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, 2017~~March 31, 2019

Commission file number: 0-12668

Hills Bancorporation



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

131 MAIN STREET, HILLS, IOWA 52235

Telephone number: (319) 679-2291

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

þ Yes o No

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

þ Yes o No

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



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

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

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

o Yes þ No

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



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

Index

APPLICABLE ONLY TO CORPORATE ISSUERS:

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



	SHARES OUTSTANDING
CLASS	~~October 31, 2017~~April 30, 2019

Common Stock, no par value	~~9,339,712~~9,351,299

Index

HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION



		Page
		Number

Item 1.	Financial Statements

	Consolidated balance sheets, ~~September 30, 2017~~March 31, 2019 (unaudited) and December 31, ~~2016~~2018	4
	Consolidated statements of income (unaudited) for three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018	5
	Consolidated statements of comprehensive income (unaudited) for three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018	6
	Consolidated statements of stockholders' equity (unaudited) for ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018	7
	Consolidated statements of cash flows (unaudited) for ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018	8
	Notes to consolidated financial statements (condensed)	10

Item 2.	Management Discussion and Analysis of Financial Condition and Results of Operations	3740

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	52

Item 4.	Controls and Procedures	53

	Part II
	OTHER INFORMATION

Item 1.	Legal proceedings	5453

Item 1A.	Risk factors	5453

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

Item 3.	Defaults upon senior securities	54

Item 4.	Mine safety disclosures	54

Item 5.	Other information	54

Item 6.	Exhibits	55

	Signatures	56

	Exhibits Index	57

Index

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


	September 30, 2017			December 31, 2016			March 31, 2019			December 31, 2018
ASSETS	(Unaudited)			December 31, 2016			(Unaudited)			December 31, 2018
Cash and cash equivalents	$	36,792		$	38,197		$	200,476		$	43,305
Investment securities available for sale at fair value (amortized cost September 30, 2017 $253,689; December 31, 2016 $269,039)	254,984			267,537
Investment securities available for sale at fair value (amortized cost March 31, 2019 $323,358 December 31, 2018 $321,660)							323,917			318,926
Stock of Federal Home Loan Bank	16,126			12,413			12,266			12,172
Loans held for sale	6,717			9,806			5,267			1,984
Loans, net of allowance for loan losses (September 30, 2017 $29,350; December 31, 2016 $26,530)	2,391,430			2,251,445
Loans, net of allowance for loan losses (March 31, 2019 $36,520; December 31, 2018 $37,810)							2,607,488			2,591,085
Property and equipment, net	37,799			37,859			36,631			37,051
Tax credit real estate investment	10,016			10,563			8,931			9,193
Accrued interest receivable	11,484			9,121			13,970			11,784
Deferred income taxes, net	12,871			12,611			9,669			10,869
Other real estate	144			237
Goodwill	2,500			2,500			2,500			2,500
Other assets	2,906			3,481			6,750			3,595
Total Assets	$	2,783,769		$	2,655,770		$	3,227,865		$	3,042,464

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities
Noninterest-bearing deposits	$	349,883		$	348,505		$	363,142		$	372,152
Interest-bearing deposits	1,723,159			1,687,807			2,233,750			2,048,972
Total deposits	$	2,073,042		$	2,036,312		$	2,596,892		$	2,421,124
Other borrowings	13,761			33,489
Federal Home Loan Bank borrowings	323,000			235,000			215,000			215,000
Accrued interest payable	1,079			984			2,051			1,812
Other liabilities	20,850			19,934			23,291			20,776
Total Liabilities	$	2,431,732		$	2,325,719		$	2,837,234		$	2,658,712

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	42,471		$	40,781		$	49,851		$	48,870

STOCKHOLDERS' EQUITY
Common stock, no par value; authorized 20,000,000 shares; issued September 30, 2017 10,318,906 shares; December 31, 2016 10,227,178 shares	$	—		$	—
Common stock, no par value; authorized 20,000,000 shares; issued March 31, 2019 10,326,417 shares; December 31, 2018 10,325,191 shares							$	—		$	—
Paid in capital	49,194			44,606			55,295			52,122
Retained earnings	337,380			319,982			375,394			371,848
Accumulated other comprehensive loss	(1,339		)	(3,359		)	(1,001		)	(3,250		)
Treasury stock at cost (September 30, 2017 1,000,774 shares; December 31, 2016 962,951 shares)	(33,198		)	(31,178		)
Treasury stock at cost (March 31, 2019 974,357 shares; December 31, 2018 988,750 shares)							(39,057		)	(36,968		)
Total Stockholders' Equity	$	352,037		$	330,051		$	390,631		$	383,752
Less maximum cash obligation related to ESOP shares	42,471			40,781			49,851			48,870
Total Stockholders' Equity Less Maximum Cash Obligations Related to ESOP Shares	$	309,566		$	289,270
Total Stockholders' Equity Less Maximum Cash Obligation Related to ESOP Shares							$	340,780		$	334,882
Total Liabilities & Stockholders' Equity	$	2,783,769		$	2,655,770		$	3,227,865		$	3,042,464

See Notes to Consolidated Financial Statements.

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Amounts In Thousands, Except Per Share Amounts)


	Three Months Ended September 30,					Nine Months Ended September 30,					Three Months Ended March 31,
	2017		2016			2017		2016			2019			2018
Interest income:
Loans, including fees	$	25,643	$	23,626		$	74,378	$	68,974		$	29,573		$	26,028
Investment securities:
Taxable	437		362			1,237		1,080			758			563
Nontaxable	783		786			2,425		2,414			1,025			889
Federal funds sold	9		6			145		124			491			551
Total interest income	$	26,872	$	24,780		$	78,185	$	72,592		$	31,847		$	28,031
Interest expense:
Deposits	$	2,319	$	1,917		$	6,730	$	5,742		$	6,499		$	3,864
Short-term borrowings	100		70			149		127
FHLB borrowings	2,233		1,935			5,938		6,224			1,575			1,874
Total interest expense	$	4,652	$	3,922		$	12,817	$	12,093		$	8,074		$	5,738
Net interest income	$	22,220	$	20,858		$	65,368	$	60,499		$	23,773		$	22,293
Provision for loan losses	130		(1,832		)	1,827		(2,004		)	(1,246		)	(765		)
Net interest income after provision for loan losses	$	22,090	$	22,690		$	63,541	$	62,503		$	25,019		$	23,058
Noninterest income:
Net gain on sale of loans	$	423	$	602		$	1,119	$	1,437		$	286		$	331
Trust fees	1,980		1,731			5,883		5,185			2,252			2,641
Service charges and fees	2,197		2,243			6,557		6,516			2,275			2,228
Net gain on sale of other real estate owned and other repossessed assets	33		342			89		376
Other noninterest income	372		396			1,599		1,541			437			428
	$	5,005	$	5,314		$	15,247	$	15,055		$	5,250		$	5,628

Noninterest expenses:
Salaries and employee benefits	$	8,134	$	8,158		$	24,707	$	22,617		$	8,722		$	8,284
Occupancy	1,087		1,017			3,148		3,001			1,186			1,101
Furniture and equipment	1,491		1,350			4,356		4,111			1,673			1,474
Office supplies and postage	516		436			1,487		1,282			459			434
Advertising and business development	628		800			2,123		2,426			638			630
Outside services	2,077		1,845			5,943		5,386			2,572			2,578
FDIC insurance assessment	217		315			636		938			209			218
Other noninterest expense	671		510			2,033		1,585			590			537
	$	14,821	$	14,431		$	44,433	$	41,346		$	16,049		$	15,256
Income before income taxes	$	12,274	$	13,573		$	34,355	$	36,212		$	14,220		$	13,430
Income taxes	3,722		4,397			10,472		11,369			3,017			2,572
Net income	$	8,552	$	9,176		$	23,883	$	24,843		$	11,203		$	10,858

Earnings per share:
Basic	$	0.92	$	0.99		$	2.56	$	2.67		$	1.20		$	1.16
Diluted	$	0.92	$	0.99		$	2.56	$	2.67		$	1.20		$	1.16

See Notes to Consolidated Financial Statements.

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited) (Amounts In Thousands)


	Three Months Ended September 30,						Nine Months Ended September 30,						Three Months Ended March 31,
	2017			2016			2017			2016			2019			2018
Net income	$	8,552		$	9,176		$	23,883		$	24,843		$	11,203		$	10,858

Other comprehensive income (loss)
Securities:
Net change in unrealized (loss) gain on securities available for sale	$	(302	)	$	(1,090	)	$	2,797		$	1,104
Net change in unrealized income (loss) on securities available for sale													$	3,293		$	(2,257	)
Reclassification adjustment for net gains realized in net income	—			—			—			—			—			—
Income taxes	116			417			(1,070		)	(423		)	(821		)	563
Other comprehensive (loss) income on securities available for sale	$	(186	)	$	(673	)	$	1,727		$	681
Other comprehensive income (loss) on securities available for sale													$	2,472		$	(1,694	)
Derivatives used in cash flow hedging relationships:
Net change in unrealized gain (loss) on derivatives	$	259		$	500		$	474		$	(1,931	)
Net change in unrealized (loss) income on derivatives													$	(298	)	$	1,054
Income taxes	(99		)	(192		)	(181		)	738			75			(263		)
Other comprehensive income (loss) on cash flow hedges	$	160		$	308		$	293		$	(1,193	)
Other comprehensive (loss) income on cash flow hedges													$	(223	)	$	791

Other comprehensive (loss) income, net of tax	$	(26	)	$	(365	)	$	2,020		$	(512	)
Other comprehensive income (loss), net of tax													$	2,249		$	(903	)

Comprehensive income	$	8,526		$	8,811		$	25,903		$	24,331		$	13,452		$	9,955

See Notes to Consolidated Financial Statements.

Index

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

Paid In Capital Retained Earnings
Accumulated Other
Comprehensive
Income (Loss)
Treasury Stock
Maximum Cash
Obligation Related
To ESOP Shares
Total
Balance, December 31, 2015 $ 43,697
$ 294,487
$ (1,195 ) $ (27,252 ) $ (37,562 ) $ 272,175
Issuance of 7,646 shares of common stock 348
—
—
—
—
348
Issuance of 3,482 shares of common stock under the employee stock purchase plan 154
—
—
—
—
154
Unearned restricted stock compensation 112
—
—
—
—
112
Forfeiture of 1,264 shares of common stock (52 ) —
—
—
—
(52 )
Share-based compensation 22
—
—
—
—
22
Income tax benefit related to share-based compensation 64
—
—
—
—
64
Change related to ESOP shares —
—
—
—
(2,220 ) (2,220 )
Net income —
24,843
—
—
—
24,843
Cash dividends ($0.65 per share) —
(6,060 ) —
—
—
(6,060 )
Purchase of 62,266 shares of common stock —
—
—
(2,819 ) —
(2,819 )
Other comprehensive loss —
—
(512 ) —
—
(512 )
Balance, September 30, 2016 $ 44,345
$ 313,270
$ (1,707 ) $ (30,071 ) $ (39,782 ) $ 286,055

Balance, December 31, 2016 $ 44,606
$ 319,982
$ (3,359 ) $ (31,178 ) $ (40,781 ) $ 289,270
Issuance of 92,621 shares of common stock 4,208
—
—
55
—
4,263
Issuance of 4,483 shares of common stock under the employee stock purchase plan 210
—
—
—
—
210
Unearned restricted stock compensation 277
—
—
—
—
277
Forfeiture of 2,934 shares of common stock (118 ) —
—
—
—
(118 )
Share-based compensation 11
—
—
—
—
11
Change related to ESOP shares —
—
—
—
(1,690 ) (1,690 )
Net income —
23,883
—
—
—
23,883
Cash dividends ($0.70 per share) —
(6,485 ) —
—
—
(6,485 )
Purchase of 40,265 shares of common stock —
—
—
(2,075 ) —
(2,075 )
Other comprehensive income —
—
2,020
—
—
2,020
Balance, September 30, 2017 $ 49,194
$ 337,380
$ (1,339 ) $ (33,198 ) $ (42,471 ) $ 309,566



	Paid In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Treasury Stock			Maximum Cash Obligation Related To ESOP Shares			Total
Balance, December 31, 2017	$	48,930		$	341,558		$	(2,446	)	$	(33,018	)	$	(43,308	)	$	311,716
Issuance of 88,943 shares of common stock	2,580			—			—			2,224			—			4,804
Issuance of 1,957 shares of common stock under the employee stock purchase plan	100			—			—			—			—			100
Unearned restricted stock compensation	118			—			—			—			—			118
Forfeiture of 208 shares of common stock	(8		)													(8		)
Change related to ESOP shares	—			—			—			—			(2,471		)	(2,471		)
Net income	—			10,858			—			—			—			10,858
Cash dividends ($0.75 per share)	—			(7,002		)	—			—			—			(7,002		)
Reclassification of stranded tax effects due to the Tax Cuts and Jobs Act				526			(526		)							—
Purchase of 47,432 shares of common stock	—			—			—			(2,694		)	—			(2,694		)
Other comprehensive loss	—			—			(903		)	—			—			(903		)
Balance, March 31, 2018	$	51,720		$	345,940		$	(3,875	)	$	(33,488	)	$	(45,779	)	$	314,518

Balance, December 31, 2018	$	52,122		$	371,848		$	(3,250	)	$	(36,968	)	$	(48,870	)	$	334,882
Issuance of 84,164 shares of common stock	2,932			—			—			2,202			—			5,134
Issuance of 1,929 shares of common stock under the employee stock purchase plan	105			—			—			—			—			105
Unearned restricted stock compensation	170			—			—			—			—			170
Forfeiture of 703 shares of common stock	(34		)	—			—			—			—			(34		)
Change related to ESOP shares	—			—			—			—			(981		)	(981		)
Net income	—			11,203			—			—			—			11,203
Cash dividends ($0.82 per share)	—			(7,657		)	—			—			—			(7,657		)
Purchase of 69,771 shares of common stock	—			—			—			(4,291		)	—			(4,291		)
Other comprehensive income	—			—			2,249			—			—			2,249
Balance, March 31, 2019	$	55,295		$	375,394		$	(1,001	)	$	(39,057	)	$	(49,851	)	$	340,780

See Notes to Consolidated Financial Statements.

