HILLS BANCORPORATION - 10-K Annual Report

HILLS BANCORPORATION

FORM 10-K

DECEMBER 31, 2003

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

\|X\|	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2003.

Commission File Number 0-12668.

HILLS BANCORPORATION
(Exact name of Registrant as specified in its charter)

Iowa		42-1208067
(State or Other Jurisdiction of Incorporation or Organization)		(IRS Employer Identification No.)

131 Main Street, Hills, Iowa 52235
(Address of principal executive offices)

Registrant’s telephone number, including area code: (319) 679-2291

Securities Registered pursuant to Section 12 (b) of the Act: None

Securities Registered pursuant to Section 12 (g) of the Act:

No par value common stock
Title of Class

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Registrant S-K (229.405 of this chapter) is not contained herein, and will not be contained to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X]

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act)
Yes |X| No

While it is difficult to determine the market value of shares owned by nonaffiliates (within the meaning of such term under the applicable regulations of the Securities and Exchange Commission), the Registrant estimates that the aggregate market value of the Registrant’s common stock held by nonaffiliates on March 22, 2004 (based upon reports of beneficial ownership that approximately 81% of the shares are so owned by nonaffiliates and upon information communicated informally to the Registrant by various purchasers and sellers that the sale price for the common stock is generally $101 per share) was $124,079,000.

The number of shares outstanding of the Registrant’s common stock as of March 22, 2004 is 1,516,678 shares of no par value common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement dated March 22, 2004 for the Annual Meeting of the Shareholders of the Registrant to be held April 19, 2004 (the Proxy Statement) are incorporated by reference in Part III of this Form 10-K.

EXHIBIT INDEX

The exhibits index is on Page 82.

Page 1 of 92

PART I

Item 1. Business

GENERAL

Hills Bancorporation (the “Company”) is a holding company principally engaged, through its subsidiary bank, in the business of banking. The Company was incorporated December 12, 1982 and all operations are conducted within the state of Iowa. The Company became owner of 100% of the outstanding stock of Hills Bank and Trust Company, Hills, Iowa (“Hills Bank and Trust” or the “Bank”) as of January 23, 1984 when stockholders of Hills Bank and Trust exchanged their shares for shares of the Company. Effective July 1, 1996, the Company formed a new subsidiary, Hills Bank, which acquired for cash all the outstanding shares of a bank in Lisbon, Iowa. Subsequently an office of Hills Bank was opened in Mount Vernon, Iowa, a community that is contiguous to Lisbon. Effective November 17, 2000, Hills Bank was merged into Hills Bank and Trust. On September 20, 1996, another subsidiary, Hills Bank Kalona, acquired cash and other assets and assumed the deposits of the Kalona, Iowa office of Boatmen’s Bank Iowa, N.A. Effective October 26, 2002, Hills Bank Kalona was merged into Hills Bank and Trust.

The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers. The Bank is actively engaged in all areas of commercial banking, including acceptance of demand, savings and time deposits; making commercial, real estate, agricultural and consumer loans; maintaining night and safe deposit facilities; and performing collection, exchange and other banking services tailored for individual customers. The Bank administers estates, personal trusts, and pension plans and provides farm management and investment advisory and custodial services for individuals, corporations and nonprofit organizations. The Bank makes commercial and agricultural loans, real estate loans, automobile, installment and other consumer loans. In addition, the Bank earns substantial fees from originating mortgages that are sold in the secondary residential real estate market without mortgage servicing rights being retained.

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 that, 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 Bank’s business is not seasonal, except that loan origination fees are driven by interest rate movements and are higher in a low rate environment. The Company had no employees as of December 31, 2003 and the Bank had 309 regular and 102 part-time employees.

Page 2 of 92

Item 1. Business (Continued)

Johnson County

The Bank’s primary trade area includes the Johnson County communities of Iowa City, Coralville, Hills and North Liberty, located near Interstate 80 and Interstate 380 in Eastern Iowa. These communities have a combined population of approximately 86,000. Johnson County, Iowa has a population of approximately 114,000. The University of Iowa in Iowa City has approximately 30,000 students and 24,500 full and part-time employees, including employees of The University of Iowa Hospitals and Clinics. Other principal employers in Johnson County include the following:

Employer	Type of Business	Employees

Iowa City Community School District	Education	1,250

Hy-Vee Food Stores	Grocery Stores	1,200

Veterans Administration Medical Center	Health Care	1,200

Mercy Hospital	Health Care	1,150

National Computer Systems	Information Service - Computers	950

American College Testing Program	Educational Testing Service	850

United Technologies	Automotive Products Manufacturing	850

Rockwell Collins	Electronic Manufacturing	800

Oral B Laboratories	Consumer Products	800

Proctor & Gamble	Consumer Products	600

City of Iowa City	City Government	600

Page 3 of 92

Item 1. Business (Continued)

Linn County

The Bank also operates offices in the Linn County, Iowa communities of Lisbon, Marion, Mount Vernon and Cedar Rapids, Iowa. Lisbon has a population of approximately 1,900 and Mount Vernon, located two miles from Lisbon, has a population of 3,800. Both communities are strong economically and are within easy commuting distances to Cedar Rapids and Iowa City, Iowa. Cedar Rapids has a metropolitan population of approximately 154,000, including approximately 27,000 from Marion and is located approximately 10 miles west of Lisbon, Iowa and approximately 25 miles north of Iowa City on Interstate 380. The total population of Linn County is approximately 195,000.The largest employer in the Cedar Rapids area is Rockwell Collins, manufacturer of communications instruments, with about 6,300 employees. Other large employers in the Cedar Rapids area and their approximate number of employees are as follows:

Employer	Type of Business	Employees

Cedar Rapids, College, Linn-Mar, Marion and Grant Wood School Districts	Education	4,050

Maytag Appliances, Amana Iowa	Appliance Manufacturing	2,950

AEGON USA, Inc.	Insurance	2,500

IES Utilities	Electric Utility	2,300

St. Luke’s Hospital	Health Care	2,250

Hy-Vee Food Stores	Grocery Stores	1,950

McLeod*USA	Telecommunications	1,950

Mercy Medical Center	Health Care	1,700

MCI Communications, Inc	Long Distance Service	1,600

City of Cedar Rapids	City Government	1,300

Quaker Oats Company	Cereals and Chemicals	1,250

APAC Teleservices	Telemarketing	1,200

Kirkwood Community College	Education	1,150

Washington County

The Bank has an office located in Kalona, Iowa, which is in Washington County. Kalona is located approximately 20 miles south of Iowa City. Kalona has a population of approximately 2,300. The population of Washington County is approximately 21,000. Kalona is primarily an agricultural community, but it is located within easy driving distance for employment in Iowa City, Coralville and North Liberty (combined population 85,000) and Washington, Iowa (population 7,000).

Page 4 of 92

Item 1. Business (Continued)

COMPETITION

The financial services industry is highly competitive. The Bank must compete with financial services providers, such as banks, savings and loan associations, credit unions, finance companies, mortgage banking companies, insurance companies and money market and mutual fund companies. It also faces increased competition from non-banking institutions such as brokerage houses and insurance companies, as well as from financial services subsidiaries of commercial and manufacturing companies. Many of these competitors enjoy the benefits of fewer regulatory constraints and lower cost structures.

Effective March 13, 2000, securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. This may significantly change the competitive environment in which the Company conducts business. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services. These technological advances may diminish the importance of depository institutions and other financial intermediaries in the transfer of funds between parties.

The Bank is in direct competition for loans and deposits and financial services with a number of other banks and credit unions in Johnson and Linn County. A comparison of the number of office locations and deposits in the two counties as of June, 2003 is as follows:

	Johnson County					Linn County

		Offices	Deposits (in millions)			Offices		Deposits (in millions)


Hills Bank and Trust Company		6		$	672		5		$	119
Branches of largest competing regional bank		5			214		10			776
Largest competing independent bank		6			374		9			353
Largest competing credit union		5			242		6			340
All other bank and credit union offices		20			331		65			1,969

Total Market in County		42			1,833		95			3,557

THE ECONOMY

The Bank’s primary trade territory is Johnson County, Iowa. Linn County, Iowa is becoming an increasingly important market, and the Bank now has five offices open in Linn County. The Bank also has one office in Kalona in Washington County, Iowa. The table that follows shows the employment information as of December 31, 2003, regarding the labor force and unemployment levels in the three counties in which the Bank has office locations along with data on the United States and the State of Iowa.

	Labor Force	Unemployed	Rate %

United States	146,878,000	8,398,000	5.72	%
State of Iowa	1,633,200	71,200	4.36	%
Johnson County	76,600	2,600	3.39	%
Linn County	118,300	5,100	4.31	%
Washington County	10,720	440	4.10	%

Page 5 of 92

Item 1. Business (Continued)

The unemployment rate for the Bank’s trade territory is favorable and the rate has historically been lower than both the United States and the State of Iowa. As discussed with the employment table of large employers in Johnson and Linn County, the University of Iowa’s impact on the local economy is very important in maintaining acceptable employment levels. Johnson and Linn County has been one of the strongest economic areas in Iowa and has had substantial economic growth in the past ten years. The largest segment of the employed population is employed in manufacturing, management, professional or related occupations.

The economies in the counties continue to be enhanced by local Iowa colleges and the University of Iowa. In addition to providing quality employment, they enroll students who provide economic benefits to the area. The following table indicates Fall 2003 enrollment.

The University of Iowa		29,745
	Iowa City
Coe College		1,317
	Cedar Rapids
Cornell College		1,117
	Mount Vernon
Kirkwood Community College		15,032
	Cedar Rapids, Iowa City and Washington
Mount Mercy College		1,473
	Cedar Rapids

The State of Iowa continues to collect decreasing tax revenues while spending continues to increase, and the Iowa legislature has required the University of Iowa to reduce spending in the last three fiscal years. The University has reacted to its budget constraints without significant lay-offs and has continued to review and reduce employment, when necessary, through attrition. However, salary increases at the University have been minimal.

The Bank also serves a number of smaller communities in Johnson, Linn and Washington counties that are more dependent upon the agricultural economy, which historically has been affected by commodity prices and weather. The average price per acre of farm land continues to be an important factor to consider when reviewing the local economy. The average acre in Iowa in 2003 was $2,275 compared to $2,083 in 2002. The range of average land prices in Johnson, Linn and Washington counties is between $2,546 and $2,926 per acre. The increase was 8.5% from 2002. The Bank’s total agricultural loans comprise about 4.3% of the Bank’s total loans.

