for credit losses applicable to individually evaluated loans and the related loan balance of individually evaluated loans for the three and nine months ended September 30, 2022 were as follows:
Three Months Ended September 30, 2022
AgriculturalCommercial and
Financial
Real Estate:
Construction and
land development
Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family
Real Estate:
Mortgage, multi-
family and
commercial
OtherTotal
(Amounts In Thousands)
Allowance for credit losses:
Beginning balance$2,265 $5,194 $2,772 $3,330 $12,233 $11,233 $1,233 $38,260 
Charge-offs— (18)— (1)(222)— (163)(404)
Recoveries10 233 143 26 50 470 
Credit loss expense (benefit)195 (213)690 (473)631 (345)169 654 
Ending balance$2,470 $5,196 $3,464 $2,862 $12,785 $10,914 $1,289 $38,980 
Nine Months Ended September 30, 2022
 AgriculturalCommercial and
Financial
Real Estate:
Construction and
land development
Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family
Real Estate:
Mortgage, multi-
family and
commercial
OtherTotal
 (Amounts In Thousands)
Allowance for credit losses:
Beginning balance$2,261 $4,269 $2,300 $3,433 $11,498 $10,498 $1,211 $35,470 
Charge-offs(1)(309)— (21)(471)(1)(389)(1,192)
Recoveries78 445 296 686 76 114 1,702 
Credit loss expense (benefit)132 791 1,157 (846)1,072 341 353 3,000 
Ending balance$2,470 $5,196 $3,464 $2,862 $12,785 $10,914 $1,289 $38,980 
Ending balance, individually evaluated for credit losses$295 $$55 $— $42 $308 $— $704 
Ending balance, collectively evaluated for credit losses$2,175 $5,192 $3,409 $2,862 $12,743 $10,606 $1,289 $38,276 
Loans:
Ending balance$98,555 $248,179 $254,810 $248,103 $1,179,214 $832,714 $84,546 $2,946,121 
Ending balance, individually evaluated for credit losses$552 $1,354 $392 $1,687 $5,637 $4,395 $— $14,017 
Ending balance, collectively evaluated for credit losses$98,003 $246,825 $254,418 $246,416 $1,173,577 $828,319 $84,546 $2,932,104 
Page 23

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Changes in the allowance for credit losses for the three and nine months ended September 30, 2021 were as follows:
Three Months Ended September 30, 2021
AgriculturalCommercial and
Financial
Real Estate:
Construction and
land development
Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family
Real Estate:
Mortgage, multi-
family and
commercial
OtherTotal
(Amounts In Thousands)
Allowance for credit losses:
Beginning balance$2,055 $4,802 $2,483 $4,904 $10,879 $9,707 $1,110 $35,940 
Charge-offs— (14)— — (181)(255)(138)(588)
Recoveries29 431 — 140 23 21 646 
Credit loss expense (benefit)34 (871)(188)(241)26 743 89 (408)
Ending balance$2,118 $4,348 $2,297 $4,663 $10,864 $10,218 $1,082 $35,590 
Nine Months Ended September 30, 2021
 AgriculturalCommercial and
Financial
Real Estate:
Construction and
land development
Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage,
1 to 4 family
Real Estate:
Mortgage, multi-
family and
commercial
OtherTotal
 (Amounts In Thousands)
Allowance for credit losses:
Beginning balance, prior to adoption of ASC 326$2,508 $4,885 $2,319 $4,173 $12,368 $9,415 $1,402 $37,070 
Impact of adopting ASC 326(328)298 327 763 522 1,396 (232)2,746 
Charge-offs— (90)(3)(1)(263)(265)(234)(856)
Recoveries117 966 93 25 648 240 98 2,187 
Credit loss expense (benefit)(179)(1,711)(439)(297)(2,411)(568)48 (5,557)
Ending balance$2,118 $4,348 $2,297 $4,663 $10,864 $10,218 $1,082 $35,590 
Ending balance, individually evaluated for credit losses$$$128 $$59 $$— $203 
Ending balance, collectively evaluated for credit losses$2,115 $4,344 $2,169 $4,659 $10,805 $10,213 $1,082 $35,387 
Loans:        
Ending balance$94,210 $228,181 $191,790 $241,650 $1,013,641 $799,855 $84,534 $2,653,861 
Ending balance, individually evaluated for credit losses$1,426 $1,394 $1,028 $1,583 $5,566 $5,758 $— $16,755 
Ending balance, collectively evaluated for credit losses$92,784 $226,787 $190,762 $240,067 $1,008,075 $794,097 $84,534 $2,637,106 
Page 24

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

The allowance for credit losses, the allowance for credit losses applicable to individually and collectively evaluated loans and the related loan balances as of December 31, 2021:
 AgriculturalCommercial and FinancialReal Estate: Construction
and land
development
Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4 family
Real Estate:
Mortgage, multi-family and
commercial
OtherTotal
 (Amounts In Thousands)
2021
Allowance for credit losses:
Ending balance$2,261 $4,269 $2,300 $3,433 $11,498 $10,498 $1,211 $35,470 
Ending balance, individually evaluated for credit losses$$189 $124 $— $49 $$20 $384 
Ending balance, collectively evaluated for credit losses$2,260 $4,080 $2,176 $3,433 $11,449 $10,497 $1,191 $35,086 
Loan balances:        
Ending balance$106,933 $222,002 $207,507 $232,744 $1,023,906 $784,169 $82,972 $2,660,233 
Ending balance, individually evaluated for credit losses$788 $2,062 $603 $1,277 $6,187 $5,696 $20 $16,633 
Ending balance, collectively evaluated for credit losses$106,145 $219,940 $206,904 $231,467 $1,017,719 $778,473 $82,952 $2,643,600 
Page 25

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Changes in the allowance for credit losses for off-balance sheet credit exposures for the three and nine months ended September 30, 2022 and 2021 were as follows:
Three Months Ended September 30, 2022
AgriculturalCommercial and
Financial
Real Estate:
Construction and
land development
Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family
Real Estate:
Mortgage, multi-
family and
commercial
OtherTotal
(Amounts In Thousands)
Allowance for credit losses for off-balance sheet credit exposures:
Beginning balance$659$1,776$1,182$115$1,025$300$53$5,110
Credit loss expense (benefit)(140)(714)42450(399)(192)(19)(990)
(Charge-offs), net recoveries
Ending balance$519 $1,062 $1,606 $165 $626 $108 $34 $4,120 
Three Months Ended September 30, 2021
AgriculturalCommercial and
Financial
Real Estate:
Construction and
land development
Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family
Real Estate:
Mortgage, multi-
family and
commercial
OtherTotal
(Amounts In Thousands)
Allowance for credit losses for off-balance sheet credit exposures:
Beginning balance$494 $1,529 $864 $107 $791 $275 $30 $4,090 
Credit loss expense (benefit)15 117 132 61 13 156 (4)490 
(Charge-offs), net recoveries— — — — — — — — 
Ending balance$509 $1,646 $996 $168 $804 $431 $26 $4,580 

Page 26

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Nine Months Ended September 30, 2022
AgriculturalCommercial and
Financial
Real Estate:
Construction and
land development
Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family
Real Estate:
Mortgage, multi-
family and
commercial
OtherTotal
(Amounts In Thousands)
Allowance for credit losses for off-balance sheet credit exposures:
Beginning balance$383 $1,118 $849 $113 $794 $559 $34 $3,850 
Credit loss expense (benefit)136(56)75752(168)(451)270
(Charge-offs), net recoveries
Ending balance$519 $1,062 $1,606 $165 $626 $108 $34 $4,120 
Nine Months Ended September 30, 2021
AgriculturalCommercial and
Financial
Real Estate:
Construction and
land development
Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family
Real Estate:
Mortgage, multi-
family and
commercial
OtherTotal
(Amounts In Thousands)
Allowance for credit losses for off-balance sheet credit exposures:
Beginning balance, prior to adoption of ASC 326$— $— $— $— $— $— $— $— 
Impact of adopting ASC 3263851,585736180471212153,584
Credit loss expense (benefit)12461260(12)33321911996
(Charge-offs), net recoveries
Ending balance$509 $1,646 $996 $168 $804 $431 $26 $4,580 
The allowance for credit losses for off-balance sheet credit exposures as of December 31, 2021 were as follows:

Year Ended December 31, 2021
AgriculturalCommercial and
Financial
Real Estate:
Construction and
land development
Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family
Real Estate:
Mortgage, multi-
family and
commercial
OtherTotal
(Amounts In Thousands)
Ending balance$383 $1,118 $849 $113 $794 $559 $34 $3,850 

Page 27

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Credit loss expense for off-balance sheet credit exposures is included in credit loss expense on the consolidated statement of income for the nine months ended September 30, 2022 and 2021.

Management regularly reviews loans in the portfolio to assess credit quality indicators and to determine appropriate loan classification and grading in accordance with applicable bank regulations. The Company's risk rating methodology assigns risk ratings ranging from 1 to 6, where a higher rating represents higher risk. The Company differentiates its lending portfolios into loans sharing common risk characteristics for which expected credit loss is measured on a pool basis and loans not sharing common risk characteristics for which credit loss is measured individually.

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. Loans are secured with cash, cash equivalents, or collateral with very low loan to values. The borrower would qualify for unsecured debt and guarantors provide excellent secondary support to the relationship. The borrower has a long-term relationship with Hills Bank, maintains high deposit balances and has an established payment history with Hills Bank and an established business in an established industry.

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. The relationship is not quite as strong as a borrower that is assigned an excellent rating but still has a very strong liquidity position, low leverage, and track record of strong performance. These loans have a strong collateral position with limited risk to bank capital. The collateral will not materially lose value in a distressed liquidation. Guarantors provide additional secondary support to mitigate possible bank losses. The borrower has a long-term relationship with Hills Bank with an established track record of payments; loans with shorter remaining loan amortization; deposit balances are consistent; loan payments could be made from cash reserves in the interim period; and source of income is coming from a stable industry.

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. The borrower's financial performance is consistent, ratios and trends are positive and the primary repayment source can clearly be identified and supported with acceptable financial information. The loan relationship could be vulnerable to changes in economic or industry conditions but have the ability to absorb unexpected issues. The loan collateral coverage is considered acceptable and guarantors can provide financial support but net worth might not be as liquid as a 1 or 2 rated relationship. The borrower has an established relationship with Hills Bank. The relationship is making timely loan payments, any operating line is revolving and deposit balances are positive with limited to no overdrafts. Management and industry is considered stable.