Index

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


	Nine Months Ended September 30,						Three Months Ended March 31,
	2017			2016			2019			2018
Cash Flows from Operating Activities
Net income	$	23,883		$	24,843		$	11,203		$	10,858
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation	2,270			2,182			847			821
Provision for loan losses	1,827			(2,004		)	(1,246		)	(765		)
Share-based compensation	11			22
Forfeiture of common stock	(118		)	(52		)	(34		)	(8		)
Compensation expensed through issuance of common stock	208			348			108			91
Excess tax benefits from share-based compensation	—			(64		)
Provision for deferred income taxes	(1,513		)	54			454			303
Net gain on sale of other real estate owned and other repossessed assets	(89		)	(376		)	(11		)	(2		)
Increase in accrued interest receivable	(2,363		)	(1,867		)	(2,186		)	(593		)
Amortization of premium on investment securities, net	437			452			100			134
Decrease in other assets	1,049			650
Increase (decrease) in accrued interest payable and other liabilities	1,288			(92		)
Decrease (increase) in other assets							426			(86		)
Decrease in accrued interest payable and other liabilities							(955		)	(1,465		)
Loans originated for sale	(109,522		)	(151,545		)	(29,847		)	(31,571		)
Proceeds on sales of loans	113,730			150,047			26,850			31,480
Net gain on sales of loans	(1,119		)	(1,437		)	(286		)	(331		)
Net cash and cash equivalents provided by operating activities	$	29,979		$	21,161		$	5,423		$	8,866

Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	48,937		$	46,148		$	10,251		$	10,711
Purchases of investment securities available for sale	(37,735		)	(31,456		)	(12,143		)	(25,856		)
Loans made to customers, net of collections	(141,994		)	(97,285		)	(15,208		)	7,953
Proceeds on sale of other real estate owned and other repossessed assets	364			764			62			2
Purchases of property and equipment	(2,210		)	(4,180		)	(427		)	(651		)
Income from tax credit real estate, net	547			545			262			390
Net cash and cash equivalents used in investing activities	$	(132,091	)	$	(85,464	)	$	(17,203	)	$	(7,451	)

Cash Flows from Financing Activities
Net increase in deposits	$	36,730		$	105,710		$	175,768		$	153,212
Net decrease in other borrowings	(19,728		)	(4,148		)
Net increase (decrease) in FHLB borrowings	88,000			(15,000		)
Net decrease in FHLB borrowings							—			(60,000		)
Issuance of common stock, net of costs	3,762			—			5,026			4,713
Stock options exercised	238			—
Excess tax benefits related to share-based compensation	—			64
Issuance of treasury stock	55			—
Purchase of treasury stock	(2,075		)	(2,819		)	(4,291		)	(2,694		)
Proceeds from the issuance of common stock through the employee stock purchase plan	210			154			105			100
Dividends paid	(6,485		)	(6,060		)	(7,657		)	(7,002		)
Net cash and cash equivalents provided by financing activities	$	100,707		$	77,901		$	168,951		$	88,329

(Continued)

Index

~~(Continued)~~

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)
	Nine Months Ended September 30,					Three Months Ended March 31,
	2017			2016		2019		2018
(Decrease) increase in cash and cash equivalents	$	(1,405	)	$	13,598
Increase in cash and cash equivalents						$	157,171	$	89,744
Cash and cash equivalents:
Beginning of period	38,197			35,427		43,305		154,353
End of period	$	36,792		$	49,025	$	200,476	$	244,097

Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	6,635		$	5,776	$	6,260	$	3,844
Interest paid on other obligations	6,087			6,351		1,575		1,874
Income taxes paid	10,530			10,201		—		—

Noncash activities:
Increase in maximum cash obligation related to ESOP shares	$	1,690		$	2,220	$	981	$	2,471
Transfers to other real estate owned	182			310		51		62
Sale and financing of other real estate owned	262			135
Right-of-use assets obtained in exchange for operating lease obligations						3,581		—

See Notes to Consolidated Financial Statements.

Index

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~~three month period ended ~~September 30, 2017~~March 31, 2019 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, ~~2017.~~2019. For further information, refer to the consolidated financial statements and footnotes thereto included in the Form 10-K Annual Report of Hills Bancorporation and subsidiary (the “Company”) for the year ended December 31, ~~2016~~2018 filed with the Securities Exchange Commission on March ~~3, 2017.~~5, 2019. The consolidated balance sheet as of December 31, ~~2016,~~2018, has been derived from the audited consolidated financial statements for that period.

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

Revenue Recognition

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

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

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

A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity's obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. As of March 31, 2019, the Company did not have any significant contract balances.

An entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered. The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission). The Company utilizes the practical expedient which allows entities to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less. The Company has not incurred or capitalized any contract acquisition costs as of March 31, 2019.

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Effect of New Financial Accounting Standards:

In May 2014, The FASB and International Accounting Standards Board (IASB) issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). The core principle of ASU 2014-09 is that a company should recognize revenue to depict the transfer of promised good or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. ~~For financial institutions, significant changes are not expected given that most financial instruments are not in the scope of the accounting standard update.~~ ASU 2014-09 is effective for annual periods and interim periods within those annual periods beginning after December 15, ~~2016. In August 2015, FASB issued ASU 2015-14 deferring the effective date for annual periods and interim periods within those annual periods after December 15,~~ 2017. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The Company has evaluated all of its noninterest income streams and contracts to determine potential impact. The adoption of ASU 2014-09 by the Company ~~will~~did not have a material ~~impact.~~impact on the recognition of revenue though did require additional disclosures on our material noninterest income streams discussed in revenue recognition above.

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 created Subtopic 321-10, Investments-Equity Securities which is applicable to all entities except those in industries that account for substantially all investments at fair value through earnings or the change in net assets. Under this new subtopic, equity securities are generally required to be measured at fair value with unrealized holding gains and losses reflected in net income. ASU 2016-01 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. The ~~adoption of~~Company adopted ASU 2016-01 byfor the ~~Company is not expected to have~~period ending March 31, 2018. There was no material impact on the financial statements however it required a ~~material impact.~~change in disclosure and related methodology located in Note 6 Fair Value Measurements.

In February 2016, the FASB issued ASU No. 2016-02 (Topic 842), Leases. The ASU provides guidance requiring lessees to recognize right-of-use (ROU) assets and lease liabilities for all leases other than those that meet the definition of short-term leases. For short-term leases, lessees may elect an accounting policy by class of underlying asset under which these assets and liabilities are not recognized and lease payments are generally recognized over the lease term on a straight-line basis. Under this new ASU, lessees will recognize right-of use assets and lease liabilities for most leases currently accounted for as operating leases under generally accepted accounting principles. For public companies, ASU 2016-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company isadopted the ASU on January 1, 2019 and used the alternative transition approach which permits the effects of adoption to be applied at the effective date. Consequently, financial information will not be updated and the disclosures required under the new standard will not be provided for dates and periods before January 1, 2019. The new standard provides a number of optional practical expedients in transition. We elected the ~~process~~'package of ~~analyzing a comprehensive list~~practical expedients', which permits us not to reassess under the new standard our prior conclusions about lease identification, lease classification and initial direct costs. We also elected the short-term lease exemption and combining the lease and nonlease components practical expedients. We did not elect the use-of-hindsight or the practical expedient pertaining to land easements; the latter not being applicable to us. The most significant impact upon adoption relates to the recognition of new ROU assets and lease ~~agreements. The~~liabilities on our balance sheet for our equipment and real estate operating leases. Upon adoption, we recognized additional operating liabilities of ~~ASU 2016-02 by~~$3.58 million, with corresponding ROU assets of the ~~Company is not~~same amount based on the present value of the remaining rental payments, including options to extend that are expected to ~~have a material impact.~~be exercised, under current leasing standards for existing operating leases. There was no cumulative effect of adopting the standard.

~~Index~~

~~HILLS BANCORPORATION~~

~~NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)~~

~~(Unaudited)~~

In March 2016, the FASB issued ASU No. 2016-04, Liabilities - Extinguishments of Liabilities (Subtopic 405-20), Recognition of Breakage for Certain Prepaid Stored-Value Products. ASU 2016-04 applies to all entities that offer certain prepaid stored - value products. The ASU provides guidance for the derecognition of financial liabilities related to the issuance of these products and aligns the recognition of breakage to current authoritative guidance. For public companies, ASU 2016-04 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. The ~~adoption of ASU 2016-04 by the Company is not expected to have a material impact.~~

~~In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718),~~ ~~Improvements to Employee Share-Based Payment Accounting~~. The ASU simplifies several aspects of the accounting for share-based payment transaction, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. For public companies, ASU 2016-09 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. The Company adopted ASU ~~2016-09~~2016-04 for the period ending March 31, ~~2017.~~2018. There was no material impact on the financial statements.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments (CECL). The ASU changes the way entities recognize impairment of financial assets by requiring immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the "incurred loss" model required under current GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

our allowance. For public companies, ASU 2016-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019, early adoption is permitted for the fiscal year beginning after December 15, 2018. The Company ~~is in the process of implementing~~has implemented a software solution provided by a third party vendor to assist in the analysis of historical loan data to determine the CECL model that will be implemented. The Company anticipates running parallel calculations of the "incurred loss" and CECL models for the quarter ending June 30, 2019. We expect to recognize a one-time cumulative-effect adjustment to our allowance for loan losses as of the beginning of the first reporting period in which the new standard is adopted. The amount of the one-time cumulative-effect adjustment has not yet been determined.

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

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

~~Index~~

~~HILLS BANCORPORATION~~

~~NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)~~

~~(Unaudited)~~

~~In March 2017, the FASB issued ASU No. 2017-08, Receivable - Nonrefundable Fees and Other Costs (Subtopic 310-20),~~ ~~Premium Amortization on Purchased Callable Debt Securities.~~ This ASU shortens the amortization period for certain callable debt securities held at a premium. The premium will be amortized to the earliest call date. For public companies, ASU 2017-08 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018. The Company adopted ASU 2017-08 for the period ending March 31, 2017. There was no material impact on the financial statements.

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

In February 2018, the FASB issued ASU No. 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220), Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This ASU allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. ASU 2018-02 is effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. The Company adopted ASU 2018-02 for the period ending March 31, 2018 and elected the specific identification method accounting policy. There was a $0.53 million reclassification recorded in stockholders' equity for the period ending March 31, 2018.

In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718), Improvements to Nonemployee Share-Based Payment Accounting. The amendments in this ASU expand the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. ASU 2018-07 is effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within that fiscal year. The Company adopted ASU No. 2018-07 for the period ending March 31, 2019. There was no material impact on the financial statements.

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820), Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. The amendments in this ASU modify the disclosure requirements on fair value measurements in Topic 820, Fair Value Measurement, including removal of the requirement to disclose the valuation processes for Level 3 fair value measurements and the additional requirement to disclose the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 is effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The amendments on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements, and the narrative description of measurement uncertainty should be applied prospectively for only the most recent interim or annual period presented in the initial fiscal year of adoption. All other amendments should be applied retrospectively to all periods presented upon their effective date. Early adoption is permitted upon issuance of this ASU. An entity is permitted to early adopt any removed or modified disclosures upon issuance of this ASU and delay adoption of the additional disclosures until their effective date. The adoption of ASU ~~2017-12~~2018-13 by the Company is not expected to have a material impact.

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

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


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.

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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,					Three Months Ended March 31,
	2017			2016			2017		2016			2019		2018
Common shares outstanding at the beginning of the period	9,329,514			9,283,341			9,264,227		9,322,054			9,336,441		9,335,154
Weighted average number of net shares (redeemed) issued	(4,596		)	(7,633		)	64,144		(31,950		)
Weighted average number of net shares issued												30,816		48,969
Weighted average shares outstanding (basic)	9,324,918			9,275,708			9,328,371		9,290,104			9,367,257		9,384,123
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method	3,559			6,584			4,874		6,357			4,008		3,890
Weighted average number of shares (diluted)	9,328,477			9,282,292			9,333,245		9,296,461			9,371,265		9,388,013
Net income (In thousands)	$	8,552		$	9,176		$	23,883	$	24,843		$	11,203	$	10,858
Earnings per share:
Basic	$	0.92		$	0.99		$	2.56	$	2.67		$	1.20	$	1.16
Diluted	$	0.92		$	0.99		$	2.56	$	2.67		$	1.20	$	1.16

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 3.	Other Comprehensive Income (Loss)

The following table summarizes the balances of each component of accumulated other comprehensive income (AOCI), included in stockholders’ equity, at ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016:~~2018:


	September 30, 2017			December 31, 2016			March 31, 2019			December 31, 2018
	(amounts in thousands)						(amounts in thousands)
Net unrealized gain (loss) on available-for-sale securities	$	1,295		$	(1,502	)
Net unrealized income (loss) on available-for-sale securities							$	559		$	(2,734	)
Net unrealized loss on derivatives used for cash flow hedges	(3,464		)	(3,938		)	(1,894		)	(1,596		)
Tax effect	$	830		$	2,081		$	334		$	1,080
Net-of-tax amount	$	(1,339	)	$	(3,359	)	$	(1,001	)	$	(3,250	)


Note 4.	Securities

The carrying values of investment securities at ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016~~2018 are summarized in the following table (dollars in thousands):


	September 30, 2017				December 31, 2016				March 31, 2019				December 31, 2018
	Amount		Percent		Amount		Percent		Amount		Percent		Amount		Percent
Securities available for sale
U.S. Treasury	$	39,894	15.65	%	$	27,482	10.27	%	$	91,573	28.27	%	$	83,155	26.07	%
Other securities (FHLB, FHLMC and FNMA)	48,759		19.12		61,660		23.05		27,531		8.50		34,871		10.93
State and political subdivisions	166,331		65.23		178,395		66.68		204,813		63.23		200,900		63.00
Total securities available for sale	$	254,984	100.00	%	$	267,537	100.00	%	$	323,917	100.00	%	$	318,926	100.00	%

Investment securities have been classified in the consolidated balance sheets according to management’s intent. Available-for-sale securities consist of debt securities not classified as trading or held to maturity. Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity. There were no trading or held to maturity securities as of ~~September 30, 2017~~March 31, 2019 or December 31, ~~2016.~~2018. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016~~2018 (in thousands):


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Estimated Fair Value
September 30, 2017:
March 31, 2019:
U.S. Treasury	$	39,823	$	90	$	(19	)	$	39,894	$	91,181	$	726	$	(334	)	$	91,573
Other securities (FHLB, FHLMC and FNMA)	48,992		11		(244		)	48,759		27,846		—		(315		)	27,531
State and political subdivisions	164,874		1,721		(264		)	166,331		204,331		1,189		(707		)	204,813
Total	$	253,689	$	1,822	$	(527	)	$	254,984	$	323,358	$	1,915	$	(1,356	)	$	323,917
December 31, 2016:
December 31, 2018:
U.S. Treasury	$	27,418	$	82	$	(18	)	$	27,482	$	83,839	$	124	$	(808	)	$	83,155
Other securities (FHLB, FHLMC and FNMA)	62,047		65		(452		)	61,660		35,371		—		(500		)	34,871
State and political subdivisions	179,574		626		(1,805		)	178,395		202,450		278		(1,828		)	200,900
Total	$	269,039	$	773	$	(2,275	)	$	267,537	$	321,660	$	402	$	(3,136	)	$	318,926

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at ~~September 30, 2017,~~March 31, 2019, were as follows (in thousands):


	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due in one year or less	$	42,320	$	42,423	$	57,358	$	57,169
Due after one year through five years	138,727		139,316		186,161		186,388
Due after five years through ten years	72,022		72,625		79,278		79,787
Due over ten years	620		620		561		573
Total	$	253,689	$	254,984	$	323,358	$	323,917

As of ~~September 30, 2017~~March 31, 2019 investment securities with a carrying value of ~~$30.46~~$11.72 million were pledged to collateralize ~~repurchase agreements,~~ derivative financial instruments and other borrowings.