SUPERVISION AND REGULATION

Financial institutions and their holding companies are extensively regulated under federal and state law. As a result, the growth and earnings performance of the Company can be affected not only by management decisions and general economic conditions but also by the requirements of applicable state and federal statutes and regulations and the policies of various governmental regulatory authorities, including the Iowa Superintendent of Banking (the “Superintendent”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Federal Deposit Insurance Corporation (the “FDIC”), the Internal Revenue Service and state taxing authorities and the Securities and Exchange Commission (the “SEC”). The effect of applicable statues, regulations and regulatory policies can be significant and cannot be predicted with a high degree of certainty.

Federal and state laws and regulations generally applicable to financial institutions, such as the Company and its subsidiary Bank, regulate, among other things, the scope of business, investments, reserves against deposits, capital levels relative to operations, the nature and amount of collateral for loans, the establishment of branches, mergers, consolidations and dividends. The system of supervision and regulation applicable to the Company and its subsidiary Bank establishes a comprehensive framework for their respective operations and is intended primarily for the protection of the FDIC’s deposit insurance funds and the depositors, rather than the stockholders, of financial institutions.

Page 6 of 92

Item 1. Business (Continued)

The following is a summary of the material elements of the regulatory framework applicable to the Company and its subsidiary Bank. It does not describe all of the statutes, regulations and regulatory policies that apply, nor does it restate all of the requirements of the statutes, regulations and regulatory policies that are described. As such, the following is qualified in its entirety by reference to the applicable statutes, regulations and regulatory policies. Any change in applicable law, regulations or regulatory policies may have a material effect on the business of the Company and its subsidiary Bank.

Significant Regulatory Developments

The Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act (the “Act”), was enacted on November 12, 1999. The Act allows eligible bank holding companies to engage in a wider range of non-banking activities and grants them greater authority to engage in securities and insurance activities. Under the Act, an eligible bank holding company that elects to become a financial holding company may engage in any activity that the Federal Reserve, in consultation with the Secretary of the Treasury, determines by regulation or order is financial in nature, incidental to any such financial activity, or complementary to any such financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. A financial service corporation can engage in a number of financial activities including insurance and securities underwriting and other agency activities, merchant banking and insurance company portfolio investment activities. Activities that are ancillary to financial activities are also allowed. Additionally, the Act amends the federal securities laws to incorporate functional regulation of bank securities and activities and provides for the functional regulation of insurance activities by establishing which insurance products banks and bank subsidiaries may provide as principal. National banks are also authorized by the Act to engage, through “financial subsidiaries,” in certain activities that are permissible for financial holding companies (as described above) and certain activities that the Secretary of the Treasury, in consultation with the Federal Reserve, determines are financial in nature or incidental to any such financial activity.

Various bank regulatory agencies have issued regulations as mandated by the Act. During June 2000, all of the federal bank regulatory agencies jointly issued regulations implementing the privacy provisions of the Act. In addition, the Federal Reserve issued interim regulations establishing procedures for bank holding companies to elect to become financial holding companies and listing the financial activities permissible for financial holding companies, as well as describing the extent to which financial holding companies may engage in securities and merchant banking activities. The Federal Reserve has issued an interim regulation regarding the parameters under which state member banks may establish and maintain financial subsidiaries. At this time, it is not possible to predict the impact the Act and its implementing regulations may have on the Company. As of the date of this filing, the Company has not applied for or received approval to operate as a financial holding company. In addition, the Bank has not applied for or received approval to establish financial subsidiaries.

In the area of privacy, the Act requires clear disclosure by all financial institutions of their privacy policies regarding the sharing of nonpublic information with both affiliates and third parties. Further, the Act requires a notice to consumers and an opportunity to “opt out” of sharing of nonpublic personal information with nonaffiliated third parties, subject to certain limited exceptions. The Act also reforms laws that regulate ATMs, Community Reinvestment Banks and Deposit Production Offices. Specifically, the Act requires ATM operators who impose a fee for use of an ATM by a non-customer to post a notice both on the machine and on the screen that a fee will be charged and the amount of the fee, and further requires a notice when ATM cards are issued that surcharges may be imposed by other parties when transactions are initiated from ATMs not operated by the card issuer. The Act also clarifies that nothing in the act repeals any provision of the Continuity Reinvestment Act (“CRA”); however, the Act requires full disclosure of all CRA agreements and reduces the frequency of CRA exams for small banks and savings and loans (those with no more than $250 million in assets). The Act allows community banks all the powers as a matter of right that large institutions have accumulated on an ad hoc basis, including the ability to underwrite municipal bonds in the future. Finally, the Act expands the prohibition of deposit production offices contained in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Riegle-Neal Act”) to include all branches of an out-of-state bank holding company.

Page 7 of 92

Item 1. Business (Continued)

Regulation of the Company

General. The Company, as the sole shareholder of the Bank, is a bank holding company. As a bank holding company, the Company is registered with, and is subject to regulation by, the Federal Reserve under the Bank Holding Company Act, as amended (the “BHCA”). Under the BHCA, the Company is subject to periodic examination by the Federal Reserve. The Company is also required to file with the Federal Reserve periodic reports of the Company’s operations and such additional information regarding the Company and its subsidiaries as the Federal Reserve may require.

Source of Strength Policy. According to Federal Reserve Board policy, bank/financial holding companies are expected to act as a source of financial strength to each subsidiary bank and to commit resources to support each such subsidiary. This support may be required at times when a bank/financial holding company may not be able to provide support. Similarly, under the cross-guarantee provisions of the Federal Deposit Insurance Act, in the event of a loss suffered or anticipated by the FDIC – either as a result of default of a banking or thrift subsidiary of a bank/financial holding company such as the Company or related to FDIC assistance provided to a subsidiary in danger of default – the other banking subsidiaries of such bank/financial holding company may be assessed for the FDIC’s loss, subject to certain exceptions.

Investments and Activities. Under the BHCA, a bank holding company must obtain Federal Reserve approval before: (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after the acquisition, it would own or control more than 5% of the shares of the other bank or bank holding company (unless it already owns or controls the majority of such shares), (ii) acquiring all or substantially all of the assets of another bank or (iii) merging or consolidating with another bank holding company. Subject to certain conditions (including certain deposit concentration limits established by the BHCA), the Federal Reserve may allow a bank holding company to acquire banks located in any state of the United States without regard to whether the acquisition is prohibited by the law of the state in which the target bank is located. On approving interstate acquisitions, however, the Federal Reserve is required to give effect to applicable state law limitations on the aggregate amount of deposits that may be held by the acquiring bank holding company and its insured depository institution affiliates in the state in which the target bank is located (provided that those limits do not discriminate against out-of-state depository institutions or their holding companies) and state laws which require that the target bank have been in existence for a minimum period of time (not to exceed five years) before being acquired by an out-of-state bank holding company.

The BHCA also generally prohibits the Company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries. This general prohibition is subject to a number of exceptions. The principal exception allows bank holding companies to engage in, and to own shares of companies engaged in, certain businesses found by the Federal Reserve to be “so closely related to banking . . . as to be a proper incident thereto.” Under current regulations of the Federal Reserve, the Company either directly or through non-bank subsidiaries would be permitted to engage in a variety of banking-related businesses, including the operation of a thrift, sales and consumer finance, equipment leasing, the operation of a computer service bureau (including software development) and mortgage banking and brokerage. The BHCA generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank holding companies.

Federal law also prohibits any person from acquiring “control” of a bank holding company without prior notice to the appropriate federal bank regulator. “Control” is defined in certain cases as the acquisition of 10% or more of the outstanding shares of a bank or a bank holding company depending on the circumstances surrounding the acquisition.

Page 8 of 92

Item 1. Business (Continued)

Regulatory Capital Requirements

Regulatory guidelines define capital and spell out the minimum acceptable capital levels for banks. The purpose of these guidelines is to increase depositor protection and to reduce deposit insurance fund losses. Currently, the three federal banking agencies use a “risk-based” approach to gauge bank capital. Under this approach, the agencies define what is to be included in bank capital and establish the minimum capital a bank must have primarily to protect it from the risk inherent in its asset holdings.

Risk-based capital guidelines divide capital into core and supplemental capital. Core or Tier I capital is similar to what is normally thought of as capital in other businesses. It consists primarily of common and certain preferred stock, surplus and undivided profits. Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve capital adequacy guidelines. If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or non-bank businesses. Supplemental or Tier 2 capital consists, within certain specified limits, of such things as the allowance for loan losses, hybrid capital instruments and subordinated debt. These supplemental items are often forms of debt that are subordinate to claims of depositors and the FDIC. As such, they provide depositor protection and are included in bank capital. The sum of Tier 1 and Tier 2 capital, less certain deductions, represents a bank’s total capital. In the capital guidelines, Tier 1 capital must constitute at least 50% of a bank’s total capital. Thus, the use of Tier 2 capital is limited by the “hard” equity in a bank’s capital structure.

As part of their capital adequacy assessment, the regulatory agencies convert a bank’s assets, including off-balance sheet items, to risk-equivalent assets. The purpose of this conversion is to quantify the relative risk, primarily credit risk, in these assets and to determine the minimum capital necessary to compensate for this risk. For example, assets that pose little risk, such as cash held at the bank’s offices and U. S. government securities, are weighted zero, meaning that no capital support is required for these assets. Assets that pose greater risk are weighted at 20%, 50% or 100% of their dollar value, indicating the level of capital support they require. Except for banks with large “off-balance sheet” asset positions, risk weighting will nearly always lower total assets requiring capital support. However, even if a bank held nothing but cash and U.S. securities, it would still be required to maintain capital support for these assets. The reason is that banks face more than credit risk (e.g., market risk), and these other risks require that banks maintain minimum levels of capital to protect the banks and their depositors.

The Federal Reserve’s capital guidelines establish the following minimum regulatory capital requirements for bank holding companies: a risk-based requirement expressed as a percentage of total risk-weighted assets, and a leverage requirement expressed as a percentage of total assets. The risk-based requirement consists of a minimum ratio of total capital to total risk-weighted assets of 8%, at least one-half of which must be Tier 1 capital. The leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly rated companies, with a minimum requirement of 4% for all others.

The risk-based and leverage standards described above are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual banking organizations. For example, the Federal Reserve’s capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentration of credit, nontraditional activities or securities trading activities. Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios (i.e., Tier 1 capital less all intangible assets), well above the minimum levels. Current Federal Reserve minimum requirements for a well capitalized organization experiencing significant growth are a leverage ratio of 5%, a Tier 1 risk-based capital ratio of 6% and total risk-based capital ratio of 10%. As of December 31, 2003, the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements, with a leverage ratio of 8.87%, with total Tier 1 risk-based capital ratio of 13.31% and a total risk-based capital ratio of 14.56%.