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. The relationship liquidity levels are minimal and the borrower’s leverage position is brought into question. The primary repayment source is showing signs of being stressed or is not proven. If the borrower performs as planned, the loan will be repaid. The collateral coverage is still considered acceptable but there might be some concern with the type of real estate securing the debt or highly dependent on chattel assets. Some loans may be better secured than others. Guarantors still provide some support but there is not an abundance of financial strength supporting the guaranty. A monitor credit may be appropriate when the borrower is experiencing rapid growth which is impacting liquidity levels and increasing debt levels. Other attributes to consider would include if the business is a start-up or newly acquired, if the relationship has significant financing relationships with other financial institutions, the quality of financial information being received, management depth of the company, and changes to the business model. The track history with Hills Bank has some deficiencies such as slow payments or some overdrafts.

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. Potential indicators of a special mention would include past due
Page 28

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HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
payments, overdrafts, management issues, poor financial performance, industry issues, or the need for additional short-term borrowing. The ability to continue to make payments is in question; there are “red flags” such as past due payments, non-revolving credit lines, overdrafts, and the inability to sell assets. The borrower is experiencing delinquent taxes, legal issues, etc., obtaining financial information has become a challenge, collateral coverage is marginal at best, and the value and condition could be brought into question. Collateral document deficiencies have been noted and if not addressed, could become material. Guarantors provide minimal support for this relationship. The credit may include an action plan or follow up established in the asset quality process. There is a change in the borrower’s communication pattern. Industry issues may be impacting the relationship. Adverse credit scores or history of payment deficiencies could be noted.

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.  Full repayment of the loan(s) according to the original terms and conditions is in question or not expected. For these loans, it is more probable than not that the Company could sustain some loss if the deficiency(ies) is not corrected. There are identified shortfalls in the primary repayment source such as carry over debt, past due payments, and overdrafts. Obtaining quality and timely financial information is a weakness. The loan is under secured with exposure that could impact bank capital. It appears the liquidation of collateral has become the repayment source. The collateral may be difficult to foreclose or have little to no value. Collateral documentation deficiencies have been noted during the review process. Guarantor(s) provide minimal to no support of the relationship. The borrower’s communication with the bank continues to decrease and the borrower is not addressing the situation. There is some concern about the borrower’s ability and willingness to repay the loans. Problems may be the result of external issues such as economic or industry related issues.

The following tables present the credit quality indicators and origination years by type of loan in each category as of September 30, 2022 (amounts in thousands):
Agricultural
September 30, 202220222021202020192018PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$749 $— $223 $20 $$— $1,397 $2,392 
Good2,147 633 1,133 430 36 16 4,685 9,080 
Satisfactory12,541 4,596 2,721 1,006 1,253 65 21,559 43,741 
Monitor11,712 2,442 2,213 943 420 225 20,652 38,607 
Special Mention70 — — — — — 571 641 
Substandard750 — 288 60 176 — 2,820 4,094 
Total$27,969 $7,671 $6,578 $2,459 $1,888 $306 $51,684 $98,555 


Page 29

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Commercial and Financial
September 30, 202220222021202020192018PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$1,252 $758 $554 $— $202 $— $4,178 $6,944 
Good14,265 8,648 3,110 627 134 1,148 10,092 38,024 
Satisfactory45,706 26,361 12,751 5,097 2,366 900 53,506 146,687 
Monitor13,176 9,225 6,545 1,354 702 602 19,448 51,052 
Special Mention597 350 335 161 34 — 456 1,933 
Substandard1,043 461 — 47 — — 1,988 3,539 
Total$76,039 $45,803 $23,295 $7,286 $3,438 $2,650 $89,668 $248,179 


Real Estate: Construction, 1 to 4 Family Residential
September 30, 202220222021202020192018PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$— $— $— $— $— $— $— $— 
Good212 1,192 — — — — 21,356 22,760 
Satisfactory2,169 3,223 — — — — 41,936 47,328 
Monitor— — — — — — — — 
Special Mention984 — — — — — 18,202 19,186 
Substandard— 105 — — — — — 105 
Total$3,365 $4,520 $— $— $— $— $81,494 $89,379 

Real Estate: Construction, Land Development and Commercial
September 30, 202220222021202020192018PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$375 $— $— $— $— $132 $1,292 $1,799 
Good2,306 584 947 — — 227 19,733 23,797 
Satisfactory15,940 12,707 1,200 1,345 254 900 59,340 91,686 
Monitor— — — — — — — — 
Special Mention7,784 3,391 227 34 72 29,350 40,864 
Substandard6,998 191 96 — — — — 7,285 
Total$33,403 $16,873 $2,470 $1,351 $288 $1,331 $109,715 $165,431 
Page 30

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


Real Estate: Mortgage, Farmland
September 30, 202220222021202020192018PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$3,058 $58 $282 $68 $— $$120 $3,590 
Good20,914 13,439 7,917 1,626 965 3,434 5,224 53,519 
Satisfactory39,819 44,509 21,598 3,832 6,096 9,626 10,990 136,470 
Monitor26,598 5,464 6,020 3,309 891 975 3,090 46,347 
Special Mention4,185 96 208 284 — 28 — 4,801 
Substandard2,797 — — 60 336 183 — 3,376 
Total$97,371 $63,566 $36,025 $9,179 $8,288 $14,250 $19,424 $248,103 

Real Estate: Mortgage, 1 to 4 Family First Liens
September 30, 202220222021202020192018PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$1,396 $453 $265 $— $10 $515 $— $2,639 
Good22,265 4,842 8,574 1,247 2,165 10,231 1,964 51,288 
Satisfactory290,081 204,279 141,224 53,471 49,188 132,555 13,104 883,902 
Monitor26,097 23,646 25,438 4,180 5,168 10,431 5,737 100,697 
Special Mention1,148 1,215 2,623 1,590 889 4,063 11,529 
Substandard414 1,916 1,798 615 1,572 4,518 — 10,833 
Total$341,401 $236,351 $179,922 $61,103 $58,992 $162,313 $20,806 $1,060,888 


Real Estate: Mortgage, 1 to 4 Family Junior Liens
September 30, 202220222021202020192018PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$— $— $$— $— $— $16 $25 
Good228 190 474 93 — 543 1,418 2,946 
Satisfactory11,891 11,245 8,129 4,667 5,073 7,806 60,297 109,108 
Monitor399 275 432 94 289 197 2,742 4,428 
Special Mention55 121 351 64 41 186 106 924 
Substandard49 57 200 100 78 29 382 895 
Total$12,622 $11,888 $9,595 $5,018 $5,481 $8,761 $64,961 $118,326 

Page 31

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Real Estate: Mortgage, Multi-Family
September 30, 202220222021202020192018PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$299 $3,155 $2,644 $— $— $649 $— $6,747 
Good18,318 15,669 26,865 29 — 8,821 — 69,702 
Satisfactory98,677 96,242 29,386 2,385 475 14,563 10,661 252,389 
Monitor47,748 24,592 25,899 171 — 1,340 7,078 106,828 
Special Mention— — — — — — — — 
Substandard— — — — — — — — 
Total$165,042 $139,658 $84,794 $2,585 $475 $25,373 $17,739 $435,666 

Real Estate: Mortgage, Commercial
September 30, 202220222021202020192018PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$2,050 $582 $21,625 $— $— $1,186 $— $25,443 
Good19,117 23,256 14,800 2,071 1,292 5,809 11,695 78,040 
Satisfactory51,658 63,796 40,355 10,960 8,625 17,073 18,404 210,871 
Monitor20,450 16,183 24,262 3,052 1,543 7,401 4,601 77,492 
Special Mention536 892 465 169 — 245 — 2,307 
Substandard267 362 1,848 126 194 96 2,895 
Total$94,078 $105,071 $103,355 $16,378 $11,654 $31,810 $34,702 $397,048 


Loans to Individuals
September 30, 202220222021202020192018PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$58 $— $— $— $— $— $— $58 
Good22 — — 18 — — 42 
Satisfactory11,077 7,316 3,117 1,084 435 11,387 111 34,527 
Monitor221 202 73 16 28 — 542 
Special Mention65 60 — 139 
Substandard22 — 47 
Total$11,465 $7,586 $3,202 $1,128 $470 $11,387 $117 $35,355 


Page 32

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Obligations of State and Political Subdivisions
September 30, 202220222021202020192018PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$— $— $— $— $— $5,078 $— $5,078 
Good— — 1,899 — — 8,516 — 10,415 
Satisfactory2,599 844 1,975 1,523 589 14,282 8,986 30,798 
Monitor— — 849 189 99 1,763 — 2,900 
Special Mention— — — — — — — — 
Substandard— — — — — — — — 
Total$2,599 $844 $4,723 $1,712 $688 $29,639 $8,986 $49,191 

Page 33

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
The following table presents the credit quality indicators by type of loans in each category as of December 31, 2021 (amounts in thousands):
 
Agricultural
December 31, 202120212020201920182017PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$762 $213 $30 $10 $— $— $2,312 $3,327 
Good1,799 1,767 603 46 52 26 7,593 11,886 
Satisfactory10,335 6,404 1,476 1,770 403 66 26,285 46,739 
Monitor8,125 5,017 998 765 164 253 23,995 39,317 
Special Mention1,662 11 85 — — 2,807 4,572 
Substandard592 69 203 — — — 228 1,092 
Total$23,275 $13,481 $3,395 $2,591 $626 $345 $63,220 $106,933 

Commercial and Financial
December 31, 202120212020201920182017PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$965 $924 $$235 $31 $— $3,391 $5,550 
Good13,722 5,570 1,105 1,086 276 1,494 20,709 43,962 
Satisfactory44,964 20,847 7,684 3,582 2,106 331 41,832 121,346 
Monitor18,337 8,019 3,591 1,123 297 416 13,368 45,151 
Special Mention603 525 353 70 102 174 1,831 
Substandard1,092 670 266 54 92 — 1,988 4,162 
Total$79,683 $36,555 $13,003 $6,150 $2,904 $2,245 $81,462 $222,002 

Page 34

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Real Estate: Construction, 1 to 4 Family Residential
December 31, 202120212020201920182017PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$— $— $— $— $— $— $— $— 
Good212 — — — — — 18,755 18,967 
Satisfactory7,457 94 — — — — 42,988 50,539 
Monitor1,307 — — — — — 9,187 10,494 
Special Mention— — — — — — 374 374 
Substandard111 — — — — — 112 
Total$9,087 $94 $— $— $— $— $71,305 $80,486 

Real Estate: Construction, Land Development and Commercial
December 31, 202120212020201920182017PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$5,079 $— $— $— $143 $$— $5,226 
Good3,294 1,200 — — 153 242 12,678 17,567 
Satisfactory22,907 4,354 2,356 263 1,081 21 40,048 71,030 
Monitor5,694 547 38 74 — 18,832 25,192 
Special Mention— — — — — — — — 
Substandard7,515 298 193 — — — — 8,006 
Total$44,489 $6,399 $2,556 $301 $1,451 $267 $71,558 $127,021 