The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016~~2018 (in thousands):


	Less than 12 months								12 months or more								Total								Less than 12 months								12 months or more								Total
September 30, 2017 Description of Securities	#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
March 31, 2019 Description of Securities																									#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
U.S. Treasury	4	$	10,006	$	(19	)	0.19	%	—	$	—	$	—		—	%	4	$	10,006	$	(19	)	0.19	%	—	$	—	$	—		—	%	19	$	46,923	$	(334	)	0.71	%	19	$	46,923	$	(334	)	0.71	%

Other securities (FHLB, FHLMC and FNMA)	11	26,539		(81		)	0.31		4	10,208		(163		)	1.60		15	36,747		(244		)	0.66		—	—		—			—		11	27,531		(315		)	1.14		11	27,531		(315		)	1.14

State and political subdivisions	45	11,566		(66		)	0.57		65	15,212		(198		)	1.30		110	26,778		(264		)	0.99		59	30,332		(148		)	0.49		262	62,104		(559		)	0.90		321	92,436		(707		)	0.76

Total temporarily impaired securities	60	$	48,111	$	(166	)	0.35	%	69	$	25,420	$	(361	)	1.42	%	129	$	73,531	$	(527	)	0.72	%	59	$	30,332	$	(148	)	0.49	%	292	$	136,558	$	(1,208	)	0.88	%	351	$	166,890	$	(1,356	)	0.81	%

Less than 12 months 12 months or more Total
December 31, 2016
Description of Securities # Fair Value
Unrealized
Loss
% # Fair Value
Unrealized
Loss
% # Fair Value
Unrealized
Loss
%
U.S. Treasury 2
$ 4,957
$ (18 ) 0.36 % —
$ —
$ —
— % 2
$ 4,957
$ (18 ) 0.36 %

Other securities (FHLB, FHLMC and FNMA) 14
34,648
(452 ) 1.30
—
—
—
—
14
34,648
(452 ) 1.30

State and political subdivisions 365
87,841
(1,762 ) 2.01
11
1,486
(43 ) 2.89
376
89,327
(1,805 ) 2.02

Total temporarily impaired securities 381
$ 127,446
$ (2,232 ) 1.75 % 11
$ 1,486
$ (43 ) 2.89 % 392
$ 128,932
$ (2,275 ) 1.76 %

~~Index~~

~~HILLS BANCORPORATION~~

~~NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)~~

~~(Unaudited)~~



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

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

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

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

The Company considered the following information in reaching the conclusion that the impairments disclosed in the table above are temporary and not other-than-temporary impairments. None of the unrealized losses in the above table was due to the deterioration in the credit quality of any of the issues that might result in the non-collection of contractual principal and interest.

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

~~Note 5.Loans~~


Note 5.	Loans

Classes of loans are as follows:


	September 30, 2017		December 31, 2016		March 31, 2019		December 31, 2018
	(Amounts In Thousands)				(Amounts In Thousands)
Agricultural	$	76,484	$	92,871	$	93,573	$	92,673
Commercial and financial	214,199		192,995		227,403		229,501
Real estate:
Construction, 1 to 4 family residential	73,404		57,864		73,868		72,279
Construction, land development and commercial	107,170		121,561		105,466		113,807
Mortgage, farmland	208,982		202,340		238,109		236,454
Mortgage, 1 to 4 family first liens	823,529		767,469		916,408		912,059
Mortgage, 1 to 4 family junior liens	137,271		125,400		152,183		152,625
Mortgage, multi-family	335,439		302,831		351,090		352,434
Mortgage, commercial	359,332		334,198		402,073		383,314
Loans to individuals	26,223		25,157		29,739		30,072
Obligations of state and political subdivisions	57,861		54,462		53,153		52,725
	$	2,419,894	$	2,277,148	$	2,643,065	$	2,627,943
Net unamortized fees and costs	886		827		943		952
	$	2,420,780	$	2,277,975	$	2,644,008	$	2,628,895
Less allowance for loan losses	29,350		26,530		36,520		37,810
	$	2,391,430	$	2,251,445	$	2,607,488	$	2,591,085

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 were as follows:


	Three Months Ended September 30, 2017
	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,341		$	4,586		$	3,165		$	4,009		$	8,340		$	5,414		$	1,095		$	28,950
Charge-offs	(27		)	(21		)	—			(3		)	(55		)	(86		)	(113		)	(305		)
Recoveries	56			219			33			—			203			7			57			575
Provision	92			(43		)	(182		)	2			98			107			56			130

Ending balance	$	2,462		$	4,741		$	3,016		$	4,008		$	8,586		$	5,442		$	1,095		$	29,350

	Nine Months Ended September 30, 2017																								Three Months Ended March 31, 2019
	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total			Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)																								(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,947		$	4,531		$	2,890		$	3,417		$	7,677		$	4,045		$	1,023		$	26,530		$	2,789		$	5,826		$	3,292		$	3,972		$	12,516		$	8,165		$	1,250		$	37,810
Charge-offs	(66		)	(478		)	(114		)	(3		)	(263		)	(130		)	(410		)	(1,464		)	—			(180		)	(8		)	—			(177		)	(4		)	(108		)	(477		)
Recoveries	123			882			443			—			570			236			203			2,457			10			184			2			5			110			85			37			433
Provision	(542		)	(194		)	(203		)	594			602			1,291			279			1,827			(258		)	174			(358		)	(106		)	(819		)	(23		)	144			(1,246		)

Ending balance	$	2,462		$	4,741		$	3,016		$	4,008		$	8,586		$	5,442		$	1,095		$	29,350		$	2,541		$	6,004		$	2,928		$	3,871		$	11,630		$	8,223		$	1,323		$	36,520

Ending balance, individually evaluated for impairment	$	653		$	913		$	46		$	784		$	110		$	409		$	85		$	3,000		$	258		$	1,375		$	—		$	—		$	74		$	483		$	59		$	2,249

Ending balance, collectively evaluated for impairment	$	1,809		$	3,828		$	2,970		$	3,224		$	8,476		$	5,033		$	1,010		$	26,350		$	2,283		$	4,629		$	2,928		$	3,871		$	11,556		$	7,740		$	1,264		$	34,271

Loans:

Ending balance	$	76,484		$	214,199		$	180,574		$	208,982		$	960,800		$	694,771		$	84,084		$	2,419,894		$	93,573		$	227,403		$	179,334		$	238,109		$	1,068,591		$	753,163		$	82,892		$	2,643,065

Ending balance, individually evaluated for impairment	$	6,181		$	2,985		$	1,161		$	8,179		$	7,097		$	8,097		$	85		$	33,785		$	2,740		$	4,039		$	832		$	4,189		$	6,879		$	4,333		$	59		$	23,071

Ending balance, collectively evaluated for impairment	$	70,303		$	211,214		$	179,413		$	200,803		$	953,703		$	686,674		$	83,999		$	2,386,109		$	90,833		$	223,364		$	178,502		$	233,920		$	1,061,712		$	748,830		$	82,833		$	2,619,994

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Changes in the allowance for loan losses for the three ~~and nine~~ months ended ~~September 30, 2016~~March 31, 2018 were as follows:


	Three Months Ended September 30, 2016
	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,997		$	4,011		$	2,898		$	3,927		$	8,226		$	4,201		$	1,030		$	27,290
Charge-offs	(19		)	(38		)	—			(105		)	(176		)	—			(140		)	(478		)
Recoveries	—			289			186			—			276			358			51			1,160
Provision	201			(252		)	(75		)	(204		)	(425		)	(589		)	(86		)	(1,832		)

Ending balance	$	2,777		$	4,010		$	3,009		$	3,618		$	7,901		$	3,970		$	855		$	26,140

	Nine Months Ended September 30, 2016																								Three Months Ended March 31, 2018
	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total			Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)																								(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	3,082		$	4,517		$	2,280		$	3,342		$	8,172		$	4,223		$	894		$	26,510		$	2,294		$	4,837		$	2,989		$	3,669	$	8,668		$	5,700		$	1,243		$	29,400
Charge-offs	(44		)	(172		)	—			(116		)	(704		)	(66		)	(416		)	(1,518		)	—			(30		)	—			—		(121		)	(1		)	(115		)	(267		)
Recoveries	173			910			792			—			767			379			132			3,153			12			248			143			—		98			4			37			542
Provision	(434		)	(1,245		)	(63		)	392			(334		)	(566		)	246			(2,004		)	(53		)	(397		)	(352		)	40		10			91			(104		)	(765		)

Ending balance	$	2,777		$	4,010		$	3,009		$	3,618		$	7,901		$	3,970		$	855		$	26,140		$	2,253		$	4,658		$	2,780		$	3,709	$	8,655		$	5,794		$	1,061		$	28,910

Ending balance, individually evaluated for impairment	$	746		$	221		$	223		$	549		$	283		$	62		$	29		$	2,113		$	199		$	759		$	40		$	—	$	75		$	493		$	63		$	1,629

Ending balance, collectively evaluated for impairment	$	2,031		$	3,789		$	2,786		$	3,069		$	7,618		$	3,908		$	826		$	24,027		$	2,054		$	3,899		$	2,740		$	3,709	$	8,580		$	5,301		$	998		$	27,281

Loans:

Ending balance	$	88,104		$	188,365		$	178,820		$	193,819		$	883,693		$	619,214		$	74,917		$	2,226,932		$	83,940		$	214,004		$	166,761		$	218,462	$	980,150		$	705,576		$	83,032		$	2,451,925

Ending balance, individually evaluated for impairment	$	12,276		$	2,529		$	2,877		$	8,371		$	6,497		$	3,356		$	29		$	35,935		$	2,823		$	2,550		$	946		$	3,615	$	6,564		$	8,025		$	63		$	24,586

Ending balance, collectively evaluated for impairment	$	75,828		$	185,836		$	175,943		$	185,448		$	877,196		$	615,858		$	74,888		$	2,190,997		$	81,117		$	211,454		$	165,815		$	214,847	$	973,586		$	697,551		$	82,969		$	2,427,339

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 ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016,~~2018, respectively (amounts in thousands):


	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial		Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
September 30, 2017
March 31, 2019
Grade:
Excellent	$	2,502	$	10,234	$	548	$	2,950	$	4,091	$	2,718	$	—	$	203
Good	12,073		47,103		6,773		26,216		15,703		47,718		12,376		17,416
Satisfactory	37,109		117,612		49,639		41,317		39,421		123,709		44,934		57,452
Monitor	14,622		28,619		15,248		33,226		27,703		38,547		14,185		21,312
Special Mention	4,653		5,410		897		2,607		836		8,566		1,978		7,576
Substandard	5,525		5,221		299		854		5,819		6,145		395		1,507
Total	$	76,484	$	214,199	$	73,404	$	107,170	$	93,573	$	227,403	$	73,868	$	105,466


	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family		Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family
September 30, 2017
March 31, 2019
Grade:
Excellent	$	5,102	$	2,064	$	494	$	5,712	$	5,469	$	2,307	$	526	$	22,051
Good	52,634		29,490		3,569		82,368		50,050		31,571		4,071		59,203
Satisfactory	105,155		681,699		124,625		188,549		126,988		756,430		138,533		189,192
Monitor	34,985		77,461		4,869		52,341		45,440		97,980		6,241		58,506
Special Mention	2,434		11,136		1,328		—		1,117		9,414		1,141		15,947
Substandard	8,672		21,679		2,386		6,469		9,045		18,706		1,671		6,191
Total	$	208,982	$	823,529	$	137,271	$	335,439	$	238,109	$	916,408	$	152,183	$	351,090


	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total		Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
September 30, 2017
March 31, 2019
Grade:
Excellent	$	18,735	$	—	$	8,961	$	57,302	$	35,391	$	—	$	7,985	$	80,741
Good	103,662		476		29,137		393,501		86,117		193		15,414		339,832
Satisfactory	183,140		24,962		16,186		1,569,993		195,035		28,663		21,563		1,721,920
Monitor	44,316		349		3,577		309,613		74,094		588		8,191		392,787
Special Mention	7,037		216		—		35,718		2,901		229		—		49,705
Substandard	2,442		220		—		53,767		8,535		66		—		58,080
Total	$	359,332	$	26,223	$	57,861	$	2,419,894	$	402,073	$	29,739	$	53,153	$	2,643,065

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial		Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
December 31, 2016
December 31, 2018
Grade:
Excellent	$	4,205	$	4,241	$	—	$	244	$	3,667	$	3,322	$	—	$	209
Good	13,611		43,472		1,701		25,337		15,342		51,562		13,029		16,667
Satisfactory	40,008		108,800		44,138		46,758		39,897		121,759		42,043		68,123
Monitor	12,699		20,023		8,896		44,487		27,510		35,897		15,045		19,888
Special Mention	8,381		11,177		972		4,250		647		11,418		1,767		7,635
Substandard	13,967		5,282		2,157		485		5,610		5,543		395		1,285
Total	$	92,871	$	192,995	$	57,864	$	121,561	$	92,673	$	229,501	$	72,279	$	113,807


	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family		Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family
December 31, 2016
December 31, 2018
Grade:
Excellent	$	2,916	$	1,196	$	65	$	5,970	$	5,619	$	2,715	$	520	$	22,058
Good	47,569		15,725		3,002		71,822		52,364		33,134		4,569		60,047
Satisfactory	105,971		647,191		113,433		180,651		126,706		752,473		138,533		187,641
Monitor	29,778		66,164		4,877		40,444		41,486		96,187		6,242		60,398
Special Mention	7,004		12,914		1,566		3,636		1,055		10,439		1,130		16,065
Substandard	9,102		24,279		2,457		308		9,224		17,111		1,631		6,225
Total	$	202,340	$	767,469	$	125,400	$	302,831	$	236,454	$	912,059	$	152,625	$	352,434


	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total		Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
December 31, 2016
December 31, 2018
Grade:
Excellent	$	15,873	$	—	$	—	$	34,710	$	34,096	$	—	$	8,117	$	80,323
Good	89,801		65		37,539		349,644		86,453		315		15,652		349,134
Satisfactory	185,650		24,446		16,417		1,513,463		177,271		28,797		20,685		1,703,928
Monitor	34,979		293		506		263,146		74,990		647		8,271		386,561
Special Mention	3,797		195		—		53,892		3,228		217		—		53,601
Substandard	4,098		158		—		62,293		7,276		96		—		54,396
Total	$	334,198	$	25,157	$	54,462	$	2,277,148	$	383,314	$	30,072	$	52,725	$	2,627,943

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The below are descriptions of the credit quality indicators:

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

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

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

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

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

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

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Past due loans as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016~~2018 were as follows:


	30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Loans Receivable		Accruing Loans Past Due 90 Days or More		30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Loans Receivable		Accruing Loans Past Due 90 Days or More
	(Amounts In Thousands)														(Amounts In Thousands)
September 30, 2017
March 31, 2019
Agricultural	$	3	$	23	$	1,367	$	1,393	$	75,091	$	76,484	$	1,121	$	2,057	$	445	$	1,616	$	4,118	$	89,455	$	93,573	$	583
Commercial and financial	380		262		264		906		213,293		214,199		200		1,158		371		242		1,771		225,632		227,403		—
Real estate:
Construction, 1 to 4 family residential	—		22		—		22		73,382		73,404		—		692		—		—		692		73,176		73,868		—
Construction, land development and commercial	3,320		—		—		3,320		103,850		107,170		—		1,036		32		—		1,068		104,398		105,466		—
Mortgage, farmland	—		1,355		83		1,438		207,544		208,982		—		6,954		—		630		7,584		230,525		238,109		—
Mortgage, 1 to 4 family first liens	733		1,578		2,235		4,546		818,983		823,529		412		9,145		666		2,790		12,601		903,807		916,408		—
Mortgage, 1 to 4 family junior liens	201		137		62		400		136,871		137,271		58		190		395		—		585		151,598		152,183		—
Mortgage, multi-family	—		—		—		—		335,439		335,439		—		143		—		—		143		350,947		351,090		—
Mortgage, commercial	142		—		16		158		359,174		359,332		—		1,633		—		281		1,914		400,159		402,073		—
Loans to individuals	38		67		—		105		26,118		26,223		—		124		46		—		170		29,569		29,739		—
Obligations of state and political subdivisions	—		—		—		—		57,861		57,861		—		—		—		—		—		53,153		53,153		—
	$	4,817	$	3,444	$	4,027	$	12,288	$	2,407,606	$	2,419,894	$	1,791	$	23,132	$	1,955	$	5,559	$	30,646	$	2,612,419	$	2,643,065	$	583

December 31, 2016
December 31, 2018
Agricultural	$	56	$	—	$	302	$	358	$	92,513	$	92,871	$	—	$	1,026	$	—	$	135	$	1,161	$	91,512	$	92,673	$	—
Commercial and financial	24		121		718		863		192,132		192,995		—		988		459		225		1,672		227,829		229,501		—
Real estate:
Construction, 1 to 4 family residential	—		—		—		—		57,864		57,864		—		—		—		212		212		72,067		72,279		212
Construction, land development and commercial	—		231		85		316		$	121,245	121,561		—		233		202		—		435		113,372		113,807		—
Mortgage, farmland	319		—		—		319		202,021		202,340		—		193		388		—		581		235,873		236,454		—
Mortgage, 1 to 4 family first liens	5,649		978		1,943		8,570		$	758,899	767,469		192		3,972		833		3,234		8,039		904,020		912,059		158
Mortgage, 1 to 4 family junior liens	330		51		579		960		124,440		125,400		443		199		36		—		235		152,390		152,625		—
Mortgage, multi-family	—		—		40		40		$	302,791	302,831		—		—		—		—		—		352,434		352,434		—
Mortgage, commercial	371		—		207		578		333,620		334,198		—		733		344		—		1,077		382,237		383,314		—
Loans to individuals	203		32		—		235		$	24,922	25,157		—		195		—		22		217		29,855		30,072		—
Obligations of state and political subdivisions	—		—		—		—		54,462		54,462		—		—		—		—		—		52,725		52,725		—
	$	6,952	$	1,413	$	3,874	$	12,239	$	2,264,909	$	2,277,148	$	635	$	7,539	$	2,262	$	3,828	$	13,629	$	2,614,314	$	2,627,943	$	370

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

Certain impaired loan information by loan type at ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016,~~2018, was as follows:


	September 30, 2017						December 31, 2016						March 31, 2019						December 31, 2018
	Non-accrual loans (1)		Accruing loans past due 90 days or more		TDR loans		Non- accrual loans (1)		Accruing loans past due 90 days or more		TDR loans		Non-accrual loans (1)		Accruing loans past due 90 days or more		TDR loans		Non- accrual loans (1)		Accruing loans past due 90 days or more		TDR loans
	(Amounts In Thousands)						(Amounts In Thousands)						(Amounts In Thousands)						(Amounts In Thousands)
Agricultural	$	1,656	$	1,121	$	2,446	$	1,741	$	—	$	91	$	1,308	$	583	$	97	$	1,338	$	—	$	120
Commercial and financial	947		200		1,839		1,354		—		1,057		1,857		—		2,143		1,476		—		2,686
Real estate:
Construction, 1 to 4 family residential	—		—		—		—		—		265		395		—		—		—		212		—
Construction, land development and commercial	—		—		341		85		—		118		—		—		326		—		—		328
Mortgage, farmland	1,454		—		1,462		1,205		—		1,389		1,037		—		3,903		1,062		—		3,301
Mortgage, 1 to 4 family first liens	4,415		412		1,399		4,097		192		1,375		5,833		—		1,132		5,799		158		1,143
Mortgage, 1 to 4 family junior liens	12		58		26		136		443		26		—		—		24		—		—		24
Mortgage, multi-family	223		—		—		243		—		—		143		—		—		145		—		—
Mortgage, commercial	630		—		1,057		1,077		—		1,087		1,196		—		925		1,009		—		937
	$	9,337	$	1,791	$	8,570	$	9,938	$	635	$	5,408	$	11,769	$	583	$	8,550	$	10,829	$	370	$	8,539


(1)	There were ~~$3.76~~$5.07 million and ~~$4.23~~$4.84 million of TDR loans included within nonaccrual loans as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016,~~2018, respectively.

Loans 90 days or more past due that are still accruing interest increased ~~$1.16~~$0.21 million from December 31, ~~2016~~2018 to ~~September 30, 2017~~March 31, 2019 due to an increase in the number of accruing loans past due ~~greater than~~ 90 days ~~including a $1.12 agricultural relationship.~~or more. As of ~~September 30, 2017~~March 31, 2019 there were 103 accruing loans past due 90 days or more. The average ~~balance of~~ accruing loans past due as of ~~September 30, 2017~~March 31, 2019 are ~~$0.18~~$0.19 million. There were 62 accruing loans past due 90 days or more as of December 31, ~~2016~~2018 and the average loan balance was ~~$0.11~~$0.19 million. The accruing loans past due 90 days or more balances are believed to be adequately collateralized and the Company expects to collect all principal and interest as contractually due under these loans.

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

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Below is a summary of information for TDR loans as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016:~~2018:


	September 30, 2017					December 31, 2016					March 31, 2019					December 31, 2018
	Number of contracts	Recorded investment		Commitments outstanding		Number of contracts	Recorded investment		Commitments outstanding		Number of contracts	Recorded investment		Commitments outstanding		Number of contracts	Recorded investment		Commitments outstanding
		(Amounts In Thousands)					(Amounts In Thousands)					(Amounts In Thousands)					(Amounts In Thousands)
Agricultural	9	$	3,762	$	267	4	$	1,460	$	167	6	$	1,512	$	12	5	$	1,316	$	91
Commercial and financial	15	2,526		157		14	2,053		117		13	3,646		135		13	3,867		75
Real estate:
Construction, 1 to 4 family residential	—	—		193		3	265		1,225		—	—		—		—	—		—
Construction, land development and commercial	2	341		721		1	118		107		2	326		—		2	328		—
Mortgage, farmland	7	2,834		—		7	2,594		—		9	4,873		—		8	4,291		—
Mortgage, 1 to 4 family first liens	13	1,486		—		12	1,471		—		15	1,695		—		16	1,710		—
Mortgage, 1 to 4 family junior liens	1	26		54		1	26		65		1	24		—		1	24		—
Mortgage, multi-family	—	—		—		—	—		—		—	—		—		—	—		—
Mortgage, commercial	8	1,355		—		10	1,650		—		9	1,798		—		9	1,839		—
Loans to individuals	—	—		—		—	—		—		—	—		—		—	—		—
	55	$	12,330	$	1,392	52	$	9,637	$	1,681	55	$	13,874	$	147	54	$	13,375	$	166

The following is a summary of TDR loans that were modified during the three ~~and nine~~ months ended ~~September 30, 2017:~~

March 31, 2019:


	Three Months Ended September 30, 2017					Nine Months Ended September 30, 2017					Three Months Ended March 31, 2019
	Number of contracts	Pre-modification recorded investment		Post-modification recorded investment		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)					(Amounts In Thousands)
Agricultural	—	$	—	$	—	6	$	10,890	$	10,890	1	$	250	$	250
Commercial and financial	3	1,451		1,451		4	1,546		1,546		—	—		—
Real estate:
Construction, 1 to 4 family residential	—	—		—		—	—		—		—	—		—
Construction, land development and commercial	—	—		—		1	231		231		—	—		—
Mortgage, farmland	—	—		—		2	598		598		1	620		620
Mortgage, 1 to 4 family first lien	1	106		106		1	106		106		—	—		—
Mortgage, 1 to 4 family junior liens	—	—		—		—	—		—		—	—		—
Mortgage, multi-family	—	—		—		1	249		249		—	—		—
Mortgage, commercial	—	—		—		—	—		—		—	—		—
	4	$	1,557	$	1,557	15	$	13,620	$	13,620	2	$	870	$	870

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The Company had commitments to lend ~~$1.39~~$0.15 million in additional borrowings to restructured loan customers as of ~~September 30, 2017.~~March 31, 2019. The Company had commitments to lend ~~$1.68~~$0.17 million in additional borrowings to restructured loan customers as of December 31, ~~2016.~~2018. These commitments were in the normal course of business. The additional borrowings were not used to facilitate payments on these loans.

There ~~were no~~was one TDR ~~loans~~loan that ~~were~~was in payment default (defined as past due 90 days or more) totaling $0.25 million during the period ended ~~September 30, 2017~~March 31, 2019 and none for the year ended December 31, ~~2016.~~2018.

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Information regarding impaired loans as of and for the three ~~and nine~~ months ended ~~September 30, 2017~~March 31, 2019 is as follows:


	September 30, 2017						Three Months Ended September 30, 2017				Nine Months Ended September 30, 2017				March 31, 2019						Three Months Ended March 31, 2019
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:	(Amounts In Thousands)														(Amounts In Thousands)
Agricultural	$	1,739	$	1,981	$	—	$	1,778	$	3	$	1,767	$	1	$	1,359	$	1,653	$	—	$	1,377	$	9
Commercial and financial	1,333		2,047		—		1,598		17		1,375		5		1,639		2,493		—		1,682		11
Real estate:
Construction, 1 to 4 family residential	116		151		—		116		4		116		1		110		148		—		111		—
Construction, land development and commercial	341		374		—		345		10		342		3		722		738		—		722		4
Mortgage, farmland	2,598		2,925		—		2,513		42		2,603		14		4,189		4,667		—		4,198		39
Mortgage, 1 to 4 family first liens	5,268		6,640		—		5,434		37		5,336		13		6,068		7,860		—		6,143		9
Mortgage, 1 to 4 family junior liens	12		485		—		25		—		13		—		—		252		—		—		—
Mortgage, multi-family	223		357		—		233		—		226		—		143		213		—		144		—
Mortgage, commercial	1,607		2,300		—		1,727		34		1,670		11		2,047		2,745		—		2,068		10
Loans to individuals	—		14		—		—		—		—		—		—		14		—		—		—
	$	13,237	$	17,274	$	—	$	13,769	$	147	$	13,448	$	48	$	16,277	$	20,783	$	—	$	16,445	$	82

With an allowance recorded:
Agricultural	$	4,442	$	4,503	$	653	$	4,897	$	169	$	4,491	$	53	$	1,381	$	1,552	$	258	$	1,396	$	8
Commercial and financial	1,652		1,698		913		1,732		62		1,743		21		2,400		2,429		1,375		2,476		23
Real estate:
Construction, 1 to 4 family residential	199		199		13		136		5		180		2		—		—		—		—		—
Construction, land development and commercial	505		505		33		321		11		354		4		—		—		—		—		—
Mortgage, farmland	5,581		5,581		784		5,667		183		5,584		61		—		—		—		—		—
Mortgage, 1 to 4 family first liens	1,734		1,861		106		1,761		54		1,743		17		787		794		73		789		4
Mortgage, 1 to 4 family junior liens	83		83		4		86		3		83		1		24		24		1		24		—
Mortgage, multi-family	6,187		6,187		407		6,251		210		6,228		71		1,402		1,402		282		1,408		17
Mortgage, commercial	80		80		2		81		3		80		1		741		741		201		744		8
Loans to individuals	85		85		85		88		7		90		3		59		59		59		56		2
	$	20,548	$	20,782	$	3,000	$	21,020	$	707	$	20,576	$	234	$	6,794	$	7,001	$	2,249	$	6,893	$	62

Total:
Agricultural	$	6,181	$	6,484	$	653	$	6,675	$	172	$	6,258	$	54	$	2,740	$	3,205	$	258	$	2,773	$	17
Commercial and financial	2,985		3,745		913		3,330		79		3,118		26		4,039		4,922		1,375		4,158		34
Real estate:
Construction, 1 to 4 family residential	315		350		13		252		9		296		3		110		148		—		111		—
Construction, land development and commercial	846		879		33		666		21		696		7		722		738		—		722		4
Mortgage, farmland	8,179		8,506		784		8,180		225		8,187		75		4,189		4,667		—		4,198		39
Mortgage, 1 to 4 family first liens	7,002		8,501		106		7,195		91		7,079		30		6,855		8,654		73		6,932		13
Mortgage, 1 to 4 family junior liens	95		568		4		111		3		96		1		24		276		1		24		—
Mortgage, multi-family	6,410		6,544		407		6,484		210		6,454		71		1,545		1,615		282		1,552		17
Mortgage, commercial	1,687		2,380		2		1,808		37		1,750		12		2,788		3,486		201		2,812		18
Loans to individuals	85		99		85		88		7		90		3		59		73		59		56		2
	$	33,785	$	38,056	$	3,000	$	34,789	$	854	$	34,024	$	282	$	23,071	$	27,784	$	2,249	$	23,338	$	144

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Information regarding impaired loans as of December 31, ~~2016~~2018 is as follows:


	Recorded Investment		Unpaid Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:	(Amounts In Thousands)						(Amounts In Thousands)
Agricultural	$	800	$	971	$	—	$	1,395	$	1,663	$	—
Commercial and financial	1,540		2,175		—		1,650		2,503		—
Real estate:
Construction, 1 to 4 family residential	117		151		—		111		148		—
Construction, land development and commercial	204		290		—		328		344		—
Mortgage, farmland	2,594		2,887		—		3,612		4,071		—
Mortgage, 1 to 4 family first liens	5,011		6,137		—		6,089		7,819		—
Mortgage, 1 to 4 family junior liens	153		646		—		—		254		—
Mortgage, multi-family	243		362		—		145		213		—
Mortgage, commercial	1,901		2,727		—		1,871		2,486		—
Loans to individuals	—		19		—		—		14		—
	$	12,563	$	16,365	$	—	$	15,201	$	19,515	$	—

With an allowance recorded:
Agricultural	$	10,920	$	10,978	$	856	$	1,065	$	1,229	$	479
Commercial and financial	937		955		718		2,512		2,512		1,189
Real estate:
Construction, 1 to 4 family residential	815		815		105		698		698		4
Construction, land development and commercial	—		—		—		—		—		—
Mortgage, farmland	5,434		5,434		390		—		—		—
Mortgage, 1 to 4 family first liens	1,266		1,374		79		899		974		70
Mortgage, 1 to 4 family junior liens	612		667		11		24		24		2
Mortgage, multi-family	—		—		—		7,447		7,447		305
Mortgage, commercial	967		1,004		34		75		75		1
Loans to individuals	150		150		150		64		64		64
	$	21,101	$	21,377	$	2,343	$	12,784	$	13,023	$	2,114

Total:
Agricultural	$	11,720	$	11,949	$	856	$	2,460	$	2,892	$	479
Commercial and financial	2,477		3,130		718		4,162		5,015		1,189
Real estate:
Construction, 1 to 4 family residential	932		966		105		809		846		4
Construction, land development and commercial	204		290		—		328		344		—
Mortgage, farmland	8,028		8,321		390		3,612		4,071		—
Mortgage, 1 to 4 family first liens	6,277		7,511		79		6,988		8,793		70
Mortgage, 1 to 4 family junior liens	765		1,313		11		24		278		2
Mortgage, multi-family	243		362		—		7,592		7,660		305
Mortgage, commercial	2,868		3,731		34		1,946		2,561		1
Loans to individuals	150		169		150		64		78		64
	$	33,664	$	37,742	$	2,343	$	27,985	$	32,538	$	2,114

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Impaired loans ~~increased $0.12~~decreased $4.91 million from December 31, ~~2016~~2018 to ~~September 30, 2017.~~March 31, 2019. Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans. Impaired loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement. Impaired loans were ~~1.40%~~0.87% of loans held for investment as of ~~September 30, 2017~~March 31, 2019 and ~~1.48%~~1.06% as of December 31, ~~2016.~~2018. The ~~increase~~decrease in impaired loans is due mainly to an increase in TDR loans of $3.16 million and an increase in accruing loans past due 90 days or more of $1.16 million from December 31, 2016 to September 30, 2017, and is offset by a decrease in nonaccrual loans of $0.60 million, and a decrease of ~~$3.60~~$5.99 million in relationships with a specific allowance for ~~losses.~~losses, and is offset by a $0.21 million increase in 90 days or more accruing loans, an increase in TDR loans of $0.50 million, and an increase in nonaccrual loans of $0.94 million from December 31, 2018 to March 31, 2019.