Page 9 of 92

Item 1. Business (Continued)

Dividends. The Iowa Business Corporation Act (“IBCA”) allows the Company to pay dividends only out of its surplus (as defined and computed in accordance with the provision of the IBCA) or if the Company has no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Additionally, the Federal Reserve has issued a policy statement with regard to the payment of cash dividends by bank holding companies. The policy statement provides that a bank holding company should not pay cash dividends which exceed its net income or which can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing. The Federal Reserve also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.

Federal Securities Regulation. The Company’s common stock is registered with the SEC under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Consequently, the Company is subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act.

Regulation of the Bank

General. The Bank is an Iowa-chartered bank, the deposit accounts of which are insured by the FDIC’s Bank Insurance Fund (“BIF”). As an Iowa-chartered, FDIC insured bank, the Bank is subject to the examination, supervision, reporting and enforcement requirements of the Superintendent of Banking of the State of Iowa (the “Superintendent”), as the chartering authority for Iowa banks, and the FDIC, as administrator of the BIF.

Deposit Insurance. As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums based upon their respective levels of capital and results of supervisory evaluations. Institutions classified as well-capitalized (as defined by the FDIC) and considered healthy, pay the lowest premium while institutions that are less than adequately capitalized (as defined by the FDIC) and considered of substantial supervisory concern, pay the highest premium. Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period. The Bank is currently paying the minimum assessment under the FDIC’s risk assessment system.

The FDIC may terminate the deposit insurance of any insured depository institution if the FDIC determines, after a hearing, that the institution (i) has engaged in or is engaging in unsafe or unsound practices, (ii) is in an unsafe or unsound condition to continue operations or (iii) has violated any applicable law, regulation, order, or any condition imposed in writing by, or written agreement with, the FDIC. The FDIC may also suspend deposit insurance temporarily during the hearing process for a permanent termination of insurance if the institution has no tangible capital. Management of the Company is not aware of any activity or condition that could result in termination of the deposit insurance of the Bank.

Capital Requirements. Among the requirements and restrictions imposed upon state banks by the Superintendent are the requirements to maintain reserves against deposits, restrictions on the nature and amount of loans, and restrictions relating to investments, opening of bank offices and other activities of state banks. Changes in the capital structure of state banks are also approved by the Superintendent. State banks normally must have a primary capital to total assets ratio of six and one-half percent (6 ½ %). In certain instances, the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement on the Bank. The Superintendent defines the term “primary capital” to mean the sum of stockholders’ equity and the allowance for loan losses less any intangible assets. In determining the primary capital ratio, the Superintendent uses the total assets as of the date of computation. At December 31, 2003, the primary capital to total assets ratio of the Bank exceeded the ratio required by the Superintendent.

Page 10 of 92

Item 1. Business (Continued)

Capital adequacy for banks took on an added dimension with the establishment of a formal system of prompt corrective action under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). This system uses bank capital levels to trigger supervisory actions designed to quickly correct banking problems. Capital adequacy zones are used by the federal banking agencies to trigger these actions. The ratios and the definition of “adequate capital” are the same as those used by the agencies in their capital adequacy guidelines.

Federal law provides the federal banking regulators of the Bank with broad power to take prompt corrective action to resolve the problems of undercapitalized banking institutions. The extent of the regulators’ powers depends on whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized,” in each case as defined by regulation. Under prompt corrective action, banks that are inadequately capitalized face a variety of mandatory and discretionary supervisory actions. For example, “undercapitalized banks” must restrict asset growth, obtain prior approval for business expansion, and have an approved plan to restore capital. “Critically undercapitalized banks” must be placed in receivership or conservatorship within 90 days unless some other action would result in lower long-term costs to the deposit insurance fund.

Depending upon the capital category to which an institution is assigned, the regulators’ corrective powers include: requiring the institution to submit a capital restoration plan; limiting the institution’s asset growth and restricting its activities; requiring the institution to issue additional capital stock (including additional voting stock) or to be acquired; restricting transactions between the institution and its affiliates; restricting the interest rate the institution may pay on deposits; ordering a new election of directors of the institution; requiring that senior executive officers or directors be dismissed; prohibiting the institution from accepting deposits from correspondent banks; requiring the institution to divest certain subsidiaries; prohibiting the payment of principal or interest on subordinated debt; and ultimately, appointing a receiver for the institution. As of December 31, 2003, the Bank was well capitalized, as defined by FDIC regulations.

Community Investment and Consumer Protection Laws. The Community Reinvestment Act requires insured institutions to define the communities that they serve, identify the credit needs of those communities and adopt and implement a “Community Reinvestment Act Statement” pursuant to which they offer credit products and take other actions that respond to the credit needs of the community. The responsible federal banking regulator must conduct regular Community Reinvestment Act examinations of insured financial institutions and assign to them a Community Reinvestment Act rating of “outstanding,” “satisfactory,” “needs improvement” and “unsatisfactory.” In 2003, the Community Reinvestment Act rating of the Company’s banking subsidiary was either “outstanding” or “satisfactory.”

In addition to the Community Reinvestment Act, other federal and state laws regulate various lending and consumer aspects of the banking business. Governmental Agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that in some cases prospective borrowers experience unlawful discrimination in their efforts to obtain loans from depository and other lending institutions. These agencies have brought litigation against some depository institutions alleging discrimination against borrowers. Many of these suits have been settled, in some cases for material sums, short of a full trial.

Recently, these governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act. These factors include evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.

Page 11 of 92

Item 1. Business (Continued)

Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations. These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of certain loan, to customers.

Supervisory Assessments. All Iowa banks are required to pay supervisory assessments to the Superintendent to fund the Superintendent’s examination and supervision operations. Effective July 1, 2002 the Superintendent changed the method of computation of the supervisory assessment from billing for each state examination completed based on an hourly rate, to billing on an annual basis based on the assets of the bank, the expected hours needed to conduct examinations of that size bank and an additional amount if more work is required. For fiscal 2003 the assessment total was $90,215.

Dividends. The Iowa Banking Act provides that an Iowa bank may not pay dividends in an amount greater than its undivided profits.

The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized. As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2003. Notwithstanding the availability of funds for dividends, however, the Superintendent may prohibit the payment of any dividends by the Bank if the Superintendent determines such payment would constitute an unsafe or unsound practice.

Insider Transactions. The Bank is subject to certain restrictions imposed by federal law on extensions of credit to the Company and its subsidiaries, on investments in the stock or other securities of the Company and its subsidiaries and the acceptance of the stock or other securities of the Company or its subsidiaries as collateral for loans. Certain limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to directors and officers of the Company and its subsidiaries, to principal stockholders of the Company, and to “related interests” of such directors, officers and principal stockholders. In addition, federal law and regulations may affect the terms upon which any person becoming a director or officer of the Company or one of its subsidiaries or a principal stockholder of the Company may obtain credit from banks with which the Bank maintains a correspondent relationship.

Safety and Soundness Standards. The federal banking agencies have adopted guidelines that establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions. The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.

In general, the safety and soundness guidelines prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals. If an institution fails to comply with any of the standards set forth in the guidelines, the institution’s primary federal regulator may require the institution to submit a plan for achieving and maintaining compliance. If an institution fails to submit an acceptable compliance plan, or fails in any material respect to implement a compliance plan that has been accepted by its primary federal regulator, the regulator is required to issue an order directing the institution to cure the deficiency. Until the deficiency cited in the regulator’s order is cured, the regulator may restrict the institution’s rate of growth, require the institution to increase its capital, restrict the rates the institution pays on deposits or require the institution to take any action the regulator deems appropriate under the circumstances. Noncompliance with the standards established by the safety and soundness guidelines may also constitute grounds for other enforcement action by the federal banking regulators, including cease and desist orders and civil money penalty assessments.

Page 12 of 92

Item 1. Business (Continued)

Branching Authority. Historically, Iowa’s intrastate branching statutes have been rather restrictive when compared with those of other states. Iowa’s intrastate branching statutes were relaxed in recent legislation that became effective on February 21, 2001 (the “2001 Amendment”). The 2001 Amendment allows Iowa banks to move towards statewide branching by allowing every Iowa bank, with the approval of its primary regulator, to establish three new bank offices anywhere in Iowa during the next three years. The three offices are in addition to those offices allowed within certain restricted geographic areas under prior Iowa law. Effective July 1, 2004, the 2001 Amendment repeals all limitations on bank office location and effectively allows statewide branching. After that date, banks will be allowed to establish an unlimited number of offices in any location in Iowa subject only to regulatory approval.

Under the Riegle-Neal Act, both state and national banks are allowed to establish interstate branch networks through acquisitions of other banks, subject to certain conditions, including certain limitations on the aggregate amount of deposits that may be held by the surviving bank and all of its insured depository institution affiliates. The establishment of new interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is allowed by the Riegle-Neal Act only if specifically authorized by state law. The legislation allowed individual states to “opt-out” of certain provisions of the Riegle-Neal Act by enacting appropriate legislation prior to June 1, 1997. Iowa permits interstate bank mergers, subject to certain restrictions, including a prohibition against interstate mergers involving an Iowa bank that has been in existence and continuous operation for fewer than five years.

Miscellaneous. The Bank is subject to certain restrictions on loans to the Company or its non-bank subsidiaries, on investments in the stock or securities thereof, on the taking of such stock or securities as collateral for loans to any borrower, and on the issuance of a guarantee or letter of credit on behalf of the Company or its non-banking subsidiaries. The Bank is also subject to certain restrictions on most types of transactions with the Company or its non-bank subsidiaries, requiring that the terms of such transactions be substantially equivalent to terms of similar transactions with non-affiliated firms.

State Bank Activities. Under federal law and FDIC regulations, FDIC insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank. Federal law and FDIC regulations also prohibit FDIC insured state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank or its subsidiary, respectively, unless the Bank meets, and continues to meet, its minimum regulatory capital requirements and the FDIC determines the activity would not pose a significant risk to the deposit insurance fund of which the Bank is a member. These restrictions have not had, and are not currently expected to have, a material impact on the operations of the Bank.

Regulatory Enforcement Authority. The enforcement powers available to federal and state banking regulators are substantial and include, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking organizations and institutions-affiliated parties, as defined. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities.

Page 13 of 92

Item 1. Business (Continued)

CONSOLIDATED STATISTICAL INFORMATION

The following consolidated statistical information reflects selected balances and operations of the Company and the Bank for the periods indicated.

The following tables show (1) average balances of assets, liabilities and stockholders’ equity, (2) interest income and expense on a tax equivalent basis, (3) interest rates and interest differential and (4) changes in interest income and expense.