Real Estate: Mortgage, Farmland
December 31, 202120212020201920182017PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$— $3,568 $124 $60 $80 $41 $134 $4,007 
Good17,827 14,308 2,144 2,460 5,932 3,929 3,844 50,444 
Satisfactory51,639 35,616 4,689 8,358 6,745 8,339 8,242 123,628 
Monitor8,532 16,925 5,518 3,901 2,154 4,866 5,695 47,591 
Special Mention4,031 288 — — 298 190 — 4,807 
Substandard1,283 447 291 47 — 199 — 2,267 
Total$83,312 $71,152 $12,766 $14,826 $15,209 $17,564 $17,915 $232,744 

Page 35

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Real Estate: Mortgage, 1 to 4 Family First Liens
December 31, 202120212020201920182017PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$462 $914 $427 $19 $149 $404 $$2,376 
Good9,598 12,300 3,124 3,443 3,091 10,943 2,496 44,995 
Satisfactory233,412 189,247 69,037 65,201 60,906 118,608 8,443 744,854 
Monitor24,908 33,863 5,038 6,527 7,273 12,203 4,066 93,878 
Special Mention1,682 3,422 887 962 1,051 3,168 — 11,172 
Substandard1,571 1,261 1,129 1,609 576 6,142 12,289 
Total$271,633 $241,007 $79,642 $77,761 $73,046 $151,468 $15,007 $909,564 

Real Estate: Mortgage, 1 to 4 Family Junior Liens
December 31, 202120212020201920182017PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$— $13 $— $— $— $— $$19 
Good193 611 96 — 108 482 1,374 2,864 
Satisfactory13,684 10,116 5,854 7,309 5,230 6,053 55,496 103,742 
Monitor326 1,233 70 365 140 281 2,801 5,216 
Special Mention103 489 35 56 42 110 142 977 
Substandard77 209 79 441 74 99 545 1,524 
Total$14,383 $12,671 $6,134 $8,171 $5,594 $7,025 $60,364 $114,342 

Real Estate: Mortgage, Multi-Family
December 31, 202120212020201920182017PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$2,539 $4,513 $— $— $— $701 $— $7,753 
Good16,931 35,396 1,555 — — 9,289 — 63,171 
Satisfactory107,192 69,287 13,635 2,030 1,561 14,660 14,764 223,129 
Monitor26,088 35,886 176 — 131 1,584 5,669 69,534 
Special Mention640 — 820 — — — — 1,460 
Substandard12,186 — — — — 5,559 — 17,745 
Total$165,576 $145,082 $16,186 $2,030 $1,692 $31,793 $20,433 $382,792 

Page 36

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Real Estate: Mortgage, Commercial
December 31, 202120212020201920182017PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$597 $16,781 $— $— $3,313 $350 $$21,042 
Good20,143 36,773 2,619 1,356 3,811 7,085 9,812 81,599 
Satisfactory75,040 52,653 14,727 12,091 9,707 17,398 16,333 197,949 
Monitor18,664 49,774 3,923 2,202 3,037 8,461 3,387 89,448 
Special Mention5,791 795 303 — 554 337 — 7,780 
Substandard1,528 1,721 — 208 — 102 — 3,559 
Total$121,763 $158,497 $21,572 $15,857 $20,422 $33,733 $29,533 $401,377 

Loans to Individuals
December 31, 202120212020201920182017PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$— $— $— $— $— $— $— $— 
Good— — 67 21 — 94 
Satisfactory12,162 5,606 2,212 967 141 10,867 57 32,012 
Monitor200 160 15 46 — 425 
Special Mention37 32 29 — — 103 
Substandard12 24 12 — 53 
Total$12,411 $5,822 $2,335 $1,038 $150 $10,870 $61 $32,687 

Obligations of State and Political Subdivisions
December 31, 202120212020201920182017PriorRevolving Loans Amortized Cost BasisTotal
Grade:
Excellent$— $— $— $— $— $6,076 $— $6,076 
Good— 1,984 — — — 9,051 — 11,035 
Satisfactory1,009 2,034 1,551 706 11,557 3,634 9,400 29,891 
Monitor— 933 203 249 — 1,898 — 3,283 
Special Mention— — — — — — — — 
Substandard— — — — — — — — 
Total$1,009 $4,951 $1,754 $955 $11,557 $20,659 $9,400 $50,285 








Page 37

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Past due loans as of September 30, 2022 and December 31, 2021 were as follows:
 30 - 59 Days
Past Due
60 - 89 Days
Past Due
90 Days
or More
Past Due
Total Past
Due
CurrentTotal
Loans
Receivable
Accruing Loans
Past Due 90
Days or More
 (Amounts In Thousands)
September 30, 2022
Agricultural$202 $— $— $202 $98,353 $98,555 $— 
Commercial and financial701 618 1,325 246,854 248,179 — 
Real estate:
Construction, 1 to 4 family residential3,428 — 105 3,533 85,846 89,379 — 
Construction, land development and commercial151 56 287 494 164,937 165,431 — 
Mortgage, farmland118 — 60 178 247,925 248,103 — 
Mortgage, 1 to 4 family first liens842 2,423 2,253 5,518 1,055,370 1,060,888 386 
Mortgage, 1 to 4 family junior liens53 30 16 99 118,227 118,326 
Mortgage, multi-family— — — — 435,666 435,666 — 
Mortgage, commercial2,949 181 1,145 4,275 392,773 397,048 — 
Loans to individuals191 45 — 236 35,119 35,355 — 
Obligations of state and political subdivisions— — — — 49,191 49,191 — 
 $8,635 $3,353 $3,872 $15,860 $2,930,261 $2,946,121 $393 
December 31, 2021       
Agricultural$41 $— $219 $260 $106,673 $106,933 $
Commercial and financial300 537 468 1,305 220,697 222,002 91 
Real estate:   
Construction, 1 to 4 family residential276 — — 276 80,210 80,486 — 
Construction, land development and commercial194 66 96 356 126,665 127,021 — 
Mortgage, farmland503 362 — 865 231,879 232,744 — 
Mortgage, 1 to 4 family first liens5,085 864 2,481 8,430 901,134 909,564 104 
Mortgage, 1 to 4 family junior liens246 41 124 411 113,931 114,342 — 
Mortgage, multi-family640 — — 640 382,152 382,792 — 
Mortgage, commercial466 — 829 1,295 400,082 401,377 — 
Loans to individuals177 26 208 32,479 32,687 — 
Obligations of state and political subdivisions394 — — 394 49,891 50,285 — 
 $8,322 $1,896 $4,222 $14,440 $2,645,793 $2,660,233 $201 
 
Page 38

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
The Company does not have a material amount of loans that are past due less than 90 days where there are serious doubts as to the ability of the borrowers to comply with the loan repayment terms.

Certain nonaccrual and TDR loan information by loan type at September 30, 2022 and December 31, 2021, was as follows:

 September 30, 2022December 31, 2021
 Non-accrual
loans (1)
Accruing loans
past due 90 days
or more
TDR loansNon-
accrual
loans (1)
Accruing loans
past due 90 days
or more
TDR loans
 (Amounts In Thousands)(Amounts In Thousands)
Agricultural$— $— $23 $221 $$374 
Commercial and financial678 — 675 707 91 1,085 
Real estate:   
Construction, 1 to 4 family residential105 — — 111 — — 
Construction, land development and commercial287 — — 290 — 202 
Mortgage, farmland643 — 1,045 251 — 1,206 
Mortgage, 1 to 4 family first liens4,055 386 1,170 4,685 104 1,364 
Mortgage, 1 to 4 family junior liens178 19 200 — 20 
Mortgage, multi-family— — 625 — — 1,460 
Mortgage, commercial1,819 — 1,952 2,026 — 2,210 
Loans to individuals— — — — — — 
Obligations of state and political subdivisions — — —  — 
 $7,765 $393 $5,509 $8,491 $201 $7,921 

(1)There were $3.18 million and $2.28 million of TDR loans included within nonaccrual loans as of September 30, 2022 and December 31, 2021, respectively.

Loans 90 days or more past due that are still accruing interest increased $0.19 million from December 31, 2021 to September 30, 2022. As of September 30, 2022, there were four accruing loans past due 90 days or more with an average loan balance of $0.98 million. There were 6 accruing loans past due 90 days or more as of December 31, 2021 with an average loan balance of $0.03 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. There was no interest income recognized on nonaccrual loans for the nine months ended September 30, 2022 and year ended December 31, 2021.
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.

Section 4013 of the CARES Act, “Temporary Relief From Troubled Debt Restructurings,” allows financial institutions the option to temporarily suspend certain requirements under GAAP related to TDRs for a limited period of time during the COVID-19 pandemic. As of September 30, 2022, the total amount of the eligible loans in deferral (deferral of principal and/or interest) that met the requirements set forth under the CARES Act and therefore were not considered TDRs was 16 loans,
Page 39

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
totaling $7.4 million. As of December 31, 2021, there were 16 loans, totaling $9.4 million that met the requirements and were not considered TDRs.

As of September 30, 2022 and December 31, 2021, COVID-19 related payment deferrals were approximately 0.03% and 0.12% of total loans, respectively.

Below is a summary of information for TDR loans as of September 30, 2022 and December 31, 2021:

 September 30, 2022December 31, 2021
Number
of
contracts
Recorded
investment
Commitments
outstanding
Number
of
contracts
Recorded
investment
Commitments
outstanding
 (Amounts In Thousands)(Amounts In Thousands)
Agricultural$23 $140 $586 $— 
Commercial and financial11 1,324 50 12 1,116 60 
Real estate:
Construction, 1 to 4 family residential105 — — — — 
Construction, land development and commercial191 — 202 — 
Mortgage, farmland1,584 — 1,409 — 
Mortgage, 1 to 4 family first liens1,170 — 14 1,441 — 
Mortgage, 1 to 4 family junior liens19 — 20 — 
Mortgage, multi-family625 — 1,460 — 
Mortgage, commercial11 3,644 — 11 3,963 — 
Loans to individuals— — — — — — 
Obligations of state and political subdivisions— — — — — — 
 39 $8,685 $190 50 $10,197 $60 






















Page 40

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
The following is a summary of TDR loans that were modified during the three and nine months ended September 30, 2022:
 Three Months Ended September 30, 2022Nine Months Ended September 30, 2022
Number
of
contracts
Pre-modification
recorded
investment
Post-modification
recorded
investment
Number
of
contracts
Pre-modification
recorded
investment
Post-modification
recorded
investment
 (Amounts In Thousands)(Amounts In Thousands)
Agricultural— $— $— — $— $— 
Commercial and financial— — — 371 371 
Real estate:     
Construction, 1 to 4 family residential— — — 105 105 
Construction, land development and commercial— — — 191 191 
Mortgage, farmland— — — 1,021 1,021 
Mortgage, 1 to 4 family first lien— — — — — — 
Mortgage, 1 to 4 family junior liens— — — — — — 
Mortgage, multi-family— — — — — — 
Mortgage, commercial— — — 274 274 
Loans to individuals— — — — — — 
Obligations of state and political subdivisions— — — — — — 
 — $— $— $1,962 $1,962 

The Company has allocated $0.36 million of allowance for TDR loans and the Company had commitments to lend $0.19 million in additional borrowings to restructured loan customers as of September 30, 2022.  The Company had commitments to lend $0.06 million in additional borrowings to restructured loan customers as of December 31, 2021.  These commitments were in the normal course of business.  The additional borrowings were not used to facilitate payments on these loans. The modifications of the terms of loans performed during the nine months ended September 30, 2022 included extensions of the maturity date.