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

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

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


Note 6.	Leases

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

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

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

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

As of March 31, 2019, operating lease right-of-use assets included in other assets and liabilities was $3.58 million. The weighted average remaining lease term for operating leases was 11.20 years and the weighted average discount rate for operating leases was 3.43%. Discount rates used were determined from FHLB borrowing rates for comparable terms.

As of March 31, 2019, maturities of lease liabilities were as follows:



Year ending December 31:	(Amounts In Thousands)
2019	$	467
2020	470
2021	456
2022	447
2023	301
Thereafter	2,259
Total lease payments	4,400
Less imputed interest	(819		)
Total operating lease liabilities	$	3,581

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 6.7.	Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments as of ~~September 30, 2017~~March 31, 2019 are as follows:


	September 30, 2017										March 31, 2019
	Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)
	(Amounts In Thousands)										(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents	$	36,792	$	36,792	$	36,792	$	—	$	—	$	200,476	$	200,476	$	200,476	$	—	$	—
Investment securities	271,110		271,110		—		271,110		—		336,183		336,183		91,573		244,610		—
Loans held for sale	6,717		6,717		—		6,717		—		5,267		5,267		—		5,267		—
Loans
Agricultural	74,022		73,954		—		—		73,954		91,032		93,028		—		—		93,028
Commercial and financial	209,458		209,387		—		—		209,387		221,399		225,946		—		—		225,946
Real estate:
Construction, 1 to 4 family residential	72,141		72,151		—		—		72,151		72,589		73,965		—		—		73,965
Construction, land development and commercial	105,417		105,340		—		—		105,340		103,817		105,134		—		—		105,134
Mortgage, farmland	204,974		205,401		—		—		205,401		234,238		235,465		—		—		235,465
Mortgage, 1 to 4 family first liens	817,072		813,125		—		—		813,125		907,397		888,705		—		—		888,705
Mortgage, 1 to 4 family junior liens	136,028		140,222		—		—		140,222		150,507		148,210		—		—		148,210
Mortgage, multi-family	332,893		330,677		—		—		330,677		347,138		344,083		—		—		344,083
Mortgage, commercial	356,436		354,673		—		—		354,673		397,802		395,694		—		—		395,694
Loans to individuals	25,591		25,575		—		—		25,575		28,921		30,424		—		—		30,424
Obligations of state and political subdivisions	57,398		56,681		—		—		56,681		52,648		52,338		—		—		52,338
Accrued interest receivable	11,484		11,484		—		11,484		—		13,970		13,970		—		13,970		—
Total financial instrument assets	$	2,717,533	$	2,713,289	$	36,792	$	289,311	$	2,387,186	$	3,163,384	$	3,148,888	$	292,049	$	263,847	$	2,592,992
Financial instrument liabilities
Deposits
Noninterest-bearing deposits	$	349,883	$	349,883	$	—	$	349,883	$	—	$	363,142	$	363,142	$	—	$	363,142	$	—
Interest-bearing deposits	1,723,159		1,727,433		—		1,727,433		—		2,233,750		2,243,433		—		2,243,433		—
Other borrowings	13,761		13,761		—		13,761		—		—		—		—		—		—
Federal Home Loan Bank borrowings	323,000		312,026		—		312,026		—		215,000		208,188		—		208,188		—
Interest rate swaps	3,464		3,464		—		3,464		—		1,894		1,894		—		1,894		—
Accrued interest payable	1,079		1,079		—		1,079		—		2,051		2,051		—		2,051		—
Total financial instrument liabilities	$	2,414,346	$	2,407,646	$	—	$	2,407,646	$	—	$	2,815,837	$	2,818,708	$	—	$	2,818,708	$	—

	Face Amount										Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	413,805	$	—	$	—	$	—	$	—	$	393,424	$	—	$	—	$	—	$	—
Letters of credit	11,398		—		—		—		—		8,918		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	425,203	$	—	$	—	$	—	$	—	$	402,342	$	—	$	—	$	—	$	—


(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.

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, ~~2016~~2018 are as follows:


	December 31, 2016										December 31, 2018
	Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)
	(Amounts In Thousands)										(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents	$	38,197	$	38,197	$	38,197	$	—	$	—	$	43,305	$	43,305	$	43,305	$	—	$	—
Investment securities	279,950		279,950		—		279,950		—		331,098		331,098		83,155		247,943		—
Loans held for sale	9,806		9,806		—		9,806		—		1,984		1,984		—		1,984		—
Loans
Agricultural	89,924		89,862		—		—		89,862		89,884		93,736		—		—		93,736
Commercial and financial	188,464		188,292		—		—		188,292		223,675		227,774		—		—		227,774
Real estate:
Construction, 1 to 4 family residential	56,841		56,715		—		—		56,715		70,982		72,419		—		—		72,419
Construction, land development and commercial	119,694		119,716		—		—		119,716		111,812		112,960		—		—		112,960
Mortgage, farmland	198,923		199,043		—		—		199,043		232,482		235,771		—		—		235,771
Mortgage, 1 to 4 family first liens	760,909		764,174		—		—		764,174		902,261		882,908		—		—		882,908
Mortgage, 1 to 4 family junior liens	124,283		129,339		—		—		129,339		150,859		148,128		—		—		148,128
Mortgage, multi-family	301,162		297,646		—		—		297,646		348,351		342,099		—		—		342,099
Mortgage, commercial	331,822		328,948		—		—		328,948		379,232		376,257		—		—		376,257
Loans to individuals	24,515		24,499		—		—		24,499		29,349		29,962		—		—		29,962
Obligations of state and political subdivisions	54,081		52,860		—		—		52,860		52,198		51,945		—		—		51,945
Accrued interest receivable	9,121		9,121		—		9,121		—		11,784		11,784		—		11,784		—
Total financial instrument assets	$	2,587,692	$	2,588,168	$	38,197	$	298,877	$	2,251,094	$	2,979,256	$	2,962,130	$	126,460	$	261,711	$	2,573,959
Financial instrument liabilities:
Deposits
Noninterest-bearing deposits	$	348,505	$	348,505	$	—	$	348,505	$	—	$	372,152	$	372,152	$	—	$	372,152	$	—
Interest-bearing deposits	1,687,807		1,691,679		—		1,691,679		—		2,048,972		2,059,336		—		2,059,336		—
Other borrowings	33,489		33,489		—		33,489		—		—		—		—		—		—
Federal Home Loan Bank borrowings	235,000		231,232		—		231,232		—		215,000		207,948		—		207,948		—
Interest rate swaps	3,938		3,938				3,938				1,596		1,596				1,596
Accrued interest payable	984		984		—		984		—		1,812		1,812		—		1,812		—
Total financial instrument liabilities	$	2,309,723	$	2,309,827	$	—	$	2,309,827	$	—	$	2,639,532	$	2,642,844	$	—	$	2,642,844	$	—

	Face Amount										Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	388,666	$	—	$	—	$	—	$	—	$	375,940	$	—	$	—	$	—	$	—
Letters of credit	9,024		—		—		—		—		9,033		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	397,690	$	—	$	—	$	—	$	—	$	384,973	$	—	$	—	$	—	$	—


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

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



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



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



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

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

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

ASSETS

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

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

The pricing for investment securities is obtained from an independent source. There are no ~~level 1 or level~~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~~three months ended ~~September 30, 2017.~~March 31, 2019. If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.

Loans held for sale and Loans: ASU 2016-1, Financial Instruments -Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. This update is effective for financial statement periods beginning after December 15, 2017. Therefore, the fair value presented herein may not be comparable to prior periods. Methodologies utilized for this financial statement period are as follows:

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

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

Fair value has been estimated in accordance with ASC 820, Fair Value Measurements and Disclosures, and is intended to represent the price that would be received in an orderly transaction between market participants as of the measurement date. In general, fair

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

value is based upon quoted market prices, where available. If such quoted market prices are not available, at least one significant assumption not observable in the market was utilized. These unobservable assumptions reflect estimates that market participants would use in pricing the asset or liability. Inputs to these valuation techniques are subjective in nature, involve uncertainties and require significant judgment and therefore cannot be determined with precision. Accordingly, the fair value estimates presented are not necessarily indicative of the amounts to be realized in a current market exchange. Loans are classified as Level 3.

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

~~Index~~

~~HILLS BANCORPORATION~~

~~NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)~~

~~(Unaudited)~~

~~Loans~~Impaired loans: ~~The Company does~~A loan is considered to be impaired when it is probable that all of the principal and interest due may not ~~record loans at fair value on~~be collected according to its contractual terms. Generally, when a recurring basis. For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values (Level 3). The fair values for other loans are determined using estimated future cash flows, discounted atloan is considered impaired, the interest rates currently being offered for loans with similar terms to borrowers with similar credit quality utilizing an entrance price concept (Level 3). The Company does record nonrecurring fair value adjustments to loans to reflect (1) partial write-downs that areamount of reserve required under ASC 310, Receivables, is measured based on the fair value of the underlying collateral. The Company makes such measurements on all material loans deemed impaired using the fair value of the collateral for collateral dependent loans. The fair value of collateral used by the Company is determined by obtaining an observable market price or by obtaining an appraised value from an independent, licensed or certified appraiser, using observable market data. This data includes information such as selling price of similar properties and capitalization rates of similar properties sold within the market, expected future cash flows or earnings of the subject property based on current market expectations, and other relevant factors. All appraised values are adjusted for market-related trends based on the Company's experience in sales and other appraisals of similar property types as well as estimated selling costs. Each quarter management reviews all collateral dependent impaired loans on a loan-by-loan basis to determine whether updated appraisals are necessary based on loan performance, collateral type and guarantor support. At times, the Company measures the fair value of collateral dependent impaired loans using appraisals with dates prior to one year from the date of review. These appraisals are discounted by applying current, observable market data about similar property types such as sales contracts, estimations of value by individuals familiar with the market, other appraisals, sales or ~~(2)~~collateral assessments based on current market activity until updated appraisals are obtained. Depending on the ~~full charge-off~~length of time since an appraisal was performed, the ~~loan carrying value (Level 3)~~data provided through reviews and estimated selling costs, collateral values are typically discounted by 0-35%. These loans are considered Level 3 as the instruments used to determine fair market value require significant management judgment and estimation.

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

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

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

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

LIABILITIES

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

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

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

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

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

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

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


	September 30, 2017										March 31, 2019
	Readily Available Market Prices(1)		Observable Market Prices(2)			Company Determined Market Prices(3)		Total at Fair Value			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)										(Amounts In Thousands)
U.S. Treasury	$	—	$	39,894		$	—	$	39,894		$	91,573	$	—		$	—	$	91,573
State and political subdivisions	—		166,331			—		166,331			—		204,813			—		204,813
Other securities (FHLB, FHLMC and FNMA)	—		48,759			—		48,759			—		27,531			—		27,531
Derivative Financial Instruments
Interest rate swaps	$	—	(3,464		)	$	—	(3,464		)	$	—	(1,894		)	$	—	(1,894		)
Total	$	—	$	251,520		$	—	$	251,520		$	91,573	$	230,450		$	—	$	322,023


	December 31, 2016										December 31, 2018
	Readily Available Market Prices(1)		Observable Market Prices(2)			Company Determined Market Prices(3)		Total at Fair Value			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)										(Amounts In Thousands)
U.S. Treasury	$	—	$	27,482		$	—	$	27,482		$	83,155	$	—		$	—	$	83,155
State and political subdivisions	—		178,395			—		178,395			—		200,900			—		200,900
Other securities (FHLB, FHLMC and FNMA)	—		61,660			—		61,660			—		34,871			—		34,871
Derivative Financial Instruments
Interest rate swaps	—		(3,938		)	—		(3,938		)	—		(1,596		)	—		(1,596		)
Total	$	—	$	263,599		$	—	$	263,599		$	83,155	$	234,175		$	—	$	317,330


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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

There were no transfers between Levels 1, 2 or 3 during the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and the year ended December 31, ~~2016.~~2018.

Index

HILLS BANCORPORATION

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, 2017								Three Months Ended September 30, 2017		Nine Months Ended September 30, 2017		March 31, 2019								Three Months Ended March 31, 2019
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses				Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses
	(Amounts in Thousands)												(Amounts in Thousands)
Loans (4)
Agricultural	$	—	$	—	$	4,350	$	4,350	$	—	$	23	$	—	$	—	$	2,090	$	2,090	$	—
Commercial and financial	—		—		1,667		1,667		8		135		—		—		2,566		2,566		50
Real Estate:																					—
Construction, 1 to 4 family residential	—		—		186		186		—		—		—		—		—		—		—
Construction, land development and commercial	—		—		697		697		—		—		—		—		612		612		8
Mortgage, farmland	—		—		6,862		6,862		—		—		—		—		3,674		3,674		—
Mortgage, 1 to 4 family first liens	—		—		6,214		6,214		31		150		—		—		6,746		6,746		90
Mortgage, 1 to 4 family junior liens	—		—		34		34		71		88		—		—		23		23		—
Mortgage, multi-family	—		—		6,003		6,003		—		—		—		—		1,120		1,120		—
Mortgage, commercial	—		—		1,101		1,101		86		111		—		—		2,108		2,108		—
Loans to individuals	—		—		—		—		10		20		—		—		—		—		—
Foreclosed assets (5)	—		—		—		—		—		—		—		—		—		—		—
Total	$	—	$	—	$	27,114	$	27,114	$	206	$	527	$	—	$	—	$	18,939	$	18,939	$	148


(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.