AVERAGE BALANCES
(Average Daily Basis)

		Year Ended December 31st

		2003		2002		2001

		(Amounts In Thousands)
ASSETS
	Cash and due from banks	$	25,186	$	27,815	$	24,493
	Taxable securities		150,149		143,422		132,227
	Nontaxable securities		63,689		56,369		42,783
	Federal funds sold		41,269		34,827		29,551
	Loans, net		829,710		733,822		646,196
	Property and equipment, net		22,148		21,598		18,889
	Other assets		23,159		21,650		19,575

		$	1,155,310	$	1,039,503	$	913,714


LIABILITIES AND STOCKHOLDERS’ EQUITY
	Noninterest-bearing demand deposits	$	108,414	$	92,145	$	78,687
	Interest-bearing demand deposits		122,918		96,054		76,366
	Savings deposits		214,088		194,230		169,561
	Time deposits		399,747		381,973		357,882
	Securities sold under agreements to repurchase		29,323		21,240		17,444
	FHLB borrowings		167,595		153,543		123,211
	Other liabilities		6,448		6,173		5,924
	Redeemable common stock held by Employee Stock Ownership Plan		13,908		12,572		11,872
	Stockholders’ equity		92,869		81,573		72,767

		$	1,155,310	$	1,039,503	$	913,714

Page 14 of 92

INTEREST INCOME AND EXPENSE

				Year Ended December 31,

				2003		2002		2001

				(Amounts In Thousands)

Income:
	Loans (1)			$	54,434	$	54,491	$	53,121
	Taxable securities				6,268		7,412		7,670
	Nontaxable securities (1)				3,590		3,433		2,924
	Federal funds sold				382		520		1,132

			Total interest income		64,674		65,856		64,847


Expense:
	Interest-bearing demand deposits				1,011		1,094		1,412
	Savings deposits				1,950		2,900		4,611
	Time deposits				13,959		18,300		20,611
	Securities sold under agreements to repurchase				394		375		617
	FHLB borrowings				9,091		8,472		7,184

		Total interest expense			26,405		31,141		34,435


		Net interest income		$	38,269	$	34,715	$	30,412

(1) Presented on a tax equivalent basis using a rate of 34% for the three years presented.

Page 15 of 92

Item 1. Business (Continued)

INTEREST RATES AND INTEREST DIFFERENTIAL

		Year Ended December 31,

		2003			2002			2001

Average yields:
	Loans (1)		6.55	%		7.41	%		8.20	%
	Loans (tax equivalent basis)		6.56			7.43			8.22
	Taxable securities		4.17			5.17			5.80
	Nontaxable securities		3.72			4.02			4.51
	Nontaxable securities (tax equivalent basis)		5.64			6.09			6.83
	Federal funds sold		0.93			1.49			3.85
	Interest-bearing demand deposits		0.82			1.14			1.85
	Savings deposits		0.91			1.49			2.72
	Time deposits		3.49			4.79			5.76
	Securities sold under agreements to repurchase		1.34			1.79			3.53
	FHLB borrowings		5.42			5.52			5.83
	Yield on average interest-earning assets		5.96			6.80			7.62
	Rate on average interest-bearing liabilities		2.83			3.68			4.63
	Net interest spread (2)		3.13			3.12			2.99
	Net interest margin (3)		3.53			3.58			3.58

(1)	Non-accruing loans are not significant and have been included in the average loan balances for purposes of this computation.

(2)	Net interest spread is the difference between the yield on average interest-earning assets and the yield on average interest-paying liabilities stated on a tax equivalent basis using a federal and state tax rate of 34% and 5%, respectively, for the three years presented.

(3)	Net interest margin is net interest income, on a tax equivalent basis, divided by average interest-earning assets.

Page 16 of 92

Item 1. Business (Continued)

CHANGES IN INTEREST INCOME AND EXPENSE

			Changes Due To Volume			Changes Due To Rates				Total Changes

			(Amounts In Thousands)
Year ended December 31, 2003:
	Change in interest income:
		Loans		$	6,704		$	(6,761	)		$	(57	)
		Taxable securities			337			(1,481	)			(1,144	)
		Nontaxable securities			423			(266	)			157
		Federal funds sold			83			(221	)			(138	)

					7,547			(8,729	)			(1,182	)

	Change in interest expense:
		Interest-bearing demand deposits			265			(348	)			(83	)
		Savings deposits			271			(1,221	)			(950	)
		Time deposits			818			(5,159	)			(4,341	)
		Securities sold under agreements to repurchase			127			(154	)			(27	)
		FHLB borrowings			773			(108	)			665

					2,254			(6,990	)			(4,736	)

	Change in net interest income			$	5,293		$	(1,739	)		$	3,554


Year ended December 31, 2002:
	Change in interest income:
		Loans		$	6,777		$	(5,407	)		$	1,370
		Taxable securities			617			(875	)			(258	)
		Nontaxable securities			852			(343	)			509
		Federal funds sold			177			(789	)			(612	)

					8,423			(7,414	)			1,009

	Change in interest expense:
		Interest-bearing demand deposits			308			(626	)			(318	)
		Savings deposits			598			(2,309	)			(1,711	)
		Time deposits			1,321			(3,638	)			(2,317	)
		Securities sold under agreements to repurchase			114			(350	)			(236	)
		FHLB borrowings			1,687			(399	)			1,288

					4,028			(7,322	)			(3,294	)

	Change in net interest income			$	4,395		$	(92	)		$	4,303

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 at tax equivalent amounts.

Page 17 of 92

Item 1. Business (Continued)

LOANS

The following table shows the composition of loans (before deducting the allowance for loan losses) as of December 31 for each of the last five years. The table does not include loans held for sale to the secondary market.

		December 31,

		2003		2002		2001		2000		1999

		(Amounts In Thousands)

Agricultural		$	38,153	$	37,937	$	34,304	$	28,560	$	27,302
Commercial and financial			47,938		46,828		44,363		37,832		36,848
Real estate, construction			66,644		47,201		40,430		38,184		40,879
Real estate, mortgage			696,453		621,226		533,257		497,744		435,639
Loans to individuals			31,591		32,906		34,713		33,715		31,030

	Total	$	880,779	$	786,098	$	687,067	$	636,035	$	571,698

There were no foreign loans outstanding for any of the years presented.

MATURITY DISTRIBUTION OF LOANS

The following table shows the principal payments due on loans as of December 31, 2003:

	Amount Of Loans		One Year Or Less (1)		One To Five Years		Over Five Years

	(Amounts In Thousands)

Commercial	$	86,091	$	43,425	$	35,656	$	7,010
Real Estate		763,097		91,925		250,054		421,118
Other		31,591		11,609		19,492		490

Totals	$	880,779	$	146,959	$	305,202	$	428,618

The types of interest rates applicable to these principal payments are shown below:

Fixed rate	$	398,683	$	94,619	$	259,564	$	44,500
Variable rate		482,096		52,340		45,638		384,118

	$	880,779	$	146,959	$	305,202	$	428,618

(1)	A significant portion of the commercial loans are due in one year or less. A significant percentage of the notes are re-evaluated prior to their maturity and are likely to be extended.

Page 18 of 92

Item 1. Business (Continued)

NONACCRUAL, PAST DUE AND RESTRUCTURED LOANS

The following table summarizes the Company’s non-accrual, past due, restructured and impaired loans as of December 31 for each of the years presented:

	2003		2002		2001		2000		1999

	(Amounts In Thousands)

Nonaccrual loans	$	3,944	$	1,538	$	1,001	$	618	$	—
Accruing loans past due 90 days or more		2,296		2,516		2,921		2,143		1,320
Restructured loans		—		—		—		—		—
Impaired loans (includes non-accrual loans)		18,177		16,261		11,288		11,068		9,265

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

Loans are placed on non-accrual status when management believes the collection of future interest is not reasonably assured. The non-accrual loans for swine production loans were $2.4 million at December 31, 2003 compared to none at December 31, 2002. The non-accrual loans are considered to be impaired loans for purposes of reviewing the adequacy of the loan loss reserve at year-end. Interest income was not materially affected by this classification.

The Company has no individual borrower or borrowers engaged in the same or similar industry exceeding 10% of total loans. The Company has no other interest-bearing assets, other than loans, that meet the non-accrual, past due, restructured or potential problem loan criteria.

Impaired loans increased by $1,916,000 as of December 31, 2003 from December 31, 2002. The increase was primarily related to swine production loans which increased $1.4 million from December 31, 2002 to December 31, 2003.

Specific allowance for losses on non-accrual and impaired loans are established if the loan balances exceed the net present value of the future cash flows or the fair value of the collateral if the loan is collateral dependent.

Page 19 of 92

Item 1. Business (Continued)

SUMMARY OF LOAN LOSS EXPERIENCE

The following table summarizes the Bank’s loan loss experience for each of the last five years:

		Year Ended December 31,

		2003			2002			2001			2000			1999

		(Amounts In Thousands)

Allowance for loan losses at beginning of year		$	12,125		$	9,950		$	10,428		$	9,750		$	8,856

Charge-offs:
	Agriculture		26			33			35			26			60
	Commercial and financial		266			562			1,225			522			181
	Real estate, mortgage		478			390			557			254			104
	Loans to individuals		874			803			724			372			418

			1,644			1,788			2,541			1,174			763

Recoveries:
	Agriculture		88			116			72			153			157
	Commercial and financial		661			371			289			276			260
	Real estate, mortgage		318			402			362			118			30
	Loans to individuals		613			625			416			357			310

			1,680			1,514			1,139			904			757

Net charge-offs (recoveries)			(36	)		274			1,402			270			6

Provision for loan losses (1)			424			2,449			924			948			900

Allowance for loan losses at end of year		$	12,585		$	12,125		$	9,950		$	10,428		$	9,750


Ratio of net charge-offs (recoveries) during year to average loans outstanding			0.00	%		0.04	%		0.22	%		0.04	%		0.00	%

(1)

For financial reporting purposes, management regularly reviews the loan portfolio and determines a provision for loan losses based upon the impact of economic conditions on the borrowers’ ability to repay, past collection experience, the risk characteristics of the loan portfolio and such other factors that deserve current recognition. The growth of the loan portfolio is a significant element in the determination of the provision for loan losses.

Page 20 of 92

Item 1. Business (Continued)

ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

The Bank regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans are impaired. If the loans are impaired, the Bank determines if a specific allowance is appropriate. In addition, the Bank’s management also reviews and, where determined necessary, provides allowances based upon reviews of specific borrowers and provides allowances for areas that management believes are of higher credit risk (agricultural loans and constructed model real estate homes as of December 31, 2003, 2002, 2001, 2000 and 1999). Loans for which there are no specific allowances are classified into one or more risk categories. Based upon the risk category assigned, the Bank allocates a percentage, as determined by management, for a required allowance needed. The percentage begins with historical loss experience factors, which are then adjusted for current economic factors.