There were no TDR loans that were in payment default (defined as past due 90 days or more) during the period ended September 30, 2022 and the year ended December 31, 2021.














Page 41

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

The following table presents the amortized cost basis of collateral dependent loans, by the primary collateral type, which are individually evaluated to determine expected credit losses, and the related ACL allocated to these loans:

Primary Type of Collateral
Real EstateAccounts ReceivableEquipmentOtherTotalACL Allocation
(Amounts In Thousands)
September 30, 2022
Agricultural$552 $— $— $— $552 $295 
Commercial and financial1,271 — 83 — 1,354 
Real estate:
Construction, 1 to 4 family residential105 — — — 105 55 
Construction, land development and commercial287 — — — 287 — 
Mortgage, farmland1,507 — 180 — 1,687 — 
Mortgage, 1 to 4 family first liens5,433 — — — 5,433 40 
Mortgage, 1 to 4 family junior liens204 — — — 204 
Mortgage, multi-family625 — — — 625 — 
Mortgage, commercial3,770 — — — 3,770 308 
Loans to individuals— — — — — — 
Obligations of state and political subdivisions— — — — — — 
$13,754 $— $263 $— $14,017 $704 

Page 42

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Primary Type of Collateral
Real EstateAccounts ReceivableEquipmentOtherTotalACL Allocation
(Amounts In Thousands)
December 31, 2021
Agricultural$734 $— $54 $— $788 $
Commercial and financial1,951 — 111 — 2,062 189 
Real estate:
Construction, 1 to 4 family residential111 — — — 111 111 
Construction, land development and commercial492 — — — 492 13 
Mortgage, farmland1,277 — — — 1,277 — 
Mortgage, 1 to 4 family first liens5,967 — — — 5,967 31 
Mortgage, 1 to 4 family junior liens220 — — — 220 18 
Mortgage, multi-family1,460 — — — 1,460 — 
Mortgage, commercial4,236 — — — 4,236 
Loans to individuals20 — — — 20 20 
Obligations of state and political subdivisions— — — — — — 
$16,468 $— $165 $— $16,633 $384 









Page 43

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
The changes in the ACL in 2022 compared to December 31, 2021 is the result of the following factors: improvements in the economic factors, primarily Iowa unemployment in the first quarter, used in the ACL calculation which resulted in a decrease of $1.09 million; increase in loan volume which resulted in an increase of $3.34 million; changes in prepayment and curtailment rates and loss driver analysis resulting in an increase of $0.35 million; increase in the individually analyzed loans reserve of $0.34 million; and increases in qualitative factors determined necessary by management which resulted in an increase of $0.57 million. The decrease in the allowance for credit losses on off-balance sheet credit exposures is primarily a result of the decreased outstanding unfunded commitments and funding rates as of September 30, 2022.

The extent to which collateral secures collateral-dependent loans is provided in the previous individually analyzed loans table and changes in the extent to which collateral secures its collateral-dependent loans are described below. Collateral-dependent loans decreased $2.62 million from December 31, 2021 to September 30, 2022.  Collateral-dependent loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans. Collateral-dependent 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.  Collateral-dependent loans were 0.48% of loans held for investment as of September 30, 2022 and 0.63% as of December 31, 2021.  The decrease in collateral-dependent loans is due to a decrease in nonaccrual loans of $0.73 million, an increase in 90 days or more accruing loans of $0.19 million and a decrease in TDR loans of $1.51 million from December 31, 2021 to September 30, 2022. There were no significant changes noted in the extent to which collateral secures collateral-dependent loans.

The Company regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans share common risk characteristics for which expected credit loss is measured on a pool basis or if the loans do not share common risk characteristics and therefore expected credit loss is measured on an individual loan basis.  If the loans are assessed for credit losses on an individual basis, 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 or where a TDR is reasonably possible.  Loans that are determined not to be collateral-dependent and for which there are no specific allowances are classified into one or more risk categories and expected credit loss is measured on a pool basis. See Note 1 Adoption of Financial Accounting Standard for further discussion of the allowance for credit losses for loans held for investment.

Specific allowances for credit losses on loans assessed individually 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 individually analyzed 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 credit loss 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 variables affecting its value may have changed since the appraisal was performed. The charge off or loss adjustment supported by an appraisal is considered the minimum charge off.  Any adjustments made to the appraised value are to provide an additional charge off or specific reserve based on the applicable facts and circumstances.  In instances where there is an estimated decline in value, a specific reserve may be provided or a charge off taken pending confirmation of the amount of the loss from an updated appraisal.  Upon receipt of the new appraisals, an additional specific reserve may be provided or charge off taken based on the appraised value of the collateral.  On average, appraisals are obtained within one month of order.

Note 6.Leases

The Bank leases branch offices, parking facilities and certain equipment under operating leases. The leases have remaining lease terms of 1 year to 15 years, some of which include options to extend the leases for up to 10 years, and some of which include options to terminate the leases within 1 year. As the options are reasonably certain to be exercised, they are recognized as part of the right-of-use assets and lease liabilities.

Page 44

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
For the nine months ended September 30, 2022 and 2021, total operating lease expense was $0.44 million and $0.44 million respectively, and is included in occupancy expenses in the consolidated statements of income. Included in this for the nine months ended September 30, 2022 and 2021 were $0.38 million and $0.37 million, respectively, of operating lease costs, $0.03 million and $0.03 million, respectively, of short term lease costs, and $0.03 million and $0.04 million, respectively, of variable lease costs.
For the nine months ended September 30, 2022 and 2021, cash paid for amounts included in the measurement of operating lease liabilities was $0.38 million and $0.38 million, respectively.
As of September 30, 2022 and December 31, 2021, operating lease right-of-use assets included in other assets was $2.21 million and $2.47 million respectively. Operating lease liabilities included in other liabilities were $2.29 million and $2.53 million as of September 30, 2022 and December 31, 2021. As of September 30, 2022 and December 31, 2021, the weighted average remaining lease term for operating leases was 9.72 years and 9.94 years, respectively, and the weighted average discount rate for operating leases was 3.52% and 3.49%, respectively. Discount rates used were determined from FHLB borrowing rates for comparable terms.
As of September 30, 2022, maturities of lease liabilities were as follows:
Year ending December 31:(Amounts In Thousands)
2022 (excluding the nine months ended September 30, 2022)$118 
2023327 
2024260 
2025263 
2026266 
Thereafter1,503 
Total lease payments2,737 
Less imputed interest(446)
Total operating lease liabilities$2,291 

Page 45

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Note 7.Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments as of September 30, 2022 are as follows:
 September 30, 2022
 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$242,121 $242,121 $242,121 $ $ 
Investment securities747,553 747,553 449,393 298,160  
Loans held for sale2,664 2,664  2,664  
Loans, net of allowance for credit losses
Agricultural96,085 96,082   96,082 
Commercial and financial242,983 241,017   241,017 
Real estate:
Construction, 1 to 4 family residential88,388 88,854   88,854 
Construction, land development and commercial162,958 160,469   160,469 
Mortgage, farmland245,241 239,221   239,221 
Mortgage, 1 to 4 family first liens1,051,289 1,028,672   1,028,672 
Mortgage, 1 to 4 family junior liens115,414 113,961   113,961 
Mortgage, multi-family431,237 423,741   423,741 
Mortgage, commercial390,563 382,178   382,178 
Loans to individuals34,515 33,826   33,826 
Obligations of state and political subdivisions48,742 48,373   48,373 
Accrued interest receivable14,520 14,520  14,520  
Total financial instrument assets$3,914,273 $3,863,252 $691,514 $315,344 $2,856,394 
Financial instrument liabilities     
Deposits     
Noninterest-bearing deposits$696,137 $696,137 $ $696,137 $ 
Interest-bearing deposits2,819,624 2,819,258  2,819,258  
Accrued interest payable1,056 1,056  1,056  
Total financial instrument liabilities$3,516,817 $3,516,451 $ $3,516,451 $ 
 Face Amount    
Financial instrument with off-balance sheet risk:     
Loan commitments$743,826 $ $ $ $— 
Letters of credit7,026    — 
Total financial instrument liabilities with off-balance-sheet risk$750,852 $ $ $ $ 
(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 46

Index
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
The carrying value and estimated fair values of the Company's financial instruments as of December 31, 2021 are as follows:

 December 31, 2021
 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$781,918 $781,918 $781,918 $ $ 
Investment securities555,900 555,900 243,925 311,975  
Loans held for sale5,716 5,716  5,716  
Loans, net of allowance for credit losses     
Agricultural104,672 103,745   103,745 
Commercial and financial217,733 216,466   216,466 
Real estate:     
Construction, 1 to 4 family residential79,668 79,311   79,311 
Construction, land development and commercial125,539 124,466   124,466 
Mortgage, farmland229,311 228,365   228,365 
Mortgage, 1 to 4 family first liens901,523 897,255   897,255 
Mortgage, 1 to 4 family junior liens111,184 110,903   110,903 
Mortgage, multi-family379,077 378,193   378,193 
Mortgage, commercial394,594 391,950   391,950 
Loans to individuals31,916 31,871   31,871 
Obligations of state and political subdivisions49,845 50,155   50,155 
Accrued interest receivable11,437 11,437  11,437  
Total financial instrument assets$3,980,033 $3,967,651 $1,025,843 $329,128 $2,612,680 
Financial instrument liabilities:     
Deposits     
Noninterest-bearing deposits$633,101 $633,101 $ $633,101 $ 
Interest-bearing deposits2,900,893 2,909,243  2,909,243  
Other borrowings249 249  249  
Federal Home Loan Bank borrowings     
Accrued interest payable1,165 1,165  1,165  
Total financial instrument liabilities$3,535,408 $3,543,758 $ $3,543,758 $ 
 Face Amount    
Financial instrument with off-balance sheet risk:     
Loan commitments$614,324 $ $ $ $— 
Letters of credit7,179    — 
Total financial instrument liabilities with off-balance-sheet risk$621,503 $ $ $ $ 
 Considered Level 1 under ASC 820.
(1)Considered Level 2 under ASC 820.
(2)Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (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 1Quoted prices in active markets for identical assets or liabilities.
Level 2Observable inputs other than quoted prices included within Level 1.  Observable inputs include the quoted prices for similar assets or liabilities in markets that are not active and inputs other than quoted prices that are observable for the asset or liability.
Level 3Unobservable inputs supported by little or no market activity for financial instruments.  Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

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

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

ASSETS

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

The pricing for investment securities is obtained from an independent source.  There are no Level 3 investment securities owned by the Company.  The Company obtains an understanding of the independent source’s valuation methodologies used to determine fair value by level of security. The Company validates assigned fair values on a sample basis using an additional third-party provider pricing service to determine if the fair value measurement is reasonable. Due to the nature of our investment portfolio, we do not expect significant and unusual fluctuations as fair value changes primarily relate to interest rate changes.   No unusual fluctuations were identified during the nine months ended September 30, 2022. If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.
Individually analyzed loans under ASC 326 CECL: See Note 1 for further discussion of individually analyzed loans under CECL.
A loan is considered to be non-performing 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 non-performing, the amount of reserve is measured based on the fair value of the underlying collateral. The Company makes such measurements on all material loans deemed non-performing 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. These loans are considered Level 3 as the instruments used to determine fair market value require significant management judgment and estimation.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
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).