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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


	December 31, 2016								Year Ended December 31, 2016		December 31, 2018								Year Ended December 31, 2018
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses
	(Amounts in Thousands)										(Amounts in Thousands)
Loans (4)
Agricultural	$	—	$	—	$	10,773	$	10,773	$	—	$	—	$	—	$	1,160	$	1,160	$	63
Commercial and financial	—		—		1,397		1,397		143		—		—		2,882		2,882		122
Real Estate:
Construction, 1 to 4 family residential	—		—		827		827		—		—		—		—		—		—
Construction, land development and commercial	—		—		85		85		—		—		—		703		703		—
Mortgage, farmland	—		—		7,077		7,077		—		—		—		3,848		3,848		—
Mortgage, 1 to 4 family first liens	—		—		5,424		5,424		756		—		—		6,729		6,729		520
Mortgage, 1 to 4 family junior liens	—		—		194		194		—		—		—		22		22		60
Mortgage, multi-family	—		—		244		244		—		—		—		7,286		7,286		—
Mortgage, commercial	—		—		1,541		1,541		65		—		—		1,458		1,458		349
Loans to individuals	—		—		—		—		—		—		—		—		—		—
Foreclosed assets (5)	—		—		75		75		20		—		—		—		—		—
Total	$	—	$	—	$	27,637	$	27,637	$	984	$	—	$	—	$	24,088	$	24,088	$	1,114


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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


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


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


Note 7.8.	Stock Repurchase Program

On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 1,500,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, ~~2018.~~2020. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors. The Company has purchased ~~1,003,216~~1,196,650 shares of its common stock in privately negotiated transactions from August 1, 2005 through ~~September 30, 2017.~~March 31, 2019. Of these ~~1,003,216~~1,196,650 shares, ~~14,538~~69,771 shares were purchased during the quarter ended ~~September 30, 2017,~~March 31, 2019, at an average price per share of ~~$52.80.~~$61.50.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 8.9.	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 ~~$68.95~~$98.32 million. The concentrations of credit by type of loan are set forth in Note 5 to the Consolidated Financial Statements. Outstanding letters of credit were granted primarily to commercial borrowers. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the economic conditions in Johnson, Linn and Washington Counties, Iowa.

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

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

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments at ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016~~2018 is as follows:


	September 30, 2017		December 31, 2016		March 31, 2019		December 31, 2018
	(Amounts In Thousands)				(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	54,200	$	48,785	$	60,782	$	59,330
Credit cards	49,107		45,738		54,165		52,802
Commercial, real estate and home construction	138,982		113,251		100,245		89,171
Commercial lines and real estate purchase loans	171,516		180,892		178,232		174,637
Outstanding letters of credit	11,398		9,024		8,918		9,033


Note 9.10.	Income Taxes

Federal income tax expense for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018 was computed using the consolidated effective federal tax rate. The Company also recognized income tax expense pertaining to state franchise taxes payable individually by the subsidiary bank. The Company files a consolidated tax return for federal purposes and separate tax returns for State of Iowa purposes. The tax years ended December 31, ~~2016, 2015,~~2018, 2017, and ~~2014~~2016 remain subject to examination by the Internal Revenue Service. For state tax purposes, the tax years ended December 31, ~~2016, 2015,~~2018, 2017, and ~~2014~~2016 remain open for examination. There were no material unrecognized tax benefits at ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016~~2018 and therefore no interest or penalties on unrecognized tax benefits has been recorded. As of ~~September 30, 2017,~~March 31, 2019, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending ~~September 30, 2018.~~March 31, 2020. Income taxes as a percentage of income before taxes were ~~30.48%~~21.22% for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~31.40%~~19.15% for the same period in ~~2016.~~2018.

On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cut and Jobs Act (the “Tax Act”). The Tax Act established new tax laws that reduced the U.S. federal corporate income tax rate from 35% to 21% in 2018.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note ~~10.~~11.	Derivative Financial Instruments

In the normal course of business, the Bank may use derivative financial instruments to manage its interest rate risk. These instruments carry varying degrees of credit, interest rate and market or liquidity risks. Derivative instruments are recognized as either assets or liabilities in the accompanying financial statement and are measured at fair value. The Bank’s objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates. The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amount to be exchanged between the counterparties. The Bank is exposed to credit risk in the event of nonperformance by counterparties to financial instruments. The Bank minimizes this risk by entering into derivative contracts with large, stable financial institutions. The Bank has not experienced any losses from nonperformance by counterparties. The Bank monitors counterparty risk in accordance with the provisions of ASC 815. In addition, the Bank’s interest rate-related derivative instruments contain language outlining collateral pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty. The Bank was required to pledge ~~$3.46~~$1.89 million of collateral as of ~~September 30, 2017.~~March 31, 2019.

Cash Flow Hedges:

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

The table below identifies the balance sheet category and fair values of the Bank’s derivative instruments designated as cash flow hedges as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016:~~2018:


	Notional Amount		Fair Value			Balance Sheet Category	Maturity	Notional Amount		Fair Value			Balance Sheet Category	Maturity
	(Amounts in Thousands)							(Amounts in Thousands)
September 30, 2017
March 31, 2019
Interest rate swap	$	25,000	$	(853	)	Other Liabilities	11/9/2020	$	25,000	$	(182	)	Other Liabilities	11/9/2020
Interest rate swap	25,000		(2,611		)	Other Liabilities	11/7/2023	25,000		(1,712		)	Other Liabilities	11/7/2023

December 31, 2016
December 31, 2018
Interest rate swap	$	25,000	$	(1,097	)	Other Liabilities	11/9/2020	$	25,000	$	(120	)	Other Liabilities	11/9/2020
Interest rate swap	25,000		(2,841		)	Other Liabilities	11/7/2023	25,000		(1,476		)	Other Liabilities	11/7/2023

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The table below identifies the gains and losses recognized on the Bank’s derivative instruments designated as cash flow hedges for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~the~~ year ended December 31, ~~2016:~~2018:


	Effective Portion						Ineffective Portion
	Recognized in OCI			Reclassifed from AOCI into Income			Recognized in Income on Derivatives			Recognized in OCI			Reclassified from AOCI into Income			Recognized in Income on Derivatives
	Amount of Gain (Loss)			Category	Amount of Gain (Loss)		Category	Amount of Gain (Loss)		Amount of Gain (Loss)			Category	Amount of Gain (Loss)		Category	Amount of Gain (Loss)
	(Amounts in Thousands)									(Amounts in Thousands)
September 30, 2017
March 31, 2019
Interest rate swap	$	151		Interest Expense	$	—	Other Income	$	—	$	(46	)	Interest Expense	$	—	Other Income	$	—
Interest rate swap	142			Interest Expense	—		Other Income	—		(177		)	Interest Expense	—		Other Income	—

December 31, 2016
December 31, 2018
Interest rate swap	$	250		Interest Expense	$	—	Other Income	$	—	$	347		Interest Expense	$	—	Other Income	$	—
Interest rate swap	(101		)	Interest Expense	—		Other Income	—		571			Interest Expense	—		Other Income	—



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

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

Special Note Regarding Forward Looking Statements

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

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

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

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

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

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HILLS BANCORPORATION

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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HILLS BANCORPORATION

Critical Accounting Policies

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

economic conditions throughout the Midwest and the state of certain industries. Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position. Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations. Although management believes the levels of the allowance as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016~~2018 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

Overview

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

The Company is a holding company engaged in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids, Marion, and Washington, Iowa. At ~~September 30, 2017,~~March 31, 2019, the Bank has nineteen full-service locations.

Net income for the ~~nine~~three month period ended ~~September 30, 2017~~March 31, 2019 was ~~$23.88~~$11.20 million compared to ~~$24.84~~$10.86 million for the same ~~nine~~three months of ~~2016, a decrease~~2018, an increase of ~~3.86%~~3.18%. The ~~$0.96~~$0.34 million ~~decrease~~increase in net income was caused by a number of factors. The principal factors in the ~~decrease~~increase in net income for the first ~~nine~~three months of ~~2017~~2019 are ~~an increase in noninterest expenses of $3.09 million and an increase in provision for loan losses of $3.83 million. These changes were offset by~~ an increase in net interest income of ~~$4.87 million, an increase in noninterest income of $0.19~~$1.48 million and a decrease in the provision for loan losses of $0.48 million. These changes were offset by a decrease in noninterest income of $0.38 million, an increase in income tax expense of ~~$0.90~~$0.45 million and an increase in noninterest expenses of $0.79 million.

The Company achieved a return on average assets of ~~1.14%~~1.23% and a return on average equity of ~~10.39%~~11.36% for the twelve months ended ~~September 30, 2017,~~March 31, 2019, compared to the twelve months ended ~~September 30, 2016,~~March 31, 2018, which were ~~1.23%~~1.07% and ~~11.59%~~9.82%, respectively. Dividends of ~~$0.70~~$0.82 per share were paid in January ~~2017~~2019 to ~~2,390~~2,481 shareholders. The ~~2016~~2018 dividend was ~~$0.65~~$0.75 per share.

The Company’s net interest income is the largest component of revenue and it is primarily a function of the average earning assets and the net interest margin percentage. The Company achieved a net interest margin on a tax-equivalent basis of ~~3.46%~~3.27% for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 compared to ~~3.42%~~3.25% for the same ~~nine~~three months of ~~2016.~~2018. Average earning assets were ~~$2.611~~$3.013 billion year to date in ~~2017~~2019 and ~~$2.435~~$2.875 billion in ~~2016.~~2018.

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HILLS BANCORPORATION

Highlights noted on the balance sheet as of ~~September 30, 2017~~March 31, 2019 for the Company included the following:

Total assets were ~~$2.784~~$3.228 billion, an increase of ~~$128.00~~$185.40 million since December 31, ~~2016.~~2018.

Cash and cash equivalents were ~~$36.79~~$200.48 million, ~~a decrease~~an increase of ~~$1.41~~$157.17 million since December 31, ~~2016.~~2018. Cash and cash equivalents growth included approximately $84.00 million of temporary public funds.

Net loans were ~~$2.398~~$2.613 billion, an increase of ~~$136.90~~$19.69 million since December 31, ~~2016.~~2018. Loans held for sale ~~decreased $3.09~~increased $3.28 million since December 31, ~~2016.~~2018.

Deposits increased ~~$36.73~~$175.77 million since December 31, ~~2016. $74.00~~2018. Deposit growth included approximately $84.00 million ~~of deposit growth are~~in temporary public funds.

~~Federal Home Loan Bank borrowings were $323.00 million, an increase of $88.00 million since December 31, 2016.~~

Reference is made to Note 67 for a discussion of fair value measurements which relate to methods used by the Company in recording assets and liabilities on its financial statements.

Financial Condition

Loan demand ~~has been increasing and~~ is expected to remain steady throughout the year ending December 31, ~~2017~~2019 and into ~~2018.~~2020. As indicated in the table below, growth is primarily in ~~the~~farmland, mortgage 1 to 4 family first liens and commercial real estate ~~loan categories have been primarily responsible for the increase in total~~ loans.

The following table sets forth the composition of the loan portfolio as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016:~~2018:


	September 30, 2017				December 31, 2016				March 31, 2019				December 31, 2018
	Amount		Percent		Amount		Percent		Amount		Percent		Amount		Percent
	(Amounts In Thousands)				(Amounts In Thousands)				(Amounts In Thousands)				(Amounts In Thousands)
Agricultural	$	76,484	3.16	%	$	92,871	4.08	%	$	93,573	3.54	%	$	92,673	3.53	%
Commercial and financial	214,199		8.85		192,995		8.47		227,403		8.60		229,501		8.73
Real estate:
Construction, 1 to 4 family residential	73,404		3.03		57,864		2.54		73,868		2.79		72,279		2.75
Construction, land development and commercial	107,170		4.43		121,561		5.34		105,466		3.99		113,807		4.33
Mortgage, farmland	208,982		8.64		202,340		8.89		238,109		9.01		236,454		9.00
Mortgage, 1 to 4 family first liens	823,529		34.04		767,469		33.70		916,408		34.67		912,059		34.71
Mortgage, 1 to 4 family junior liens	137,271		5.67		125,400		5.51		152,183		5.76		152,625		5.81
Mortgage, multi-family	335,439		13.86		302,831		13.30		351,090		13.28		352,434		13.41
Mortgage, commercial	359,332		14.85		334,198		14.68		402,073		15.21		383,314		14.58
Loans to individuals	26,223		1.08		25,157		1.10		29,739		1.13		30,072		1.14
Obligations of state and political subdivisions	57,861		2.39		54,462		2.39		53,153		2.01		52,725		2.01
	$	2,419,894	100.00	%	$	2,277,148	100.00	%	$	2,643,065	100.00	%	$	2,627,943	100.00	%
Net unamortized fees and costs	886				827				943				952
	$	2,420,780			$	2,277,975			$	2,644,008			$	2,628,895
Less allowance for loan losses	29,350				26,530				36,520				37,810
	$	2,391,430			$	2,251,445			$	2,607,488			$	2,591,085

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HILLS BANCORPORATION

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

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

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

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

Index

HILLS BANCORPORATION

The following table presents the allowance for loan losses on loans by loan category, the percentage of the allowance for each category to the total allowance, and the percentage of all loans in each category to total loans as of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016:~~2018:


	September 30, 2017						December 31, 2016						March 31, 2019						December 31, 2018
	Amount		% of Total Allowance		% of Loans to Total Loans		Amount		% of Total Allowance		% of Loans to Total Loans		Amount		% of Total Allowance		% of Loans to Total Loans		Amount		% of Total Allowance		% of Loans to Total Loans
	(In Thousands)						(In Thousands)						(In Thousands)						(In Thousands)
Agricultural	$	2,462	8.39	%	3.16	%	$	2,947	11.11	%	4.08	%	$	2,541	6.96	%	3.54	%	$	2,789	7.38	%	3.53	%
Commercial and financial	4,741		16.15		8.85		4,531		17.08		8.47		6,004		16.44		8.60		5,826		15.41		8.73
Real estate:
Construction, 1 to 4 family residential	1,263		4.30		3.03		1,023		3.86		2.54		1,279		3.50		2.79		1,297		3.43		2.75
Construction, land development and commercial	1,753		5.97		4.43		1,867		7.04		5.34		1,649		4.52		3.99		1,995		5.28		4.33
Mortgage, farmland	4,008		13.66		8.64		3,417		12.88		8.89		3,871		10.60		9.01		3,972		10.51		9.00
Mortgage, 1 to 4 family first liens	7,343		25.02		34.04		6,560		24.72		33.70		9,954		27.26		34.67		10,750		28.43		34.71
Mortgage, 1 to 4 family junior liens	1,243		4.24		5.67		1,117		4.21		5.51		1,676		4.59		5.76		1,766		4.67		5.81
Mortgage, multi-family	2,546		8.67		13.86		1,669		6.29		13.30		3,952		10.82		13.28		4,083		10.80		13.41
Mortgage, commercial	2,896		9.87		14.85		2,376		8.95		14.68		4,271		11.69		15.21		4,082		10.80		14.58
Loans to individuals	632		2.15		1.08		642		2.42		1.10		818		2.24		1.13		723		1.91		1.14
Obligations of state and political subdivisions	463		1.58		2.39		381		1.44		2.39		505		1.38		2.01		527		1.38		2.01
	$	29,350	100.00	%	100.00	%	$	26,530	100.00	%	100.00	%	$	36,520	100.00	%	100.00	%	$	37,810	100.00	%	100.00	%

The allowance for loan losses totaled ~~$29.35~~$36.52 million at ~~September 30, 2017~~March 31, 2019 compared to ~~$26.53~~$37.81 million at December 31, ~~2016.~~2018. The percentage of the allowance to outstanding loans was ~~1.21%~~1.38% and ~~1.17%~~1.44% at ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016,~~2018, respectively. The allowance was based on management’s consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks and the overall amount of loans outstanding. The ~~increase~~decrease in the allowance in ~~2017~~2019 is the result of ~~$136.90 million million in loan growth and a~~ change in the composition and allocation of loans within credit quality ~~ratings.~~ratings and improvements in the credit quality of the Bank's loan portfolio.