The following table presents the allowance for loan losses on loans by type of loans and the percentage in each category to total loans as of December 31, 2003, 2002, 2001, 2000, and 1999:

	2003									2002

	Amount			% of Total Allowance			% Of Loans To Total Loans			Amount			% of Total Allowance			% Of Loans To Total Loans

	(In Thousands)									(In Thousands)
Agriculture		$	2,470		19.63	%		4.33	%		$	2,219		18.30	%		4.78	%
Commercial			1,421		11.29			5.44				1,374		11.33			5.91
Real estate, construction			1,076		8.55			7.57				975		8.04			5.95
Real estate			6,775		53.83			79.07				6,638		54.75			79.21
Consumer			843		6.70			3.59				919		7.58			4.15

		$	12,585		100.00	%		100.00	%		$	12,125		100.00	%		100.00	%


	2001									2000

Agriculture		$	1,032		10.37	%		4.95	%		$	1,576		15.11	%		4.48	%
Commercial			1,714		17.23			6.40				1,281		12.28			5.95
Real estate, construction			770		7.74			5.84				1,544		14.81			5.99
Real estate			5,722		57.50			77.80				5,338		51.19			78.29
Consumer			712		7.16			5.01				689		6.61			5.29

		$	9,950		100.00	%		100.00	%		$	10,428		100.00	%		100.00	%


	1999


Agriculture		$	1,025		10.51	%		4.75	%
Commercial			1,366		14.01			6.41
Real estate, construction			925		9.49			7.11
Real estate			5,698		58.44			76.33
Consumer			736		7.55			5.40

		$	9,750		100.00	%		100.00	%

The allocation of the allowance for loan losses shows an increase of $251,000 to agriculture loans and specifically this was due to loans for swine production. This area of agriculture continues to have overall concerns due to the possible large fluctuations in the hog prices. The prices in 2003 averaged approximately $36.00 per hundred weight compared to $34.20 in 2002. The change in price that can happen is reflected in the average price in 2001 which was $46.30. The average breakeven in the industry is approximately $40.00 per hundred weight, so exposure on these types of loans continues to exist. The other changes in the allocation are primarily related to volume changes of loans outstanding and no material deterioration of credit quality.

Page 21 of 92

Item 1. Business (Continued)

INVESTMENT SECURITIES

The following tables show the carrying value of the investment securities which are principally held by the Bank as of December 31, 2003, 2002 and 2000 and the maturities and weighted average yield of the investment securities as of December 31, 2003:

		December 31,

		2003		2002		2001

		(Amounts In Thousands)
Carrying value:
	U. S. Treasury securities	$	6,138	$	6,365	$	12,073
	Obligations of other U. S. Government agencies and corporations		152,710		134,936		123,165
	Obligations of state and political subdivisions		68,535		64,528		46,913

		$	227,383	$	205,829	$	182,151

				December 31, 2003

				Carrying Value			Weighted Average Yield

				(Amounts In Thousands)
Type and maturity grouping:
	U. S. Treasury maturities: within 1 year				$	6,138		4.85	%


	Obligations of other U. S. Government agencies and corporations, maturities:
		Within 1 year				29,888		5.53	%
		From 1 to 5 years				122,822		3.24

						152,710

	Obligations of state and political subdivisions, maturities:
		Within 1 year				8,529		4.30	%
		From 1 to 5 years				39,895		5.82
		From 5 to 10 years				19,667		5.24
		Over 10 years				444		5.13

						68,535

			Total		$	227,383

Page 22 of 92

Item 1. Business (Continued)

INVESTMENT SECURITIES

As of December 31, 2003, there were no investment securities, exceeding 10% of stockholders’ equity, other than securities of the U. S. Government and U. S. Government agencies and corporations.

The weighted average yield is based on the amortized cost of the investment securities. The yields are computed on a tax-equivalent basis using a federal tax rate of 34% and a state tax rate of 5%.

DEPOSITS

The following tables show the amount of average deposits and rates paid on such deposits for the years ended December 31, 2003, 2002 and 2001 and the composition of the certificates of deposit issued in denominations in excess of $100,000 as of December 31, 2003:

		December 31,

		2003		Rate			2002		Rate			2001		Rate


Average noninterest-bearing deposits		$	108,414		0.00	%	$	92,145		0.00	%	$	78,687		0.00	%
Average interest-bearing demand deposits			122,918		0.82			96,054		1.14			76,366		1.85
Average savings deposits			214,088		0.91			194,230		1.49			169,561		2.72
Average time deposits			399,747		3.49			381,973		4.79			357,882		5.76

		$	845,167				$	764,402				$	682,496


		Amount		Rate

Time certificates issued in amounts of $100,000 or more as of December 31, 2003 with maturity in:
	3 months or less	$	13,728		2.84	%
	3 through 6 months		12,649		2.69
	6 through 12 months		8,735		2.57
	Over 12 months		26,854		3.84

		$	61,966

There were no deposits in foreign banking offices.

Page 23 of 92

Item 1. Business (Continued)

RETURN ON STOCKHOLDERS’ EQUITY AND ASSETS

The following table presents the return on average assets, return on average stockholders’ equity, the dividend payout ratio and average stockholders’ equity to average assets ratio for the years ended December 31, 2003, 2002 and 2001:

	2003			2002			2001

Return on average assets		1.24	%		1.10	%		1.11	%
Return on average stockholders’ equity		15.36			14.05			13.94
Dividend payout ratio		19.99			22.87			23.58
Average stockholders’ equity to average assets ratio		8.04			7.85			7.96

SHORT-TERM BORROWINGS

The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates of securities sold under agreements to repurchase during 2003, 2002 and 2001:

	2003			2002			2001

	(Amounts In Thousands)

Outstanding balance as of December 31	$	29,926		$	20,798		$	22,409
Weighted average interest rate at year end		1.00	%		1.52	%		2.36	%
Maximum month-end balance		37,205			28,882			22,711
Average month-end balance		29,323			21,240			17,444
Weighted average interest rate for the year		1.34	%		1.79	%		3.53	%

FEDERAL HOME LOAN BANK BORROWINGS

	2003			2002			2001

	(Amounts In Thousands)

Outstanding balance as of December 31	$	167,574		$	167,606		$	137,637
Weighted average interest rate at year end		5.34	%		5.35	%		5.57	%
Maximum month-end balance		167,606			167,637			137,637
Average month-end balance		167,595			153,543			123,211
Weighted average interest rate for the year		5.42	%		5.52	%		5.83	%

Page 24 of 92

PART I

Item 2. Properties

The Company’s office and the main bank of the Bank are located at 131 Main Street, Hills, Iowa. This is a brick building containing approximately 45,000 square feet. A portion of the building was built in 1977, a two-story addition was completed in 1984, and a two-story brick addition was completed in February 2001. With the completion of the 2001 addition, the entire Bank’s processing and administrative systems, including trust, were consolidated in Hills, Iowa. A majority of these operations previously were located in the Bank’s Coralville office. As a result of the consolidation, sixty-five full-time and part-time employees were relocated.

The other offices of Hills Bank and Trust are as follows:

1.	The Iowa City office, located at 1401 South Gilbert Street, is a one-story brick building containing approximately 15,400 square feet. The branch has five drive-up teller lanes and a drive-up, 24-hour automatic teller machine. The Bank’s trust department customer service representatives are located here. This building was constructed in 1982 and has been expanded several times, most recently in 1998.

2.	The Coralville office is a two-story building built in 1972 and expanded in 2001 that contains approximately 23,000 square feet of space. This office is equipped with four drive-up teller lanes and one automatic teller machine and is used primarily for retail banking services.

3.	A 2,800 square foot branch bank in North Liberty, Iowa was opened for business in 1986. This office is a full-service location including three drive-up teller lanes and a drive-up automatic teller machine.

4.	The Bank leases an office at 132 East Washington Street in downtown Iowa City with approximately 2,500 square feet. The office has two 24-hour automatic teller machines and two private offices in addition to a tellers and customer service area. The lease expires in 2006.

5.	In December 2001, the Bank opened a new East Side office location at 2621 Muscatine Avenue, Iowa City. The office is a 5,800 square foot, one-story building, and it has three drive-up lanes and a drive-up ATM. The new office replaced a leased office that had 1,100 square feet.

6.	The Lisbon office is a two-story brick building in Lisbon, Iowa with approximately 3,000 square feet of banking retail space located on the first floor. The building was extensively remodeled in 1996 and has one drive-up lane and a walk-up, 24-hour automatic teller machine.

7.	The Mount Vernon office opened in February 1998 with the completion of a full-service, 4,200 square foot office, with four drive-up lanes and a drive-up automatic teller machine.

8.	In February 2000, the Bank opened a 2,900 square foot branch office in downtown Cedar Rapids that is leased. In April 2001, an additional contiguous 2,100 square feet of space was leased and then remodeled for retail banking purposes. The leases expire in 2007.

Page 25 of 92

Item 2. Properties (Continued)

9.	The Kalona office is a 6,400 square foot building that contains a walk-up 24-hour automatic teller machine and one drive-up lane. This is an older building that was remodeled in late 1998.

10.	In March of 2002, Hills Bank opened its eleventh office, and the second office location in the Cedar Rapids market. The new 7,200 square foot one-story building has three drive-up lanes and a drive-up ATM. The location of the office is on Williams Boulevard in Southwest Cedar Rapids.

11.	A full service office opened on February 10, 2003 in Marion, Iowa, after extensive remodeling of the property located at 800 11th Street. The office is a two-story building having approximately 8,400 square feet with three drive-up lanes and a drive-up ATM.

All of the properties owned by the Bank are free and clear of any mortgages or other encumbrances of any type.

Item 3. Legal Proceedings

There are no materials pending legal proceedings. Neither the Company nor the Bank holds any properties that are the subject of hazardous waste clean-up investigations.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders for the three months ended December 31, 2003.

Page 26 of 92

PART II

Item 5.

Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

There is no established trading market for the Company’s common stock. Its stock is not listed with any exchange or quoted in an automated quotation system of a registered securities association, nor is there any broker/dealer acting as a market maker for its stock. A bid and ask price is quoted in an Iowa City local paper and the quotes are provided by a local broker. The Company’s stock is not actively traded. As of March 15, 2004, the Company had 1,416 stockholders.

Based on the Company’s stock transfer records and information informally provided to the Company, its stock trading transactions have been as follows:

Year	Number Of Shares Traded		Number Of Transactions		High Selling Price		Low Selling Price

2003		7,487		26	$	101.00	$	88.00
2002		16,917		22		88.00		82.00
2001		9,273		28		82.00		77.00

The Company paid aggregate annual cash dividends in 2003, 2002 and 2001 of $2,853,000, $2,622,000 and $2,392,000, respectively, or $1.90 per share in 2003, $1.75 per share in 2002 and $1.60 per share in 2001. In January 2004, the Company declared and paid a dividend of $2.10 per share totaling $3,185,000. The decision to declare any such cash dividends in the future and the amount thereof rests within the discretion of the Board of Directors and will remain subject to, among other things, certain regulatory restrictions imposed on the payment of dividends by the Bank, and the future earnings, capital requirements and financial condition of the Company.