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

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

 September 30, 2022
 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$449,393 $— $— $449,393 
State and political subdivisions— 216,489 — 216,489 
Mortgage-backed securities and collateralized mortgage obligations— 50,094 — 50,094 
Other securities (FHLB, FHLMC and FNMA)— 31,577 — 31,577 
Total$449,393 $298,160 $— $747,553 

 December 31, 2021
 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$243,925 $— $— $243,925 
State and political subdivisions— 263,516 — 263,516 
Mortgage-backed securities and collateralized mortgage obligations— 9,446 — 9,446 
Other securities (FHLB, FHLMC and FNMA)— 34,467 — 34,467 
Total$243,925 $307,429 $— $551,354 
 
(1)Considered Level 1 under ASC 820.
(2)Considered Level 2 under ASC 820.
(3)Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

There were no transfers between Levels 1, 2 or 3 during the nine months ended September 30, 2022 and the year ended December 31, 2021.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

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

 September 30, 2022Three Months Ended September 30, 2022Nine Months Ended September 30, 2022
 Readily
Available
Market
Prices(1)
Observable
Market
Prices(2)
Company
Determined
Market
Prices(3)
Total at
Fair
Value
Total LossesTotal Losses
 (Amounts in Thousands)
Loans (4)
Agricultural$— $— $55 $55 $— $— 
Commercial and financial— — 1,280 1,280 — 225 
Real Estate:— 
Construction, 1 to 4 family residential— — 50 50 — — 
Construction, land development and commercial— — 287 287 — — 
Mortgage, farmland— — 1,687 1,687 — 104 
Mortgage, 1 to 4 family first liens— — 5,158 5,158 153 243 
Mortgage, 1 to 4 family junior liens— — 194 194 — 
Mortgage, multi-family— — 625 625 — — 
Mortgage, commercial— — 3,408 3,408 — — 
Loans to individuals— — — — — — 
Foreclosed assets (5)— — — — — — 
Total$— $— $12,744 $12,744 $153 $577 
 
(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, 2021Year Ended December 31, 2021
 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$— $— $399 $399 $— 
Commercial and financial— — 1,527 1,527 — 
Real Estate:
Construction, 1 to 4 family residential— — 383 383 — 
Construction, land development and commercial— — 96 96 — 
Mortgage, farmland— — 1,114 1,114 — 
Mortgage, 1 to 4 family first liens— — 5,902 5,902 212 
Mortgage, 1 to 4 family junior liens— — 202 202 
Mortgage, multi-family— — 1,460 1,460 — 
Mortgage, commercial— — 4,176 4,176 255 
Loans to individuals— — — — — 
Foreclosed assets (5)— — — — — 
Total$— $— $15,259 $15,259 $476 
(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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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”).  On August 9, 2022, the Company’s Board of Directors authorized the expansion of the 2005 Stock Repurchase Program to allow an additional 750,000 shares for repurchase and the continuation through December 31, 2027. 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 1,473,471 shares of its common stock in privately negotiated transactions from August 1, 2005 through September 30, 2022.  Of these 1,473,471 shares, 7,541 shares were purchased during the quarter ended September 30, 2022, at an average price per share of $71.47.
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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 $76.68 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.

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

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments.  The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.  A summary of the Bank’s commitments at September 30, 2022 and December 31, 2021 is as follows:
 
 September 30, 2022December 31, 2021
 (Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans$86,255 $78,961 
Credit cards65,321 65,913 
Commercial, real estate and home construction240,536 170,539 
Commercial lines and real estate purchase loans351,714 298,911 
Outstanding letters of credit7,026 7,179 
 
Note 10.Income Taxes

Federal income tax expense for the nine months ended September 30, 2022 and 2021 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, 2021, 2020, and 2019 remain subject to examination by the Internal Revenue Service.  For state tax purposes, the tax years ended December 31, 2021, 2020, and 2019 remain open for examination.  There were no material unrecognized tax benefits at September 30, 2022  and December 31, 2021 and therefore no interest or penalties on unrecognized tax benefits has been recorded.  As of September 30, 2022, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending September 30, 2023. In the quarter ended September 30, 2022, the Company's income tax expense included a one-time increase in state income tax expense related to the 2022 enactment of changes in the Iowa bank franchise tax rates. This legislation reduces the Iowa bank franchise tax rate applied to apportioned income for 2023 and future years and required the Company to reduce net deferred tax assets and caused the one-time increase in 2022 tax expense. Income taxes as a percentage of income before taxes were 22.70% for the nine months ended September 30, 2022 and 22.58% for the same period in 2021.  Excluding the one-time state tax expense, the income taxes as a percentage of income before taxes for the nine months ended September 30, 2022 would have been 22.10%.

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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. This includes current concerns related to higher inflation, rising energy prices, the Russia-Ukraine war and supply chain imbalances.

The effects of recent financial market disruptions and/or an economic recession, and monetary and other governmental actions designed to address such disruptions, including in response to the COVID-19 pandemic.

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

The credit quality and credit agency ratings of the securities in the Company’s investment securities portfolio, a deterioration or downgrade of which could lead to recognition of an allowance for credit losses on the affected securities and the recognition of a credit 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, including, but not limited to, potential changes in U.S. tax laws and regulations.

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.

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

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

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

The economic impact of natural disasters, diseases and/or pandemics, including any extended impact from the COVID-19 pandemic, and 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.

Economic Environment

U.S. economic activity slowed during the first nine months of 2022 reflecting the impacts of significantly higher inflation and rising interest rates as well as repercussions from the Russia-Ukraine war alongside continued economic impacts from the COVID-19 pandemic which have resulted in supply chain disruptions and increased energy prices. After contracting during the first two quarters of the year, U.S. Gross Domestic Product ("GDP") is currently forecast to grow in the third quarter of 2022, while the personal consumption expenditures price index is currently forecast to increase to an annual rate of 6.3 percent in September 2022, well above the FRB's target inflation rate. The FRB increased short-term interest rates by a total of 300 basis points during the first nine months of 2022 and has indicated that it will increase short-term interest rates further during the fourth quarter of 2022 in order to fight inflation.

These conditions have created significant uncertainty about the future economic environment which will continue to evolve and potentially impact our business in future periods. Concerns over interest rate levels, energy prices, domestic and global policy issues, trade policy in the U.S. and geopolitical events, as well as the implications of those events on the markets in general, further add to the global uncertainty. There is also a risk that interest rate increases to fight inflation could lead to a recession. Interest rate levels and energy prices, in combination with global economic conditions, fiscal and monetary policy and the level of regulatory and government scrutiny of financial institutions will likely continue to impact our results for the remainder of 2022 and into 2023.

Our credit administration continues to closely monitor and analyze 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, senior management is cautiously optimistic that the Company is positioned to continue managing the impact of the varied set of risks and uncertainties currently impacting the economy and remain adequately capitalized. However, the Company may be required to make additional credit loss provisions as warranted by the extremely fluid economic condition.


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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 credit losses.

Allowance for Credit Losses

On January 1, 2021, the Company adopted ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires the allowance for credit losses use the current expected credit loss (CECL) methodology. The following is a discussion of the methodologies used by the Company with the adoption of ASC 326.

The preparation of financial statements in accordance with the accounting principles generally accepted in the United States ("U.S. GAAP") requires management to make a number of judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, income and expense in the financial statements. Various elements of our accounting policies, by their nature, involve the application of highly sensitive and judgmental estimates and assumptions. Some of these policies and estimates relate to matters that are highly complex and contain substantial inherent uncertainties. Management has made significant estimates in several areas, including the allowance for credit losses (see Note 5 - Loans and Note 4 - Securities) and the fair value of debt securities (see Note 4 - Securities).

We have identified the following accounting policies and estimates that, due to the inherent judgments and assumptions and the potential sensitivity of the financial statements to those judgments and assumptions, are critical to an understanding of our financial statements. We believe that the judgments, estimates and assumptions used in the preparation of the Company's financial statements are appropriate. For a further description of our accounting policies, see Note 1 - Summary of Significant Accounting Policies in the financial statements included in this Form 10-Q.

The allowance for credit losses for loans represents management's estimate of all expected credit losses over the expected contractual life of our existing loan portfolio. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the then-existing loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for credit losses in those future periods.

We employ a disciplined process and methodology to establish our allowance for credit losses that has two basic components: first, an asset-specific component involving individual loans that do not share risk characteristics with other loans and the measurement of expected credit losses for such individual loans; and second, a pooled component for estimated expected credit losses for pools of loans that share similar risk characteristics.

Based upon this methodology, management establishes an asset-specific allowance for loans that do not share risk characteristics with other loans based on the amount of expected credit losses calculated on those loans and charges off amounts determined to be uncollectible. Factors we consider in measuring the extent of expected credit loss include payment status, collateral value, borrower financial condition, guarantor support and the probability of collecting scheduled principal and interest payments when due.