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

Management has determined that the allowance for loan losses was appropriate at ~~September 30, 2017,~~March 31, 2019, and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for loan losses is based on a comprehensive, well documented, and consistently applied analysis of the Company’s loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for loan losses is reviewed and compared to industry data. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.

Index

HILLS BANCORPORATION

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

Investment securities available for sale held by the Company ~~decreased~~increased by ~~$12.55~~$4.99 million from December 31, ~~2016~~2018 to ~~September 30, 2017.~~March 31, 2019. The fair value of securities available for sale was ~~$1.30~~$0.56 million more than the amortized cost of such securities as of ~~September 30, 2017.~~March 31, 2019. At December 31, ~~2016,~~2018, the fair value of the securities available for sale was ~~$1.50~~$2.73 million less than the amortized cost of such securities.

Deposits increased ~~$36.73~~$175.77 million in the first ~~nine~~three months of ~~2017. Repurchase agreements decreased $19.73 million since December 31, 2016.~~2019 primarily due to increases in temporary public funds deposits, broker deposits and rate specials on certificate of deposits. In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Brokered deposits are included in total deposits and totaled ~~$73.09~~$137.87 million as of ~~September 30, 2017~~March 31, 2019 with an average rate of ~~0.99%~~2.57%. Brokered deposits were ~~$112.70~~$132.46 million as of December 31, ~~2016~~2018 with an average interest rate of ~~0.59%~~2.46%. As of ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016,~~2018, brokered deposits were ~~3.53%~~5.31% and ~~5.53%~~5.47% of total deposits, respectively.

Federal Home Loan Bank (FHLB) borrowings were $215 million as of March 31, 2019 and December 31, 2018. It is expected that the FHLB ~~Borrowings increased $88.00 million to $323.00 million for~~funding source will be considered in the ~~nine months ended September 30, 2017. This increase was primarily used to fund the $136.90 million of~~future if loan growth ~~for~~continues to exceed core deposit increases and the ~~nine months ended September 30, 2017.~~interest rates on funds borrowed from the FHLB are favorable compared to other funding alternatives.

Dividends and Equity

In January ~~2017,~~2019, Hills Bancorporation paid a dividend of ~~$6.49~~$7.66 million or ~~$0.70~~$0.82 per share. The dividend was ~~$0.65~~$0.75 per share in January ~~2016.~~2018. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of ~~September 30, 2017~~March 31, 2019 totaled ~~$309.57~~$340.78 million. On January 1, 2015, the final rules of the Federal Reserve Board went into effect implementing in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision. The final rule also adopted changes to the agencies’ regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

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


	Actual				For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions		Actual				For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Ratio		Ratio		Amount		Ratio		Ratio		Ratio
As of September 30, 2017:
As of March 31, 2019:
Company:
Total risk-based capital	$	379,401	16.63	%	8.000	%	10.000	%	$	419,583	17.27	%	8.000	%	10.000	%
Tier 1 risk-based capital	350,876		15.38		6.000		8.000		389,132		16.01		6.000		8.000
Tier 1 common equity	350,876		15.38		4.500		6.500		389,132		16.01		4.500		6.500
Leverage ratio	350,876		12.76		4.000		5.000		389,132		12.50		4.000		5.000
Bank:
Total risk-based capital	380,050		16.67		8.000		10.000		420,141		17.30		8.000		10.000
Tier 1 risk-based capital	351,549		15.42		6.000		8.000		389,708		16.05		6.000		8.000
Tier 1 common equity	351,549		15.42		4.500		6.500		389,708		16.05		4.500		6.500
Leverage ratio	351,549		12.79		4.000		5.000		389,708		12.53		4.000		5.000

Index

HILLS BANCORPORATION


	Actual				For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions		Actual				For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Ratio		Ratio		Amount		Ratio		Ratio		Ratio
As of December 31, 2016:
As of December 31, 2018:
Company:
Total risk-based capital	$	357,440	16.17	%	8.00	%	10.00	%	$	414,772	17.18	%	8.00	%	10.00	%
Tier 1 risk-based capital	330,910		14.97		6.00		8.00		384,502		15.93		6.00		8.00
Tier 1 common equity	330,910		14.97		4.50		6.50		384,502		15.93		4.50		6.50
Leverage ratio	330,910		12.63		4.00		5.00		384,502		12.68		4.00		5.00
Bank:
Total risk-based capital	357,895		16.20		8.00		10.00		416,198		17.25		8.00		10.00
Tier 1 risk-based capital	331,365		15.00		6.00		8.00		385,943		16.00		6.00		8.00
Tier 1 common equity	331,365		15.00		4.50		6.50		385,943		16.00		4.50		6.50
Leverage ratio	331,365		12.66		4.00		5.00		385,943		12.73		4.00		5.00

Index

HILLS BANCORPORATION

Discussion of operations for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018

Net Income Overview

Net income ~~decreased $0.96~~increased $0.34 million for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 compared to the first ~~nine~~three months of ~~2016.~~2018. Total net income was ~~$23.88~~$11.20 million in ~~2017~~2019 and ~~$24.84~~$10.86 million in the comparable period in ~~2016,~~2018, an ~~decrease~~increase of ~~3.86%~~3.18%. The changes in net income in ~~2017~~2019 from the first ~~nine~~three months of ~~2016~~2018 were primarily the result of the following:

Net interest income increased by ~~$4.87~~$1.48 million, before provision expense. Total interest income increased by ~~$5.70~~$3.82 million as a result of growth in the volume of earning assets. Total interest expense increased by $2.34 million primarily due to rising interest rates increasing the costs of funding.

The provision for loan losses ~~increased~~decreased by ~~$3.83~~$0.48 million.

Noninterest income ~~increased~~decreased by ~~$0.19~~$0.38 million.

Noninterest expenses increased by ~~$3.09~~$0.79 million.

Income tax expense ~~decreased~~increased by ~~$0.90~~$0.45 million.

For the ~~nine~~three month period ended ~~September 30, 2017~~March 31, 2019 and ~~September 30, 2016~~March 31, 2018 basic earnings per share was ~~$2.56~~$1.20 and ~~$2.67,~~$1.16, respectively. Diluted earnings per share was ~~$2.56~~$1.20 for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 compared to ~~$2.67~~$1.16 for the same period in ~~2016.~~2018.

The Company’s net income ~~continues to be~~is driven primarily by three important factors. The first important factor is the interaction between changes in net interest margin and changes in average volumes of the Bank's earnings assets. Net interest income of ~~$65.37~~$23.77 million for the first ~~nine~~three months of ~~2017~~2019 was derived from the Company’s ~~$2.611~~$3.013 billion of average earning assets during that period and its tax-equivalent net interest margin of ~~3.46%~~3.27%. Average earning assets in the ~~nine~~three months ended ~~September 30, 2016~~March 31, 2018 were ~~$2.435~~$2.875 billion and the tax-equivalent net interest margin was ~~3.42%~~3.25%. ~~Net interest margin is the yield generated from earning assets minus interest expense represented as a percentage of the Bank's earning assets.~~ The importance of net interest margin is illustrated by the fact that an increase or decrease in the net interest margin of 10 basis points would have resulted approximately in a ~~$1.96~~$0.75 million change in income before income taxes in the ~~nine~~three month period ended ~~September 30, 2017.~~March 31, 2019. Net interest income for the Company increased primarily as a result of growth in the volume of earning assets. The Company expects net interest ~~income to remain stable through 2017 and net interest~~ compression to impact earnings ~~in future years.~~for the foreseeable future. The Company believes growth in net interest income will be contingent on the growth of the Company’s earnings assets.

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than ~~$2.398~~$2.613 billion at ~~September 30, 2017~~March 31, 2019. The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historically higher credit risk. The provision for loan losses was ana reduction of expense of ~~$1.83~~$1.25 million in ~~2017~~2019 compared to a reduction of expense of ~~$2.00~~$0.77 million in ~~2016. The majority of the increase was the result of $14.09 million in loans in which a specific reserve of $1.47 million was allocated.~~2018. The Company believes that the provision for loan losses may increase for the foreseeable future resulting from projected increases in the size of the Company’s loan portfolio.

The third significant factor affecting the Company’s net income is income tax expense. Federal and state income tax expenses were ~~$10.47~~$3.02 million and ~~$11.37~~$2.57 million for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016,~~2018, respectively. Income taxes as a percentage of income before taxes were ~~30.48%~~21.22% in 2019 and 19.15% in 2018. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cut and ~~31.40%~~Jobs Act (the “Tax Act”). The Tax Act established new tax laws that reduced the U.S. federal corporate income tax rate from 35% to 21% in ~~2016.~~2018. The quarter ended March 31, 2019 will be the first with all comparable periods on a Post-Tax Act basis, therefore the Company expects income taxes as a percentage of income before taxes to be more comparable in current and future periods than it was over the previous fiscal year.

Index

HILLS BANCORPORATION

Discussion of operations for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018

Net Interest Income

Net interest income increased for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 compared to the comparable period in ~~2016.~~2018. The increase was as a result of growth in the average volume of earning assets. Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the average volume of earning assets for the period and the net interest margin. The net interest margin for the first ~~nine~~three months of ~~2017~~2019 was ~~3.46%~~3.27% compared to ~~3.42%~~3.25% in ~~2016~~2018 for the same period. Interest expense increased $2.34 million for the three months ended March 31, 2019 compared to the three months ended March 31, 2018 primarily due to increasing interest rates on deposits. The measure is shown on a tax-equivalent basis using a tax rate of ~~35%~~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~~three months ended in ~~2017~~2019 compared to the comparable period in ~~2016~~2018 are shown in the following table:


						Increase (Decrease) in Net Interest Income														Increase (Decrease) in Net Interest Income
	Change in Average Balance			Change in Average Rate		Volume Changes			Rate Changes			Net Change			Change in Average Balance			Change in Average Rate		Volume Changes			Rate Changes			Net Change
	(Amounts in Thousands)														(Amounts in Thousands)
Interest income:
Loans, net	$	178,712		(0.01	)%	$	5,544		$	(92	)	$	5,452		$	169,047		0.25	%	$	1,857		$	1,682		$	3,539
Taxable securities	3,507			0.15		58			99			157			14,054			0.36		67			128			195
Nontaxable securities	6,405			(0.10	)	146			(129		)	17			14,551			0.20		92			102			194
Federal funds sold	(12,386		)	0.45		(48		)	69			21			(59,155		)	0.84		(232		)	172			(60		)
	$	176,238				$	5,700		$	(53	)	$	5,647		$	138,497				$	1,784		$	2,084		$	3,868

Interest expense:
Interest-bearing demand deposits	$	29,000		0.01	%	$	(30	)	$	(65	)	$	(95	)	$	6,058		0.32	%	$	(8	)	$	(533	)	$	(541	)
Savings deposits	80,031			0.10		(131		)	(548		)	(679		)	29,532			0.39		(49		)	(809		)	(858		)
Time deposits	1,080			0.07		5			(219		)	(214		)	116,749			0.53		(439		)	(797		)	(1,236		)
Other borrowings	(1,163		)	—		—			—			—			—			—		—			—			—
FHLB borrowings	28,718			(0.52	)	(749		)	1,035			286			(255,661		)	—		299			—			299
Interest-bearing other liabilities	(21,623		)	0.30		39			(61		)	(22		)	(4		)	1.18		—			—			—
	$	116,043				$	(866	)	$	142		$	(724	)	$	(103,326	)			$	(197	)	$	(2,139	)	$	(2,336	)
Change in net interest income						$	4,834		$	89		$	4,923							$	1,587		$	(55	)	$	1,532

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

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


(Tax Equivalent Basis)	2017		2016		2019		2018
Yield on average interest-earning assets	4.11	%	4.08	%	4.35	%	4.05	%
Rate on average interest-bearing liabilities	0.85		0.84		1.39		1.04
Net interest spread	3.26	%	3.24	%	2.96	%	3.01	%
Effect of noninterest-bearing funds	0.20		0.18		0.31		0.24
Net interest margin (tax equivalent interest income divided by average interest-earning assets)	3.46	%	3.42	%	3.27	%	3.25	%

Index

HILLS BANCORPORATION

Discussion of operations for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. The Federal Open Market Committee met ~~six~~two times during the first ~~nine~~three months of ~~2017.~~2019. The target rate ~~was increased in June, 2017~~remained at ~~1.25%.~~2.50% as of March 31, 2019. Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate. As of ~~September 30, 2017,~~March 31, 2019, the rate indexes for the one, three and five year indexes were ~~1.31%~~2.40%, ~~1.62%~~2.21% and ~~1.92%~~2.23%, respectively. The one year index increased ~~122.03%~~14.83% from ~~0.59%~~2.09% at ~~September 30, 2016,~~March 31, 2018, the three year index ~~increased 84.10%~~decreased 7.53% and the five year index ~~increased 68.42%~~decreased 12.89%. The three year index was ~~0.88%~~2.39% and the five year index was ~~1.14%~~2.56% at ~~September 30, 2016.~~March 31, 2018. The targeted federal funds rate was ~~1.25%~~2.50% and ~~0.50%~~1.75% at ~~September 30, 2017~~March 31, 2019 and ~~2016,~~2018, respectively. The Company anticipates ~~possible increases in~~ short term and long term rates in the indexes to remain consistent for ~~the remainder of 2017.~~2019.

Provision for Loan Losses

The provision for loan losses was ana reduction of expense of ~~$1.83~~$1.25 million for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 compared to a reduction of expense of ~~$2.00~~$0.77 million in ~~2016, an~~2018, a reduction of expense ~~increase~~ of ~~$3.83~~$0.48 million. The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio. The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks. The ~~increase~~decrease in expense in ~~2017~~2019 is the ~~net~~ result of ~~an increase in net loans,~~ a change in the composition and allocation of loans within credit quality ratings as compared to March 31, 2018 and ~~a specific allowance~~improvements in the credit quality of ~~$1.47 million recorded for $14.09 million in 2~~the Bank's loan ~~relationships.~~portfolio.