As of December 31, 2003, stock option information is as follows:

Number of shares that would be issued if all options were exercised		19,291

Weighted average price of options outstanding	$	77.27

Number of additional shares that could be granted		45,976

There are no stock option plans that have not been approved by the stockholders.

Page 27 of 92

Item 6. Selected Financial Data

CONSOLIDATED FIVE-YEAR STATISTICAL SUMMARY

			2003			2002			2001			2000			1999

YEAR-END TOTALS (Amounts in Thousands)
	Total assets		$	1,183,223		$	1,098,547		$	976,105		$	875,750		$	773,966
	Investment securities			236,157			214,211			189,960			161,066			156,198
	Federal funds sold			13,233			32,514			29,428			28,065			206
	Loans held for sale			1,960			6,884			5,575			1,266			681
	Loans, net			868,194			773,973			677,117			625,607			564,700
	Deposits			868,767			802,321			720,018			652,706			562,086
	Federal Home Loan Bank borrowings			167,574			167,606			137,637			120,668			108,700
	Redeemable common stock			14,864			12,951			12,194			11,550			10,953
	Stockholders’ equity			96,765			88,084			78,155			68,524			60,264

EARNINGS (Amounts in Thousands)
	Interest income		$	63,381		$	64,561		$	63,718		$	59,992		$	51,121
	Interest expense			26,405			31,141			34,435			33,064			26,313
	Provision for loan losses			424			2,449			924			948			900
	Other income			13,356			10,230			9,257			7,514			6,437
	Other expenses			28,641			24,615			22,859			20,069			18,309
	Income taxes			6,998			5,122			4,613			4,059			3,570
	Net income			14,269			11,464			10,144			9,366			8,466

PER SHARE
	Net income:
		Basic	$	9.44		$	7.65		$	6.78		$	6.26		$	5.70
		Diluted		9.42			7.58			6.72			6.21			5.66
	Cash dividends			1.90			1.75			1.60			1.45			1.30
	Book value as of December 31			63.80			58.68			52.15			45.82			40.29
	Increase (decrease) in book value due to:
		ESOP obligation		(9.80	)		(8.63	)		(8.14	)		(7.72	)		(7.32	)
		Accumulated other comprehensive income		2.04			3.15			2.02			0.47			(0.66	)

SELECTED RATIOS
	Return on average assets			1.24	%		1.10	%		1.11	%		1.14	%		1.18	%
	Return on average equity			15.36			14.05			13.94			14.94			14.54
	Net interest margin			3.53			3.58			3.58			3.62			3.83
	Average stockholders’ equity to average total assets			8.04			7.85			7.96			7.63			8.11
	Dividend payout ratio			19.99			22.87			23.58			23.18			22.56

Page 28 of 92

Item 7. Management’s Discussion and Analysis of Financial Condition And Results of Operations

Special Note Regarding Forward-Looking Statements

The discussion following contains certain forward-looking statements with respect to the financial condition, the results of operations and business of the Company. These statements involve certain risks and uncertainties, which are often inherent in the ongoing operation of financial institutions such as the Company’s subsidiary bank.

Forward-looking statements discuss matters that are not facts and are typically identified by the words “believe,” “expect,” “anticipate,” “target,” “goal,” “objective,” “intend,” “estimate,” “will,” “can,” “would,” “should,” “could,” “may” and similar expressions. They discuss expectations about the future and are not guarantees. Forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update them to reflect changes that occur after the date they are made.

There are several factors – many of which are beyond the control of the Company or its subsidiary Bank – that could cause results to differ significantly from expectations. Some of these factors are described below. There are factors other than those described below that could cause results to differ from expectations. Any factor described below could by itself, or together with one or more other factors, adversely affect the business, earnings and/or financial condition of the Company and its subsidiary Bank.

The risks involved in the operations and strategies of the Company and its subsidiary Bank include competition from other financial institutions, changes in interest rates, changes in economic or market conditions as well as events and trends affecting specific assets, the effect of credit quality and market perceptions of value on the fair values of financial instruments and regulatory factors. These risks, which are not inclusive, cannot be accurately estimated.

For example, a financial institution may accept deposits at fixed interest rates, at different times and for different terms, and lend funds at fixed interest rates, at different times and for different terms. In doing so, it accepts the risk that its cost of funds may raise while the use of those funds may be at a fixed rate. Similarly, although market rates of interest may decline, the financial institution may have committed by virtue of the term of a deposit, to pay what essentially becomes an above-market rate.

Loans, and the allowance for loan losses, carry the risk that borrowers will not repay all funds in a timely manner, as well as the risk of total loss. The collateral pledged as security for loans may or may not have the value that has been attributed to it. The loan loss reserve, while believed to be adequate, may prove inadequate if one or more large-balance borrowers, or numerous mid-balance borrowers, or a combination of both, experience financial difficulty for a variety of reasons. These reasons may relate to the financial circumstances of an individual borrower, or may be caused by negative economic circumstances at the local, regional, national or international level that are beyond the control of the borrowers or the lender.

Because the business of banking is of a highly regulated nature, the decisions of governmental entities can have a major effect on operating results. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could have substantial and unpredictable effects including increasing the ability of non-banks to offer competing financial services and products.

Page 29 of 92

Item 7. Management’s Discussion and Analysis of Financial Condition And Results of Operations

The Bank’s success depends, in part, on its ability to attract and retain key people. Competition for the best people – in particular individuals with technology experience – is intense. The Bank may not be able to hire well-qualified people or pay them enough to keep them.

All of these uncertainties, as well as others, are present in the operations and business of the Company, and stockholders are cautioned that the Company’s actual results may differ materially from those included in the forward-looking statements.

Critical Accounting Policies

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these 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 policy to be related to the allowance for loan losses. The Company’s allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan loss 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 non-performing 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 in particular, the state of certain industries. 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 and analysis should be read in conjunction with the Company’s financial statements and the accompanying notes presented elsewhere herein, as well as the portion of this Management’s Discussion and Analysis section entitled “Financial Condition - Allowance for Loan Losses”. Although management believes the levels of the allowance as of both December 31, 2003 and 2002 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.

Page 30 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Financial Position

Year End Amounts (Amounts In Thousands)	2003		2002		2001		2000		1999


Loans, net of allowance for losses	$	870,154	$	780,857	$	682,692	$	626,873	$	565,381
Investment securities		236,157		214,211		189,960		161,066		156,198
Deposits		868,767		802,321		720,018		652,706		562,086
Federal Home Loan Bank borrowings		167,574		167,606		137,637		120,668		108,700
Stockholders’ equity		96,765		88,084		78,155		68,524		60,264
Total assets		1,183,223		1,098,547		976,105		875,750		773,966

In 2003, total assets grew $84.7 million, compared to an increase of $122.4 million for 2002. The percentage increase in total assets was 7.71% in 2003, compared to 12.54% in 2002. Asset growth for both years was primarily reflected in higher loan balances and investment securities. In the year ended December 31, 2003, although the total asset growth was down compared to the prior year, a review of the balance sheets shows a reduction in federal funds sold of $19.3 million that were used for asset acquisition. As an alternative, the Company could have borrowed from the FHLB and that would have increased the asset growth by $19.3 million. Also, with the use of the federal funds and a good increase in deposits, no additional amount of funding was required from the FHLB. Given the overall interest rates on federal funds and in order to use them more efficiently, it was a business decision to switch to the loan and investment alternatives.

In 2003, net loans increased by $89.3 million. The net loans include loans held for sale to the secondary market, which were $1,960,000 at December 31, 2003, having decreased from the balance of $6,884,000 at December 31, 2002. In the year 2003, as in 2002, the increase in loans was primarily attributable to real estate mortgage loans which increased $75.2 million. The increase for 2002 was $98.2 million with $88.0 in mortgage real estate loans. The increases in both years were driven by the continued low level of interest rates which during 2003 were at fifty year lows. In addition, the overall economy in the Company’s principal place of business, Johnson and Linn Counties, remain in good economic condition with unemployment levels that remain low. Competition for quality loans and deposits will continue to be a challenge. In both counties, new banks and credit unions have been opened in the last few years. Between 2001 and 2003, five new banking locations were added in Johnson County and ten in Linn County. The fifteen new locations include an office of one of the state’s largest credit unions and several large Des Moines based banks. The increased competition for both loans and deposits could result in a lower interest rate margin that could result in lower net interest income if the volume of loans and deposits does not increase to offset any such reduction in the interest margin.

Deposits increased $66.4 million, or 8.28% in 2003 compared to an increase of 11.43% in 2002. Also, for funding purposes securities sold under agreements to repurchase increased $9.1 million to $29.9 million after having decreased $1.6 million in 2002. Deposits including repurchase agreements increased 9.18% in 2003 compared to 10.87% in 2002. In 2003 and also in 2002, growth continued in deposits due to uncertainties in the stock market from 2001 and 2002, when the stock market had a significant downturn and consumers have elected not to move quickly back to stocks as an investment. Also, in the last two years, the Bank has established new offices in the Cedar Rapids and Marion area and a relocated office on the Eastside of Iowa City, all of which have been helpful in adding new deposit customers for the Bank. In Linn County, as of June 30, 2003, the Company had approximately $119 million in deposits or 3.3% of the total deposit market of $3.6 billion. The Bank has added three offices in the Cedar Rapids-Marion area since 2000, with two of the offices added in 2003 and 2002, respectively to capitalize on the strong Linn County market which in total, is twice the size of the Johnson County market. Johnson County has fourteen banks and Linn County has twenty-seven banks at the end of 2003. In addition, there are two credit unions in Johnson County while Linn County has ten credit unions. In the last two years the Company has increased its market share in both counties. While there is increasing competition in the Linn County market, the Bank’s three newest offices in Linn County grew by $45.7 million in 2002 and 2003, and management anticipates that the Bank’s market share in Linn County will continue to grow in the years ahead.

Page 31 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

In 2002, the Company increased its borrowings from the Federal Home Loan Bank (FHLB) by a net $30 million to increase total advances at December 31, 2002 to $167.6 million. As in prior years, the advances are used to fund asset growth in years where deposit sources are not sufficient. The increase in 2003 in deposits and repurchase agreements coupled with a reduction in federal funds sold of $19.3 million were enough to not require any increase in the borrowings from the FHLB. It is expected that the FHLB funding source will be used in the future when loan growth exceeds deposit increases and the interest rates are favorable compared to other funding alternatives.