When a loan does not share risk characteristics with other loans, we measure expected credit loss as the difference between the amortized cost basis in the loan and the present value of expected future cash flows discounted at the loan's effective interest rate except that, for collateral- dependent loans, credit loss is measured as the difference between the amortized cost basis in the loan and the fair value of the underlying collateral. The fair value of the collateral is adjusted for the estimated cost to sell if repayment or satisfaction of a loan is dependent on the sale (rather than only on the operation) of the collateral. In accordance with our appraisal policy, the fair value of collateral-dependent loans is based upon independent third-party appraisals or on collateral valuations prepared by in-house evaluations. Once a third-party appraisal is greater than one year old, or if its determined that market conditions, changes to the property, changes in intended use of the property or other factors indicate that an appraisal is no longer reliable, we perform an internal collateral valuation to assess whether a change in collateral value requires an additional adjustment to carrying value. When we receive an updated appraisal or collateral valuation, management reassesses the need for adjustments to the loan's expected credit loss measurements and, where appropriate, records an
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adjustment. If the calculated expected credit loss is determined to be permanent, fixed or nonrecoverable, the credit loss portion of the loan will be charged off against the allowance for credit losses. Loans designated having significantly increased credit risk are generally placed on nonaccrual and remain in that status until all principal and interest payments are current and the prospects for future payments in accordance with the loan agreement are reasonably assured, at which point the loan is returned to accrual status.

In estimating the component of the allowance for credit losses for loans that share common risk characteristics, loans are segregated into loan classes. Loans are designated into loan classes based on loans pooled by product types and similar risk characteristics or areas of risk concentration. Credit loss assumptions are estimated using a model that categorizes loan pools based on loan type and purpose. This model calculates an expected life-of-loan loss percentage for each loan category by considering the probability of default using historical life-of-loan analysis periods for agricultural, 1 to 4 family first and junior liens, commercial and consumer segments, and the severity of loss, based on the aggregate net lifetime losses incurred per loan class.

The component of the allowance for credit losses for loans that share common risk characteristics also considers factors for each loan class to adjust for differences between the historical period used to calculate historical default and loss severity rates and expected conditions over the remaining lives of the loans in the portfolio related to:
Lending policies and procedures;
International, national, regional and local economic business conditions and developments that affect the collectability of the portfolio, including the condition of various markets;
The nature of the loan portfolio, including the terms of the loans;
The experience, ability and depth of the lending management and other relevant staff;
The volume and severity of past due and adversely classified or graded loans and the volume of nonaccrual loans;
The quality of our loan review and process;
The value of underlying collateral for collateral-dependent loans;
The existence and effect of any concentrations of credit and changes in the level of such concentrations; and
The effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio.

Such factors are used to adjust the historical probabilities of default and severity of loss so that they reflect management expectation of future conditions based on a reasonable and supportable forecast. To the extent the lives of the loans in the portfolio extend beyond the period for which a reasonable and supportable forecast can be made, the bank reduces, on a straight-line basis over the remaining life of the loans, the adjustments so that model reverts back to the historical rates of default and severity of loss.

The credit loss expense recorded through earnings is the amount necessary to maintain the allowance for credit losses at the amount of expected credit losses inherent within the loans held for investment portfolio. The amount of expense and the corresponding level of allowance for credit losses for loans are based on our evaluation of the collectability of the loan portfolio based on historical loss experience, reasonable and supportable forecasts, and other significant qualitative and quantitative factors.

The allowance for credit losses for loans, as reported in our consolidated balance sheet, is adjusted by an expense for credit losses, which is recognized in earnings, and reduced by the charge-off of loan amounts, net of recoveries. For further information on the allowance for credit losses for loans, see Note 1 - Summary of Significant Accounting Policies and Note 5 - Loans in the notes to the financial statements of this Form 10-Q.













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Overview

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

The Company is a holding company engaged in the business of commercial banking.  The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned.  The Bank was formed in Hills, Iowa in 1904.  The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids, Marion, and Washington, Iowa.  At September 30, 2022, the Bank has nineteen full-service locations.

Net income for the nine month period ended September 30, 2022 was $35.72 million compared to $41.93 million for the same nine months of 2021, a decrease of $6.21 million or 14.82%.  The principal factors in the decrease in net income for the first nine months of 2022 were a credit loss expense of $7.83 million, primarily due to increased loan growth, increased outstanding loan commitments and lower prepayment and curtailment rates with increasing interest rates; a decrease in noninterest income of $4.29 million; and offset by an increase in net interest income of $4.73 million.

The Company achieved a return on average assets of 1.05% and a return on average equity of 9.85% for the twelve months ended September 30, 2022, compared to the twelve months ended September 30, 2021, which were 1.32% and 12.14%, respectively. The return on average assets and return on average equity for the nine months ended September 30, 2022 were 1.19% and 11.28%, respectively, compared to the nine months ended September 30, 2021, which were 1.42% and 13.30%, respectively.  Dividends of $1.00 per share were paid in January 2022 to 2,727 shareholders.  The dividend paid in January 2021 was $0.94 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 2.92% for the nine months ended September 30, 2022 compared to 2.83% for the same nine months of 2021.  Average earning assets were $3.924 billion year to date in 2022 and $3.823 billion in 2021.

Highlights noted on the balance sheet as of September 30, 2022 for the Company included the following:

Total assets were $4.000 billion, a decrease of $44.18 million since December 31, 2021.
Cash and cash equivalents were $242.12 million, a decrease of $539.80 million since December 31, 2021. A portion of the decrease can be attributed to increased investments of approximately $196.20 million since December 31, 2021, primarily in U.S Treasury and mortgage-backed securities as well as loan growth of approximately $285.86 million since year-end.
Net Loans, net of allowance for credit losses, were $2.910 billion, an increase of $279.30 million since December 31, 2021. The increase is primarily attributable to approximately $47.30 million growth in construction loans, $52.87 million in multi-family loans, $151.32 million growth in 1-4 family first mortgages and $26.18 million in commercial and financial loans since December 31, 2021. Loans held for sale decreased $3.05 million since December 31, 2021.
Deposits decreased $18.23 million since December 31, 2021, primarily due to decreases in brokered deposits and insured cash sweep (ICS) deposits.

Refer 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

There has been continued loan demand in 2022, primarily in commercial and financial, construction, farmland mortgages, 1 to 4 family first mortgages and multi-family mortgages. The lingering supply chain and labor market disruptions, as well as significant inflationary pressures have created significant uncertainty regarding projecting loan demand throughout the remainder of 2022. However, outstanding loan commitments continue to be significantly elevated compared to historical levels.

The following table sets forth the composition of the loan portfolio as of September 30, 2022 and December 31, 2021:

 September 30, 2022December 31, 2021
 AmountPercentAmountPercent
 (Amounts In Thousands)(Amounts In Thousands)
Agricultural$98,555 3.35 %$106,933 4.02 %
Commercial and financial248,179 8.42 222,002 8.35 
Real estate:  
Construction, 1 to 4 family residential89,379 3.03 80,486 3.03 
Construction, land development and commercial165,431 5.62 127,021 4.77 
Mortgage, farmland248,103 8.42 232,744 8.75 
Mortgage, 1 to 4 family first liens1,060,888 36.01 909,564 34.19 
Mortgage, 1 to 4 family junior liens118,326 4.02 114,342 4.30 
Mortgage, multi-family435,666 14.79 382,792 14.39 
Mortgage, commercial397,048 13.47 401,377 15.09 
Loans to individuals35,355 1.20 32,687 1.23 
Obligations of state and political subdivisions49,191 1.67 50,285 1.88 
 $2,946,121 100.00 %$2,660,233 100.00 %
Net unamortized fees and costs274  299  
 $2,946,395  $2,660,532  
Less allowance for credit losses38,980  35,470  
 $2,907,415  $2,625,062  

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.

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In accordance with Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues, and Staff Accounting Bulletin No. 119, which aligns the staff's guidance with FASB ASC Topic 326, or CECL, 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 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 specific reserves and/or charge-offs are appropriate and to begin a workout plan for the loan to minimize actual losses.

The following table presents the allowance for credit losses as of September 30, 2022 and December 31, 2021 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:
 
 September 30, 2022December 31, 2021
 Amount% of Total
Allowance
% of Loans to
Total Loans
Amount% of Total
Allowance
% of Loans to
Total Loans
 (In Thousands)(In Thousands)
Agricultural$2,470 6.34 %3.35 %$2,261 6.37 %4.02 %
Commercial and financial5,196 13.33 8.42 4,269 12.04 8.35 
Real estate:   
Construction, 1 to 4 family residential991 2.54 3.03 818 2.31 3.03 
Construction, land development and commercial2,473 6.34 5.62 1,482 4.18 4.77 
Mortgage, farmland2,862 7.34 8.42 3,433 9.68 8.75 
Mortgage, 1 to 4 family first liens9,873 25.34 36.01 8,340 23.52 34.19 
Mortgage, 1 to 4 family junior liens2,912 7.47 4.02 3,158 8.90 4.30 
Mortgage, multi-family4,429 11.36 14.79 3,715 10.47 14.39 
Mortgage, commercial6,485 16.64 13.47 6,783 19.12 15.09 
Loans to individuals840 2.15 1.20 771 2.17 1.23 
Obligations of state and political subdivisions449 1.15 1.67 440 1.24 1.88 
 $38,980 100.00 %100.00 %$35,470 100.00 %100.00 %

The allowance for credit losses (ACL) totaled $38.98 million at September 30, 2022 compared to the allowance of $35.47 million at December 31, 2021. The percentage of the allowance to outstanding loans was 1.32% and 1.33% at September 30, 2022 and December 31, 2021, 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 changes in the ACL in 2022 compared to December 31, 2021 is the result of the following factors: improvements in the economic factor forecasts, primarily Iowa unemployment, used in the ACL calculation which resulted in a decrease of $1.09 million; increase in loan volume which resulted in an increase of $3.34 million; changes in prepayment and curtailment
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rates and loss driver analysis resulting in an increase of $0.35 million; increase in the individually analyzed loans reserve of $0.34 million; and changes in qualitative factors determined necessary by management which resulted in an increase of $0.57 million.

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 credit 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 credit losses was adequate at September 30, 2022, 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 credit 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 credit losses is reviewed and compared to industry data. This review encompasses levels of total collateral-dependent loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.

Investment securities available for sale held by the Company increased by $196.20 million from December 31, 2021 to September 30, 2022.  The fair value of securities available for sale was $67.26 million less than the amortized cost of such securities as of September 30, 2022.  At December 31, 2021, the fair value of the securities available for sale was $1.97 million more than the amortized cost of such securities.

Deposits decreased $18.23 million in the first nine months of 2022 primarily due to decreases in brokered deposits and insured cash sweep (ICS) deposits. In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Brokered deposits are included in total deposits and totaled $31.67 million as of September 30, 2022 with an average rate of 1.97%.  Brokered deposits were $51.59 million as of December 31, 2021 with an average interest rate of 0.36%. As of September 30, 2022 and December 31, 2021, brokered deposits were 0.90% and 1.46% of total deposits, respectively.

There were no Federal Home Loan Bank (FHLB) borrowings as of September 30, 2022 and December 31, 2021.