The allowance for loan losses ~~increased $2.82~~decreased $1.29 million during the first ~~nine~~three months of ~~2017.~~2019 as compared to December 31, 2018. In the first ~~nine~~three months of ~~2017,~~2019, there was a ~~increase~~decrease of ~~$2.93~~$2.55 million due to ~~increases~~changes in average balances and composition of loans outstanding and a ~~$0.11~~$1.26 million ~~decrease~~increase in the amount allocated to the allowance due to declines in credit quality.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016,~~2018, recoveries were ~~$2.46~~$0.43 million and ~~$3.15~~$0.54 million, respectively; and charge-offs were ~~$1.46~~$0.48 million in ~~2017~~2019 and ~~$1.52~~$0.27 million in ~~2016.~~2018. The allowance for loan losses totaled ~~$29.35~~$36.52 million at ~~September 30, 2017~~March 31, 2019 compared to ~~$26.53~~$37.81 million at December 31, ~~2016.~~2018. The allowance represented ~~1.21%~~1.38% and ~~1.17%~~1.44% of loans held for investment at ~~September 30, 2017~~March 31, 2019 and December 31, ~~2016.~~2018.

Noninterest Income

The following table sets forth the various categories of noninterest income for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016.~~2018.


	Nine Months Ended September 30,									Three Months Ended March 31,
	2017		2016		$ Change			% Change		2019		2018		$ Change			% Change
	(Amounts in thousands)									(Amounts in thousands)
Net gain on sale of loans	$	1,119	$	1,437	$	(318	)	(22.13	)%	$	286	$	331	$	(45	)	(13.60	)%
Trust fees	5,883		5,185		698			13.46		2,252		2,641		(389		)	(14.73	)
Service charges and fees	6,557		6,516		41			0.63		2,275		2,228		47			2.11
Net gain on sale of other real estate owned and other repossessed assets	89		376		(287		)	(76.33	)
Other noninterest income	1,599		1,541		58			3.76		437		428		9			2.10
	$	15,247	$	15,055	$	192		1.28		$	5,250	$	5,628	$	(378	)	(6.72	)

Noninterest income categories experienced marginal period-to-period fluctuations for the three months ended March 31, 2019.

Index

HILLS BANCORPORATION

Discussion of operations for the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016~~2018

Loans originated for sale in the first ~~nine~~three months of ~~2017~~2019 totaled ~~$109.52~~$29.85 million compared to ~~$151.55~~$31.57 million in the same period in ~~2016,~~2018, a decrease of ~~27.73%~~5.45%. In the ~~nine~~three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016,~~2018, the net gain on sale of loans was ~~$1.12~~$0.29 million and ~~$1.44~~$0.33 million, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income. The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

~~Trust fees increased $0.70 million in the nine months ended September 30, 2017 compared to September 30, 2016 due to new trust relationships.~~

Net gain on sale of other real estate owned and other repossessed assets decreased $0.28 million in the nine months ended September 30, 2017 compared to September 30, 2016 due to a decrease in the amount of other real estate owned by the Company.

~~Noninterest Expenses~~

~~The following table sets forth the various categories of noninterest expenses for the nine months ended September 30, 2017 and 2016.~~

Nine Months Ended September 30,
2017 2016 $ Change % Change
(Amounts in thousands)
Salaries and employee benefits $ 24,707
$ 22,617
$ 2,090
9.24 %
Occupancy 3,148
3,001
147
4.90
Furniture and equipment 4,356
4,111
245
5.96
Office supplies and postage 1,487
1,282
205
15.99
Advertising and business development 2,123
2,426
(303 ) (12.49 )
Outside services 5,943
5,386
557
10.34
FDIC insurance assessment 636
938
(302 ) (32.20 )
Other noninterest expense 2,033
1,585
448
28.26
$ 44,433
$ 41,346
$ 3,087
7.47

In the nine months ended September 30, 2017 and 2016, salaries and employee benefits expense increased $2.09 million. The increase is primarily the result of annual salary adjustments and hiring of additional employees to staff branch growth. Other noninterest expense categories experienced marginal period-to-period fluctuations for the nine months ended September 30, 2017.

~~Discussion of operations for the three months ended September 30, 2017 and 2016~~

~~Net Income Overview~~

Net income decreased $0.62 million for the three months ended September 30, 2017 compared to the same period in 2016. Total net income was $8.55 million in 2017 and $9.18 million in the comparable period in 2016, a decrease of 6.80%. For the three month period ended September 30, 2017 and September 30, 2016 basic earning per share was $0.92 and $0.99, respectively. Diluted earnings per share was $0.92 for the three months ended September 30, 2017 compared to $0.99 for the same period in 2016.

~~Index~~

~~HILLS BANCORPORATION~~

~~Discussion of operations for the three months ended September 30, 2017 and 2016~~

~~Net Interest Income~~

Net interest income increased for the three months ended September 30, 2017 compared to the comparable period in 2016. The increase was primarily the result of growth in the volume of earning assets. Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin. The net interest margin for the three months ended September 30, 2017 was 3.44% compared to 3.49% in 2016 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 35% 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 2017 compared to the comparable period in 2016 are shown in the following table:

Increase (Decrease) in Net Interest Income

Change in
Average Balance

Change in
Average Rate
Volume Changes Rate Changes Net Change
(Amounts in Thousands)
Interest income:
Loans, net $ 190,297
— % $ 2,056
$ (16 ) $ 2,040
Taxable securities 5,589
0.20
35
40
75
Nontaxable securities 4,163
(0.09 ) 32
(35 ) (3 )
Federal funds sold (12,386 ) 0.12
(2 ) 5
3
$ 187,663

$ 2,121
$ (6 ) $ 2,115

Interest expense:

Interest-bearing demand deposits $ 41,015
0.02 % $ (14 ) $ (32 ) $ (46 )
Savings deposits 35,918
0.10
(16 ) (190 ) (206 )
Time deposits 15,780
0.09
(49 ) (99 ) (148 )
Other borrowings —
—
—
—
—
FHLB borrowings 86,774
(0.60 ) (767 ) 469
(298 )
Interest-bearing other liabilities (31,851 ) 0.62
22
(52 ) (30 )
$ 147,636
$ (824 ) $ 96
$ (728 )
Change in net interest income

$ 1,297
$ 90
$ 1,387

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

(Tax Equivalent Basis) 2017 2016
Yield on average interest-earning assets 4.13 % 4.12 %
Rate on average interest-bearing liabilities 0.90
0.82
Net interest spread 3.23 % 3.30 %
Effect of noninterest-bearing funds 0.21
0.19
Net interest margin (tax equivalent interest income divided by average interest-earning assets) 3.44 % 3.49 %

~~Index~~

~~HILLS BANCORPORATION~~

~~Discussion of operations for the three months ended September 30, 2017 and 2016~~

~~Provision for Loan Losses~~

The provision for loan losses was an expense of $0.13 million for the three months ended September 30, 2017 compared to a reduction of expense of $1.83 million in 2016, an expense increase of $1.96 million. The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio. The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks.

The allowance for loan losses increased $0.40 million during the three months ended September 30, 2017. In the three months ended September 30, 2017, there was a $0.32 million decrease in the amount allocated to the allowance due to credit quality and a $0.72 million increase due to the composition of loans outstanding.

In addition to provision expense, the allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the three months ended September 30, 2017 and 2016, recoveries were $0.58 million and $1.16 million, respectively; and charge-offs were $0.31 million in 2017 and $0.48 million in 2016.

~~Noninterest Income~~

~~The following table sets forth the various categories of noninterest income for the three months ended September 30, 2017 and 2016.~~

Three Months Ended September 30,
2017 2016 $ Change % Change
(Amounts in thousands)
Net gain on sale of loans $ 423
$ 602
$ (179 ) (29.73 )%
Trust fees 1,980
1,731
249
14.38
Service charges and fees 2,197
2,243
(46 ) (2.05 )
Net gain on sale of other real estate owned and other repossessed assets 33
342
(309 ) —
Other noninterest income 372
396
(24 ) (6.06 )
$ 5,005
$ 5,314
$ (309 ) (5.81 )

In the three months ended September 30, 2017 and 2016, the net gain on sale of loans was $0.42 million and $0.60 million , respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income. The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

~~Trust fees increased $0.25 million in the three months ended September 30, 2017 compared to September 30, 2016 due to new trust relationships.~~

Net gain on sale of other real estate owned and other repossessed assets decreased $0.31 million in the three months ended September 30, 2017 compared to September 30, 2016 due to a decrease in the amount of other real estate owned by the Company.

~~Index~~

~~HILLS BANCORPORATION~~

~~Discussion of operations for the three months ended September 30, 2017 and 2016~~

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016.~~2018.


	Three Months Ended September 30,									Three Months Ended March 31,
	2017		2016		$ Change			% Change		2019		2018		$ Change			% Change
	(Amounts in thousands)									(Amounts in thousands)
Salaries and employee benefits	$	8,134	$	8,158	$	(24	)	(0.29	)%	$	8,722	$	8,284	$	438		5.29	%
Occupancy	1,087		1,017		70			6.88		1,186		1,101		85			7.72
Furniture and equipment	1,491		1,350		141			10.44		1,673		1,474		199			13.50
Office supplies and postage	516		436		80			18		459		434		25			5.76
Advertising and business development	628		800		(172		)	(21.50	)	638		630		8			1.27
Outside services	2,077		1,845		232			12.57		2,572		2,578		(6		)	(0.23	)
FDIC insurance assessment	217		315		(98		)	(31.11	)	209		218		(9		)	(4.13	)
Other noninterest expense	671		510		161			31.57		590		537		53			9.87
	$	14,821	$	14,431	$	390		2.70		$	16,049	$	15,256	$	793		5.20

In the three months ended March 31, 2019 and 2018, salaries and employee benefits expense increased $0.44 million. The increase is primarily the result of annual salary adjustments and hiring of additional employees to staff growth.

Other noninterest expense categories experienced marginal period-to-period fluctuations for the three months ended March 31, 2019.

Income Taxes

Federal and state income tax expenses were ~~$3.72~~$3.02 million and ~~$4.40~~$2.57 million for the three months ended ~~September 30, 2017~~March 31, 2019 and ~~2016,~~2018, respectively. Income taxes as a percentage of income before taxes were ~~30.32%~~21.22% in 2019 and 19.15% in 2018. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cut and ~~32.40%~~Jobs Act (the “Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code that affects 2017, including, but not limited to, accelerated depreciation that will allow for full expensing of qualified property. The Tax Act also established new tax laws that reduced the U.S. federal corporate income tax rate from 35% to 21% in ~~2016.~~2018. The quarter ended March 31, 2019 will be the first with all comparable periods on a Post-Tax Act basis, therefore the Company expects income taxes as a percentage of income before taxes to be more comparable in current and future periods than it was over the previous fiscal year.

Index

HILLS BANCORPORATION

Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs. Federal funds sold and investment securities available for sale are readily marketable assets. Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position. Investment securities available for sale comprised ~~9.16%~~10.04% of the Company’s total assets at ~~September 30, 2017~~March 31, 2019 compared to ~~10.07%~~10.48% at December 31, ~~2016.~~2018.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position. As of ~~September 30, 2017,~~March 31, 2019, the Company had borrowed ~~$323.00~~$215.00 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. Advances are used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk. The Company had additional borrowing capacity available from the FHLB of approximately ~~$457.59~~$742.79 million at ~~September 30, 2017.~~March 31, 2019.

As additional sources of liquidity, the Company has the ability to borrow up to $10.00 million from the Federal Reserve Bank of Chicago, and has lines of credit with three banks totaling ~~$244.70~~$449.72 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, 2017.~~March 31, 2019.

As of ~~September 30, 2017,~~March 31, 2019, investment securities with a carrying value of ~~$30.46~~$11.72 million were pledged to collateralize public and trust deposits, ~~repurchase agreements,~~ derivative financial instruments, and other borrowings. As of December 31, ~~2016,~~2018, investment securities with a carrying value of ~~$61.81~~$9.78 million were pledged.

Contractual Obligations

There have been no material changes with regard to contractual obligations disclosed in the Company’s Form 10-K for the year ended December 31, ~~2016.~~

~~Index~~

~~HILLS BANCORPORATION~~

2018.



Item 3.	Quantitative and Qualitative Disclosures about Market Risk

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

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

Index

HILLS BANCORPORATION

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

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

The Bank's interest rate risk, as monitored by management, has not changed materially from December 31, ~~2016.~~2018.

~~Index~~

~~HILLS BANCORPORATION~~



Item 4.	Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission. There have been no changes in the Company’s internal controls over financial reporting during the ~~quarter~~three months ended ~~September 30, 2017~~March 31, 2019 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

~~Index~~

HILLS BANCORPORATION

PART II - OTHER INFORMATION



Item 1.	Legal Proceedings

~~None~~None.



Item 1A.	Risk Factors

There have been no material changes from the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, ~~2016.~~2018.

Index



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, 2017:~~March 31, 2019:

Period
Total number of shares
purchased
Average price paid per
share
Total number of
shares purchased
as part of publicly
announced plans
or programs
Maximum number
of shares that may
yet be purchased
under the plans
or programs (1)
July 1 to July 31 5,543
$ 52.50
5,543
505,779
August 1 to August 31 4,123
52.97
4,123
501,656
September 1 to September 30 4,872
53.00
4,872
496,784
Total 14,538
$ 52.80
14,538
496,784



Period	Total number of shares purchased	Average price paid per share		Total number of shares purchased as part of publicly announced plans or programs	Maximum number of shares that may yet be purchased under the plans or programs (1)
January 1 to January 31	20,497	$	61.00	20,497	352,624
February 1 to February 28	14,100	61.00		14,100	338,524
March 1 to March 31	35,174	62.00		35,174	303,350
Total	69,771	$	61.50	69,771	303,350

(1) On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 1,500,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, ~~2018.~~2020. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.



Item 3.	Defaults upon Senior Securities

Hills Bancorporation has no senior securities.



Item 4.	Mine Safety Disclosure

Not applicable.



Item 5.	Other Information

~~None~~None.

Index



Item 6.	Exhibits



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


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

Index

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 7, 2017~~May 6 2019	By: /s/ Dwight O. Seegmiller
		Dwight O. Seegmiller, Director, President and Chief Executive Officer

Date:	~~November 7, 2017~~May 6 2019	By: /s/ Shari DeMaris
		Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer

Index

HILLS BANCORPORATION

QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED ~~SEPTEMBER 30, 2017~~MARCH 31, 2019


Exhibit Number	Description	Page Number In The Sequential Numbering System September 30, 2017 Form 10-Q	Description	Page Number In The Sequential Numbering System March 31, 2019 Form 10-Q

3.2			Amended and Restated Bylaws of Hills Bancorporation.	58-67

31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	58-59	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	68-69

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	60	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	70

Page 57