Investment securities increased by $21.9 million in 2003 and $24.3 million in 2002. Because the portfolio is marked to market, changes in the value of the portfolio may vary significantly from year to year. The securities portfolio, which includes tax exempt securities and stock of the FHLB that is required for borrowings, is used for liquidity and pledging purposes and to provide a rate of return that is acceptable to management.

Stockholders’ equity was $96.8 million at December 31, 2003 compared to $88.1 million at December 31, 2002. The Company’s capital resources are discussed in detail in the Liquidity and Capital Resources section. Over the last five years, the Company has realized cumulative earnings of $53.7 million and paid shareholders dividends of $13.2 million, or 24.6% of earnings, while still maintaining capital ratios in excess of regulatory requirements.

Net Income Overview

Net income and diluted earnings per share for the last five years are as presented below:

Year	Net Income			% Increase			E.P.S.- Diluted


2003		$	14,269		24.47	%		$	9.42
2002			11,464		13.01				7.58
2001			10,144		8.31				6.72
2000			9,366		10.63				6.21
1999			8,466		13.09				5.66

Net income for 2003 reached a record high of $14,269,000, or diluted earnings per share of $9.42. For 2003, diluted earnings per share increased $1.84 per share, while 2002 results had increased $.51 per share. For the year ended December 31, 2002, net income increased by $1,320,000 from the 2001 results. Net income for the year ended December 31, 2003, represents a $2,805,000 increase over the reported income for the same period in 2002. The increase in net income is related to three significant factors. The factors are the continued growth in average earning assets, the decrease in the provision for loan losses and the increase in the gain on sale of loans. Net interest income, including fees increased $3.6 million for the year ended December 31, 2003 compared to 2002. The improvement is due to an increase in average earning assets of $116.4 million. The provision for loan losses and its effect on net income is discussed in a later section of this report. The mortgage refinancing growth continued in 2003 as the number of loans sold on the secondary market and the resulting gain on sale was $4,278,000 which is $2,287,000 more than 2002. The interest rates on secondary market loans that are sold increased in late summer as long-term investment rates rose. As a result of this, coupled with the fact that many consumers had taken advantage of lower rates, the volume of loans sold and the related level of income from this mortgage activity did not continue in the fourth quarter of 2003.

Page 32 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Annual fluctuations in the Company’s net income are driven primarily by three important factors. The first important factor is net interest margin. Net interest income of $40.0 million in 2003 was derived from the Company’s $1.084 billion of average earning assets and its net interest margin of 3.53% for that same year. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of only 10 basis points to 3.43% would result in a $1 million decrease in net income before taxes.

The second significant factor on the Company’s net income is the provision for loan losses. The majority of the Company’s investments are in loans outstanding, which amounted to more than $880 million in 2003. The Company’s allowance for loan losses was $12.6 million in 2003. An increase in problem loans would result in a higher allocation to the loan loss reserve, which in turn would reduce the Company’s net income.

The amount of loans sold on the secondary market is the third significant factor. The gain on the sale of loans on the secondary market has ranged from $316,000 in 1999 to $4,278,000 in 2003. Sales of loans on the secondary market are influenced by the real estate market and interest rates. Interest rates, which also help spur new loan growth and secondary market loans (including refinancing), have been at record lows when compared to interest rate levels over the last fifty years. Effective June 25, 2003, the Federal Reserve Open Market Committee lowered the federal funds target rate to 1.00%, the lowest level since July 1958. Prior to the June 25, 2003 decrease, the target rate was lowered 25 basis points on November 6, 2002. The June 25, 2003 decrease was the thirteenth decrease since May 16, 2000, when the federal funds rate was 6.50%.

Net Interest Income

Net interest income is the excess of the interest and fees received on interest-earning 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 volume of average earning assets has continued to grow over the last few years, primarily due to new loans. The net interest margin has remained steady over the last five years in spite of decreasing interest rates. The net interest margin was 3.53% in 2003, 3.58% in 2002, 3.58% in 2001, 3.62% in 2000 and 3.83% in 1999. The measure is shown on a tax-equivalent basis using a rate of 34% to make the interest earned on taxable and nontaxable assets more comparable.

Page 33 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Net interest income on a tax-equivalent basis changed in 2003 as follows:

								Increase (Decrease)
		Change In Average Balance			Change In Average Rate
		Change In Average Balance			Change In Average Rate			Volume Changes			Rate Changes				Net Change

		(Amounts In Thousands)
Interest income:
	Loans, net		$	95,888		(0.87	)%		$	6,704		$	(6,761	)		$	(57	)
	Taxable securities			6,727		(1.00	)			337			(1,481	)			(1,144	)
	Nontaxable securities			7,320		(0.45	)			423			(266	)			157
	Federal funds sold			6,442		(0.56	)			83			(221	)			(138	)

			$	116,377					$	7,547		$	(8,729	)		$	(1,182	)

Interest expense:
	Interest-bearing demand deposits		$	26,864		(0.32	)%			265			(348	)			(83	)
	Savings deposits			19,858		(0.58	)			271			(1,221	)			(950	)
	Time deposits			17,774		(1.30	)			818			(5,159	)			(4,341	)
	Securities sold under agreements to repurchase			8,083		(0.45	)			127			(154	)			(27	)
	FHLB borrowings			14,052		(0.10	)			773			(108	)			665

			$	86,631					$	2,254		$	(6,990	)		$	(4,736	)

Change in net interest income									$	5,293		$	(1,739	)		$	3,554

Net interest income changes for 2002 were as follows:

	Change In Average Balance		Effect Of Volume Changes		Effect Of Rate Changes			Net Change

	(Amounts In Thousands)
Interest-earning assets	$	117,683	$	8,423	$	(7,414	)	$	1,009
Interest-bearing liabilities		102,576		4,028		(7,322	)		(3,294	)

Change in net interest income			$	4,395	$	(92	)	$	4,303

Page 34 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

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

(Tax Equivalent Basis)	2003			2002			2001


Yield on average interest-earning assets		5.96	%		6.80	%		7.62	%
Rate on average interest-bearing liabilities		2.83			3.68			4.63

Net interest spread		3.13			3.12			2.99
Effect of noninterest-bearing funds		0.40			0.46			0.59

Net interest margin (tax equivalent interest income divided by average interest-earning assets)		3.53	%		3.58	%		3.58	%

Provision For Loan Losses

The provision for loan losses totaled $424,000, $2,449,000 and $924,000 for 2003, 2002 and 2001, respectively. Recoveries net of charge-off for 2003 were $36,000 while charge-offs, net of recoveries, were $274,000 for 2002 and $1,402,000 for 2001. The provision for loan losses in 2003 was $424,000 compared to $2,449,000 in 2002 or a decrease of $2,025,000. The provision adjustment computed on a quarterly basis 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, loan concentrations, the level of impaired loans which are all non-accrual and loans past due ninety days or more. In addition, management considers the credit quality based on their review of problem and watch loans, including loans with historical higher credit risks (primarily agricultural loans).

Other factors that are considered in determining the credit quality of the Company’s loan portfolio are reviewing the vacancy rates for both residential and commercial and retail space, current equity the borrower has in the property and overall financial strength of the customer including cash flow to continue to fund the loan. The Company also reviews the total economy including unemployment levels, vacancy rates of rental units and demand for commercial and retail space. In most instances the borrowers have used in their rental projections of income at least a 5% vacancy rate. As of December 31, 2003, the unemployment level in Johnson County and Linn County was 3.39% and 4.31%, respectively. These levels compare favorably to the State of Iowa at 4.36% and the national unemployment level at 5.72%. The residential rental vacancy rates in 2003 in Johnson County, the largest trade area for the Company, were 4.06% in Iowa City and 7.19% in Coralville. The State of Iowa vacancy rate is 8.2% and the national is 10.2%. The rates for Iowa City and Coralville for 2001 were both under 2%. Although the vacancy rates have increased in the Company’s trade areas, the Company has not believed it necessary to increase the number of loans in a “problem” or “watch” status based on its current evaluation of the loan portfolio.

The level of problem or watch loans that were included in the reserve computation increased significantly from December 31, 2001 to December 31, 2002 and therefore resulted in the large provision increase in 2002. The increase was due in particular for loans that were in the swine production segment that were of major concern because of the dollar amount of those loans and the severe price fluctuations that swine producers experienced during that time period, management felt it prudent to classify many of those loans as problem or watch loans. The amount of problem or watch loans considered in the estimate for December 31, 2003 was at balances that were similar to December 31, 2002. The allowance for loan losses balance is also affected by the net charge-offs for the periods presented. For the year ended December 31, 2003 and 2002, recoveries were $1,680,000 and $1,514,000, respectively; and charge-offs were $1,644,000 in 2003 and $1,788,000 in 2002.

Page 35 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (Continued)

The allowance for loan losses totaled $12,585,000 at December 31, 2003 compared to $12,125,000 at December 31, 2002. The percentage of the allowance to outstanding loans was 1.43% and 1.53% at December 31, 2003 and 2002, respectively. The percentage of the loan loss allowance to gross loans was 1.46%, 1.66% and 1.72% at December 31, 2001, 2000 and 1999, respectively. The decrease was due to loan growth (fueled primarily by an increase in real estate mortgages) and a decrease in the number of “problem” or “watch” loans compared to total loans outstanding. The allowance was based on management’s consideration of a number of factors, including loan concentrations, loans with higher credit risks (primarily agriculture loans and spec real estate construction) and overall increases in net loans outstanding. The methodology used in 2003 is consistent with the prior year. Beginning in 2001, the Bank refined the methodology used to compute the allowance for loan losses, primarily by applying estimated loss rates to several risk categories of loans instead of more general categories of loans.

Agricultural loans totaled $38,153,000 and $37,937,000 at December 31, 2003 and 2002, respectively. The level of agriculture loans the last five years compared to total loans has been between 4.95% down to 4.33% in 2003. Management has assessed the risks for agricultural loans higher than other loans due to unpredictable commodity prices, the effects of weather on crops and uncertainties regarding government support programs. In particular, loans that are in the swine production segment continue to be of major concern as prices for hogs are subject to severe fluctuations.

The University of Iowa, because of its 24,500 employees and because of the money it spends in Johnson County, has a tremendous impact on the economy of the Bank’s primary trade area. In 2002 and 2003, the University of Iowa helped Johnson County’s economy remain strong in spite of a weakened national economy. However, in the last fifteen months the economy of the state of Iowa has weakened and the University continues to suffer from budget cuts. For its fiscal year beginning July 1, 2004 the University expects continued budget constraints. The possible effects on the local economy cannot be predicted, but are likely to weaken the economy in future years.