Dividends and Equity

In January 2022, Hills Bancorporation paid a dividend of $9.31 million or $1.00 per share.  The dividend paid in January 2021 was $0.94 per share. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of September 30, 2022 totaled $409.06 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. The Bank elected to use the Community Bank Leverage Ratio (CBLR) framework as provided for in the Economic Growth, Regulatory Relief and Consumer Protection Act. Under the CBLR framework, the Bank is required to maintain a CBLR of greater than 9%. The CARES Act reduced the minimum ratio to 8% beginning in the 2nd quarter of 2020 through December 31, 2020, increasing to 8.5% for 2021 and returning to 9% beginning January 1, 2022. As of September 30, 2022 and December 31, 2021, the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements. The actual amounts and capital ratios as of September 30, 2022 and December 31, 2021 are presented below (amounts in thousands):
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 ActualFor Capital Adequacy Purposes
 AmountRatioRatio
As of September 30, 2022:
Company:
Community Bank Leverage ratio$508,533 12.84 %9.000 %
Bank:   
Community Bank Leverage ratio510,806 12.91 9.000 



 ActualFor Capital Adequacy Purposes
 AmountRatioRatio
As of December 31, 2021:
Company:
Community Bank Leverage ratio$484,486 11.80 %8.50 %
Bank:   
Community Bank Leverage ratio484,429 11.80 8.50 



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Discussion of operations for the nine months ended September 30, 2022 and 2021

Net Income Overview
Total net income was $35.72 million in 2022 and $41.93 million in the comparable period in 2021, a decrease of $6.21 million or 14.82%.  The change in net income in 2022 from the first nine months of 2021 was primarily the result of the following:

Net interest income increased by $4.73 million, before credit loss expense.
For the nine months ended September 30, 2022, a credit loss expense was $3.27 million. This represents an increase in expense of $7.83 million from the reversal of credit loss reserves of $4.56 million for the nine months ended September 30, 2021.
Noninterest income decreased by $4.29 million.
Noninterest expenses decreased by $0.56 million.
Income tax expense decreased by $1.74 million.
For the nine month period ended September 30, 2022 and September 30, 2021 basic earnings per share was $3.85 and $4.50, respectively. Diluted earnings per share was $3.85 for the nine months ended September 30, 2022 compared to $4.50 for the same period in 2021.

The Company’s net income for the period was driven primarily by three factors.  The first factor is credit loss expense recorded under CECL. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $2.910 billion at September 30, 2022. Credit loss expense was $3.27 million in 2022 compared to a reduction of expense of $4.56 million in 2021. The increase in expense when compared to the same period in 2021 is attributable to increases in outstanding loan commitments, loan volume, lower prepayment and curtailment rates with the increasing interest rates and qualitative factor increases determined by management. The reduction in expense in 2021 was primarily due to the increases to the allowance taken in 2020 in response to the COVID-19 pandemic that were released in 2021. The Company believes that credit loss expense is expected to be dependent on the Company’s loan growth, local economic conditions and asset quality.

The second factor affecting the Company’s net income is the interaction between changes in net interest margin and changes in average volumes of the Bank's earnings assets.  Net interest income of $84.19 million for the first nine months of 2022 was derived from the Company’s $3.924 billion of average earning assets during that period and its tax-equivalent net interest margin of 2.92%.  Average earning assets in the nine months ended September 30, 2021 were $3.823 billion and the tax-equivalent net interest margin was 2.83%. Net interest income for the Company increased primarily as a result of interest income on increased loan volume as well as lower interest expense from lower certificate of deposits volume and no FHLB borrowings. Also, interest income on investment securities was higher due to increased volume of U.S. Treasuries, mortgage-backed securities and municipal securities though this was offset by no PPP fee income in 2022 compared to 2021. The Company expects net interest compression to impact earnings for the foreseeable future due to competition for loans and deposits. The Company believes growth in net interest income will be contingent on the growth of the Company’s earning assets, increasing yield on loans and the continued interest rate increases by the Federal Reserve Board.

The third factor affecting the Company’s net income is noninterest income, primarily the decrease in net gain on the sale of loans. The net gain on the sale of loans was $1.38 million and $6.24 million for the nine months ended September 30, 2022 and 2021, respectively, a decrease of 77.94% for the nine months ended September 30, 2022 compared to the same period in 2021. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates as well as the current origination and refinancing activity. The volume has been significantly impacted by the Federal Reserve Board's increases to the federal funds rate so far in 2022, resulting in a significant decline in the amount of mortgage loan origination and refinance activity.











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Discussion of operations for the nine months ended September 30, 2022 and 2021

Net Interest Income

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. Net interest income on a tax equivalent basis increased $4.76 million for the nine months ended September 30, 2022 compared to the comparable period in 2021.  The increase was primarily attributable to lower interest expense from lower time deposits volume and no FHLB borrowings. Also, interest income on taxable and nontaxable securities was higher due to increased volume of U.S. Treasuries, mortgage-backed securities and municipal securities and higher rates earned on excess cash. There was no PPP fee income recorded in loan interest income in 2022 compared to $5.48 million for the comparable period in 2021. The net interest margin for the first nine months of 2022 was 2.92% compared to 2.83% in 2021 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 21% to make the interest earned on taxable and non-taxable assets more comparable.  The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the nine months ended in 2022 compared to the comparable period in 2021 are shown in the following table:
 Increase (Decrease) in Net Interest Income
 Change in
Average Balance
Change in
Average Rate
Volume ChangesRate ChangesNet Change
 (Amounts in Thousands)
Interest income:
Loans, net$67,793 (0.32)%$1,717 $(5,921)$(4,204)
Taxable securities266,077 0.13 3,012 479 3,491 
Nontaxable securities26,081 (0.14)458 (249)209 
Interest-bearing bank balances(258,601)0.61 (236)2,086 1,850 
 $101,350  $4,951 $(3,605)$1,346 
Interest expense:     
Interest-bearing demand deposits$76,593 0.04 %$(134)$(265)$(399)
Savings deposits108,376 0.03 (103)(290)(393)
Time deposits(85,899)(0.21)1,073 881 1,954 
FHLB borrowings(105,000)(2.82)2,248 — 2,248 
Interest-bearing other liabilities21 0.98 — — — 
 $(5,909) $3,084 $326 $3,410 
Change in net interest income  $8,035 $(3,279)$4,756 

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. 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)20222021
Yield on average interest-earning assets3.27 %3.30 %
Rate on average interest-bearing liabilities0.48 0.63 
Net interest spread2.79 %2.67 %
Effect of noninterest-bearing funds0.13 0.16 
Net interest margin (tax equivalent net interest income divided by average interest-earning assets)2.92 %2.83 %


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Discussion of operations for the nine months ended September 30, 2022 and 2021

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates.  The Federal Open Market Committee met six times during the first nine months of 2022.  The federal funds target rate increased to 3.25% as of September 30, 2022 from 0.25% as of the same period in 2021.  Interest rates on loans are generally affected by the federal funds target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate.  As of September 30, 2022, the rate indexes for the one, three and five year indexes were 4.05%, 4.25% and 4.06%, respectively.  The one year index increased 4,400% from 0.09% at September 30, 2021, the three year index increased 701.89% and the five year index increased 314.29%.  The three year index was 0.53% and the five year index was 0.98% at September 30, 2021. 

Credit Loss Expense

Credit loss expense was $3.27 million for the nine months ended September 30, 2022 compared to a reduction of expense of $4.56 million in 2021, an increase of expense of $7.83 million.  Credit loss expense is the amount necessary to adjust the allowance for credit losses to the level considered by management to appropriately account for the estimated current expected credit losses within the Bank's loan portfolio. The allowance for credit losses totaled $38.98 million at September 30, 2022 compared to $35.59 million as of September 30, 2021. The allowance represented 1.32% and 1.34% of loans held for investment at September 30, 2022 and 2021, respectively.

A significant component in estimating expected credit losses are economic forecasts such as Iowa unemployment, all-transactions house price index for Iowa and Iowa real gross domestic product. The increase in expense when compared to the same period in 2021 is attributable to increases in outstanding loan commitments, loan volume, lower prepayment and curtailment rates with the increasing interest rates and qualitative factor increases determined by management. The reduction in the allowance for credit losses in 2021 was primarily due to the increases to the allowance taken in 2020 in response to the COVID-19 pandemic that were released in 2021.

The allowance for credit losses balance is impacted by charge-offs, net of recoveries, for the periods presented.  For the nine months ended September 30, 2022 and 2021, recoveries were $1.70 million and $2.19 million, respectively; and charge-offs were $1.19 million in 2022 and $0.86 million in 2021.  The allowance for credit losses totaled $38.98 million at September 30, 2022 compared to $35.47 million as of December 31, 2021.  The allowance represented 1.32% and 1.33% of loans held for investment at September 30, 2022 and December 31, 2021.

Noninterest Income

The following table sets forth the various categories of noninterest income for the nine months ended September 30, 2022 and 2021.
 Nine Months Ended September 30,
 20222021$ Change% Change
 (Amounts in thousands)
Net gain on sale of loans$1,377 $6,243 $(4,866)(77.94)%
Trust fees9,338 9,645 (307)(3.18)
Service charges and fees9,444 8,729 715 8.19 
Other noninterest income814 647 167 25.81 
 $20,973 $25,264 $(4,291)(16.98)


In the nine months ended September 30, 2022 and 2021, the net gain on sale of loans was $1.38 million and $6.24 million, respectively.  The amount of the net gain on sale of secondary market mortgage loans in each period can vary significantly.  The volume of activity, margin and demand in these types of loans is directly related to the changes in interest rates and new originations and refinancing activity. The primary reason for the decrease in 2022 compared to 2021 is the increased mortgage interest rates in 2022 leading to the significant decrease in loans originated for sale. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income.
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Service charges and fees increased $0.72 million for the nine months ended September 30, 2022 compared to the same period in 2021, primarily due to increased debit and credit card interchange fees from increased volume of transactions.

Other noninterest income categories experienced marginal period-to-period fluctuations for the nine months ended September 30, 2022.

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the nine months ended September 30, 2022 and 2021.
 Nine Months Ended September 30,
 20222021$ Change% Change
 (Amounts in thousands)
Salaries and employee benefits$31,990 $31,484 $506 1.61 %
Occupancy3,265 3,135 130 4.15 
Furniture and equipment5,150 5,523 (373)(6.75)
Office supplies and postage1,377 1,268 109 8.60 
Advertising and business development1,874 1,480 394 26.62 
Outside services9,407 9,781 (374)(3.82)
FDIC insurance assessment815 777 38 4.89 
Other noninterest expense1,802 1,668 134 8.03 
 $55,680 $55,116 $564 1.02 

All noninterest expense categories experienced marginal period-to-period fluctuations for the nine months ended September 30, 2022.

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Discussion of operations for the three months ended September 30, 2022 and 2021

Net Income Overview

Net income increased $0.62 million for the three months ended September 30, 2022 compared to the same period in 2021.  Total net income was $13.74 million in 2022 and $13.13 million in the comparable period in 2021, an increase of 4.69%.  For the three month periods ended September 30, 2022 and 2021 basic earnings per share was $1.48 and $1.41, respectively. Diluted earnings per share was $1.48 for the three months ended September 30, 2022 compared to $1.41 for the same period in 2021.

Net Interest Income

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. Net interest income on a tax equivalent basis increased $3.31 million for the three months ended September 30, 2022 compared to the comparable period in 2021. The increase was a result of higher loan volume and interest income on taxable and nontaxable securities due to increased volume of U.S. Treasuries, mortgage-backed securities and municipal securities and rate earned on excess cash. The increase is also attributable to lower interest expense from lower time deposits volume and no FHLB borrowings. This is offset by higher interest expense attributable to higher rates on interest-bearing demand and savings deposits. The net interest margin for the three months ended September 30, 2022 was 3.15% compared to 2.82% in 2021 for the same period.  The measure is shown on a tax-equivalent basis using a tax rate of 21% to make the interest earned on taxable and non-taxable assets more comparable.  The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2022 compared to the comparable period in 2021 are shown in the following table:

 Increase (Decrease) in Net Interest Income
 Change in
Average Balance
Change in
Average Rate
Volume ChangesRate ChangesNet Change
 (Amounts in Thousands)
Interest income:
Loans, net$187,486 (0.23)%$2,012 $(1,548)$464 
Taxable securities314,410 0.34 1,108 495 1,603 
Nontaxable securities13,659 0.02 79 19 98 
Interest-bearing bank balances(510,827)2.11 (196)1,273 1,077 
 $4,728  $3,003 $239 $3,242 
Interest expense:     
Interest-bearing demand deposits$11,338 0.21 %$(6)$(571)$(577)
Savings deposits48,829 0.14 (6)(441)(447)
Time deposits(61,584)(0.07)241 93 334 
FHLB borrowings(105,000)(2.82)758 — 758 
Interest-bearing other liabilities30 2.16 — — — 
 $(106,387)$987 $(919)$68 
Change in net interest income  $3,990 $(680)$3,310 

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. Interest on nontaxable securities and loans is shown on a tax-equivalent basis.






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Discussion of operations for the three months ended September 30, 2022 and 2021

A summary of the net interest spread and margin is as follows:
(Tax Equivalent Basis)20222021
Yield on average interest-earning assets3.53 %3.24 %
Rate on average interest-bearing liabilities0.58 0.57 
Net interest spread2.95 %2.67 %
Effect of noninterest-bearing funds0.20 0.15 
Net interest margin (tax equivalent net interest income divided by average interest-earning assets)3.15 %2.82 %

Credit Loss Expense

Credit loss expense was a reduction of expense of $0.34 million for the three months ended September 30, 2022 compared to expense of $0.08 million in 2021, a decrease of expense of $0.42 million. The decrease in credit loss expense when compared to the same period in 2021 is primarily attributable to improvements in economic forecasts for Iowa unemployment. Credit loss expense is the amount necessary to adjust the allowance for credit losses to the level considered by management to appropriately account for the estimated current expected credit losses within the Bank's loan portfolio. A significant component in estimating expected credit losses are economic forecasts such as Iowa unemployment, all-transactions house price index for Iowa and Iowa real gross domestic product.

The allowance for credit losses balance is impacted by charge-offs, net of recoveries, for the periods presented.  For the three months ended September 30, 2022 and 2021, recoveries were $0.47 million and $0.65 million, respectively; and charge-offs were $0.40 million in 2022 and $0.59 million in 2021. 

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended September 30, 2022 and 2021.
 Three Months Ended September 30,
 20222021$ Change% Change
 (Amounts in thousands)
Net gain on sale of loans$240 $1,512 $(1,272)(84.13)%
Trust fees2,859 3,568 (709)(19.87)
Service charges and fees3,282 3,075 207 6.73 
Other noninterest income164 89 75 84.27 
 $6,545 $8,244 $(1,699)(20.61)

In the three months ended September 30, 2022 and 2021, the net gain on sale of loans was $0.24 million and $1.51 million, respectively.  The amount of the net gain on sale of secondary market mortgage loans in each period can vary significantly.  The volume of activity is directly related to changes in interest rates and new originations and refinancing activity. The primary reason for the decrease in 2022 compared to 2021 is the increased mortgage interest rates in 2022 leading to the significant decrease in loans originated for sale. 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. Trust fees decreased $0.70 million to $2.86 million for the quarter ended September 30, 2022 compared to the same period in 2021 due to the decrease in assets under management of $0.327 billion from $2.429 billion as of September 30, 2021 to $2.102 billion as of September 30, 2022. Other noninterest income categories experienced marginal period-to-period fluctuations for the three months ended September 30, 2022.




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Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended September 30, 2022 and 2021.

 Three Months Ended
September 30,
 20222021$ Change% Change
 (Amounts in thousands)
Salaries and employee benefits$10,818 $10,281 $537 5.22 %
Occupancy1,024 955 69 7.23 
Furniture and equipment1,770 1,652 118 7.14 
Office supplies and postage425 428 (3)(0.70)
Advertising and business development586 496 90 18.15 
Outside services3,491 3,496 (5)(0.14)
FDIC insurance assessment267 267 — — 
Other noninterest expense650 623 27 4.33 
 $19,031 $18,198 $833 4.58 

All noninterest expense categories experienced marginal period-to-period fluctuations for the three months ended September 30, 2022 and 2021.

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Income Taxes

Federal and state income tax expenses were $10.49 million and $12.23 million for the nine months ended September 30, 2022 and 2021, respectively. Income taxes as a percentage of income before taxes were 22.70% in 2022 and 22.58% in 2021. Federal and state income tax expenses were $4.43 million and $3.86 million for the three months ended September 30, 2022 and 2021, respectively. Income taxes as a percentage of income before taxes were 24.36% in 2022 and 22.74% in 2021. In the quarter ended September 30, 2022, the Company's income tax expense included a one-time increase in state income tax expense related to the 2022 enactment of changes in the Iowa bank franchise tax rates. This legislation reduces the Iowa bank franchise tax rate applied to apportioned income for 2023 and future years and required the Company to reduce net deferred tax assets and caused the one-time increase in tax expense for the three months ended September 30, 2022.

Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet 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 18.69% of the Company’s total assets at September 30, 2022 compared to 13.63% at December 31, 2021.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position.  As of September 30, 2022, the Company had no outstanding borrowings 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 $966.77 million at September 30, 2022.

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 $570.81 million.  The borrowings under these credit lines would be secured by the Bank’s investment securities.  The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at September 30, 2022.

As of September 30, 2022, investment securities with a carrying value of $9.02 million were pledged to collateralize public and trust deposits and other borrowings.  As of December 31, 2021, investment securities with a carrying value of $10.03 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, 2021.
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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 curves 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.

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 since December 31, 2021. Our earnings and cash flows are largely dependent upon our net interest income. Interest rates are highly sensitive to many factors that are beyond our control, including domestic and local economic conditions and the policies of various governmental and regulatory agencies and, in particular, the Federal Reserve. The FOMC, with particular attention being given to ongoing supply chain disruptions, rising energy and commodity prices and the global economic impact of the Russia-Ukraine conflict, has signaled that additional increases may be appropriate if inflation pressures remain elevated or intensify. Further increases to prevailing interest rates could influence the interest we receive on loans and investments and the amount of interest we pay on deposits and borrowings. Moreover, additional and aggressive increases to the target range for the federal funds rate, combined with ongoing geopolitical instability, raise the risk of economic recession. Any such downturn, especially in the regions in which we operate, may adversely affect our asset quality, deposit levels, loan demand and results of operations.
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 Principal Executive Officer and Interim Principal Accounting Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Based upon that evaluation, the Company’s Principal Executive Officer and Interim Principal Accounting Officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange
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Commission.  There have been no changes in the Company’s internal controls over financial reporting during the nine months ended September 30, 2022 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.


HILLS BANCORPORATION
PART II - OTHER INFORMATION
Item 1.Legal Proceedings

None.

Item 1A.Risk Factors
 
Except as otherwise noted below, there have been no material changes in the Company’s risk factors from those disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021.

Economic and Market Risks

Global Economic and Geopolitical Instability and Inflationary Risks

Instability in global economic conditions and geopolitical matters, as well as volatility in financial markets, could have a material adverse effect on the Company’s results of operations and financial condition. The macroeconomic environment in the United States is susceptible to global events and volatility in financial markets. For example, global demand for products continues to exceed supply during the economic recovery from the COVID-19 pandemic, creating significant inflationary pressures which, in turn, may adversely impact regional and global economic conditions, as well as the Company’s financial condition and results of operations.

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Item 2.Unregistered Sales of Equity Securities and Use of Proceeds
 
The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended September 30, 2022:

PeriodTotal number of shares
purchased
Average price paid per
share
Total number of
shares purchased
as part of publicly
announced plans
or programs
Maximum number
of shares that may
yet be purchased
under the plans
or programs (1)
July 1 to July 313,457 $71.00 3,457 30,613 
August 1 to August 31828 71.34 828 779,785 
September 1 to September 303,256 72.00 3,256 776,529 
Total7,541 $71.47 7,541 776,529 
 
(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”).  On August 9, 2022, the Company’s Board of Directors authorized the expansion of the 2005 Stock Repurchase Program to allow an additional 750,000 shares for repurchase and the continuation through December 31, 2027. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis.  All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis.  The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors. 
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Item 3.Defaults upon Senior Securities
 
Hills Bancorporation has no senior securities.

Item 4.Mine Safety Disclosure
 
Not applicable.
Item 5.Other Information

None.

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Item 6.Exhibits

3.1
3.2
4.1
31
32
101.INSXBRL Instance Document (1), (2)
101.SCHXBRL Taxonomy Extension Schema Document (1)
101.CALXBRL Taxonomy Extension Calculation Linkbase Document (1)
101.DEFXBRL Taxonomy Extension Definition Linkbase Document (1)
101.LABXBRL Taxonomy Extension Label Linkbase Document (1)
101.PREXBRL Taxonomy Extension Presentation Linkbase Document (1)
(1)Users of this data are advised that, pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934, and are otherwise not subject to liability under these sections.
(2)The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document.
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SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

  HILLS BANCORPORATION
   
Date:November 4, 2022 By:  /s/ Dwight O. Seegmiller
  Dwight O. Seegmiller, Director, President and Chief Executive Officer
   
Date:November 4, 2022 By:  /s/ Jason Weeks
  Jason Weeks, Interim Treasurer and Interim Principal Accounting Officer

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