Other Income

In 2003, the Company’s total other income increased $3,126,000 compared to the prior year. Gain on sale of loans to the secondary market for 2003 increased over the prior year by $2,287,000 due to continued low interest rates that enabled borrowers to re-finance. Loans sold in 2001 were $1,165,000, an increase of $849,000 over 2000. Interest rates on secondary market loans averaged under 6.05% the first half of 2003 compared to 6.69% in 2002 and 7.15% in 2001. Interest rates rose in the last quarter of 2003 and this with the factor that many customers had refinanced in late 2002 and in 2003 reduced the volume of loans sold on the secondary market. In addition, the increase in customer deposit accounts, along with increases in the fees, accounted for a $327,000 increase in deposit account charges and fees. Trust fees in 2003 had a $92,000 increase to $2,444,000 due to more assets under management. The Trust Department has $623 million of assets under management at December 31, 2003 compared to $484 million at December 31, 2002. Trust fees are based on total assets under management. The trust assets that are the most volatile are those that are held in common stock. Approximately 51% of trust assets are held in common stocks and with the major decline in the market in 2002, this effected the growth of the trust assets and trust fees. During the last half of 2003, the major stock indices have all shown much improvement and as a result the asset growth has been in part due to market value increases. An example of the increases is the Dow Jones Industrial Average which was down approximately 16% in 2002 was up over 25% in 2003. Due to the majority of the trust assets growth in terms of new accounts and market value increases coming in the last six months, trust fees did not increase significantly for 2003.

Other fees and charges increased $90,000 from 2002 compared to 2003. In 2003, the credit card processing fee income increased by $507,000 to $698,000. Also, in the other expenses section, the credit card processing expense in 2003 was $957,000 compared to $398,000 in 2002, or an increase of $559,000. Effective on January 1, 2003, the Company began including the gross amount of merchant charges in other income rather than netting it with related processing charges. This change had no effect on the income shown for credit card processing but did decrease the fee income and processing expense by approximately $400,000 for 2002 and 2001. Total other income was also offset by $177,000 due to investment securities losses in the fourth quarter of 2003. In 2002, no securities losses were reported.

Page 36 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (Continued)

In 2002, the Company’s total other income increased $973,000 compared to the prior year. Gain on sale of loans revenue for 2002 increased over the prior year by $826,000 due to continued low interest rates that enabled borrowers to re-finance. Interest rates on secondary market loans averaged under 6.50% the last half of 2002 compared to 7.15% in 2001. In addition, the increase in customer deposit accounts, along with changes in the fee structure, accounted for an $189,000 increase in deposit account charges and fees. Trust fees in 2002 were virtually unchanged form 2001, a $47,000 increase. The number of trust accounts under management increased in 2002, but the continued decline in stock values had the effect of reducing trust fees which are based on asset value.

Other Expenses

Total other expenses were $28,641,000 and $24,615,000 for the year ended December 31, 2003 and 2002, respectively. The increase includes $2,212,000 in salaries and benefits, which is the direct result of salary adjustments for 2003 and a net increase in full-time equivalents of fifteen since December 31, 2002. The new employees added included nine in the secondary loan market department and eleven in the Marion office, which opened in February 2003. Medical expenses included with salaries and benefits increased to $1.1 million from $825,000 in 2002. This increase is due to the hiring of new employees and to 20% increases in health and drug claim costs. All other expenses other than salaries and benefits increased a total of $1,814,000 or 16.57%. Credit card processing fees, which composed part of the other expenses, increased $559,000 and was offset by $507,000 of increased fee income of credit card processing included in the other income section. Direct expenses for the secondary market for items such as direct underwriting expense and related expenses were $285,000 higher in 2003 than in 2002. The increase is the result of the higher volume of loans that were sold on the secondary market during 2003. Direct expenses for the secondary market will decrease if the volume of loans sold on the secondary market decreases.

Other expenses increased $1,756,000 in 2002. Of the increase, salaries and benefits accounted for $1,804,000, occupancy and furniture and equipment expense accounted for $76,000 of the increase and all other expenses decreased $124,000. The salaries and employee benefits increased as a direct result of salary adjustments for 2002 and staff additions primarily at the new office locations. Total full-time equivalent employees increased between years by twenty-four. The benefits include a $150,000 increase in medical insurance costs due to increasing medical costs. The increased occupancy and furniture and equipment expense was the result of new locations added and new equipment purchases both in 2001 and 2002. Other expenses decreased $124,000 between 2001 and 2002. The other expenses in 2001 included $261,000 for amortization of intangible assets, which consisted principally of goodwill, equal to the excess of cost over fair value of net assets acquired in business combinations of two banks in 1996 accounted for under the purchase method. As discussed in the section of Impact of Recently Issued Accounting Standards amortization of goodwill ceased effective on January 1, 2002.

Income Taxes

Income tax expense was $6,998,000, $5,122,000 and $4,613,000 for the years ended December 31, 2003, 2002 and 2001, respectively. The corresponding percentage of income taxes compared to income before income taxes is 32.91% in 2003, 30.88% in 2002 and 31.26% in 2001. The percentages are up slightly from 2002 to 2003 due to an increase in pre tax income for the year without a corresponding increase in non-taxable interest income due to lower interest rates in 2003.

Impact of Recently Issued Accounting Standards

The FASB has issued Statement No. 143, “Accounting for Asset Retirement Obligations” which requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. For the Company, the Statement was effective January 1, 2003, and implementation did not have any impact on the financial statements.

Page 37 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (Continued)

The FASB has issued Statement No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” This statement is applicable to debt extinguishments and their classification; certain sale-leaseback transactions and intangible assets of motor carriers. Implementation of these provisions of the Statement had no effect and is not expected to have a material impact on the Company’s financial statements.

The FASB has issued Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The provisions of the Statement are effective for exit or disposal activities that are initiated after December 31, 2002. Implementation of the Statement did not have a material impact on the Company’s financial statements.

The FASB has issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”- an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34.” This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of the Interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. Implementation of these provisions of the Interpretation is not expected to have a material impact on the Company’s consolidated financial statements. The disclosure requirements of the Interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of Interpretation No. 45’s measurement and recognition provisions did not have a material impact to the Company’s financial position or results of operations.

In October 2002, the FASB issued Statement of Financial Accounting Standards No.147, “Acquisition of Certain Financial Institutions, an Amendment to FASB Statements No.72 and 144 and FASB Interpretation No.9. The statement removes acquisitions of financial institutions from the scope of the previous issued statements and interpretation and requires that those transactions be accounted for in accordance with Statement of Financial Accounting Standards No.141, “Business Combinations” and Statement of Financial Accounting Standards No.142, “Goodwill and Intangible Assets.” Thus, the requirement to recognize (and subsequently amortize) any excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired as an unidentifiable intangible asset no longer applies to acquisitions within the scope of this statement. The Company adopted FASB No. 147 on October 1, 2002 and the adoption resulted in no reclassification or revisions to prior period financial statements.

In January 2003, the FASB issued Interpretation No.46,”Consolidation of Variable Interest Entities,” which addresses consolidation by business enterprises of variable interest entities which have certain characteristics by requiring that if a business enterprise has a controlling interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity be included in the consolidated financial statements with those of the business enterprise. This statement applies to variable interest entities created after January 31, 2003 and to variable interest entities in which an enterprise obtains an interest after that date. For variable interest acquired before February 1, 2003, it applies in the first fiscal year or interim period beginning after June 15, 2003. The Company has adopted the various provisions of this statement but presently does not have any variable interest entities that would be required to be included in its consolidated financial statements.

Page 38 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition And Results of Operations (Continued)

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement established standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or asset in some circumstances). Many of those instruments were previously classified as equity. The statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company adopted the statement on July 1, 2003 and such adoption did not have a material effect on its financial position or results of operations.

In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 amends Statement 133 for decisions made (1) as part of the Derivatives Implementation Group process that effectively required amendments to Statement 133, (2) in connection with other FASB projects dealing with financial instruments, and (3) in connection with the implementation issues raised in relation to the application of the definition of a derivative, in particular, the meaning of “an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors,” the meaning of “underlying,” and the characteristics of a derivative that contains financing components. SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The Company adopted SFAS 149 on July 1, 2003 and such adoption did not have a material effect on its financial position or results of operations.

Page 39 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Interest Rate Sensitivity and Liquidity Analysis

At December 31, 2003, the Company’s interest rate sensitivity report is as follows (amounts in thousands):

				Repricing Maturities Immediately			Days												More Than One Year		Total

							2-30			31-90			91-180			181-365


Earning assets:
	Federal funds sold			$	13,233		$	—		$	—		$	—		$	—		$	—	$	13,233
	Investment securities				—			3,377			5,310			14,191			21,067			192,212		236,157
	Loans				5,832			65,012			36,949			40,998			72,264			661,685		882,740

			Total		19,065			68,389			42,259			55,189			93,331			853,897		1,132,130

Sources of funds:
	Interest-bearing checking and savings accounts				137,747			—			—			—			—			221,270		359,017
	Certificates of deposit				—			32,728			53,083			81,963			53,484			172,287		393,545
	Other borrowings - FHLB				—			60,000			30,000			10,000			10,000			57,574		167,574
	Repurchase agreements and federal funds				29,926			—			—			—			—			—		29,926

					167,673			92,728			83,083			91,963			63,484			451,131		950,062

	Other sources, primarily noninterest-bearing				—			—			—			—			—			116,206		116,206

		Total sources			167,673			92,728			83,083			91,963			63,484			567,337		1,066,268

Interest
	Rate Gap			$	(148,608	)	$	(24,339	)	$	(40,824	)	$	(36,774	)	$	29,847		$	286,560	$	65,862

Cumulative Interest Rate Gap at December 31, 2003				$	(148,608	)	$	(172,947	)	$	(213,771	)	$	(250,545	)	$	(220,698	)	$	65,862

The table set forth above includes the portion of the balances in interest-bearing checking, savings and money market accounts that management has estimated to mature within one year. The classifications are used because the Bank’s historical data indicates that these have been very stable deposits without much interest rate fluctuation. Historically, these accounts would not need to be adjusted upward as quickly in a period of rate increases so the interest risk exposure would be less than the re-pricing schedule indicates. The FHLB borrowings are classified based on their callable dates because they may be called if interest rates rise over current rates.

Inflation

Inflation has an impact on the growth of total assets and has resulted in the need to increase equity capital to maintain an appropriate equity to asset ratio. The results of operations have been affected by inflation, but the effect has been minimal.

Page 40 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Liquidity and Capital Resources

On an unconsolidated basis, the Company had cash balances of $2,343,000 as of December 31, 2003. In 2003, the holding company received dividends of $2,856,000 from its subsidiary bank and used those funds to pay dividends to its stockholders of $2,853,000.

As of December 31, 2003 and 2002, stockholders’ equity, before deducting for the maximum cash obligation related to ESOP, was $111,629,000 and $101,035,000 respectively. This measure of equity as a percent of total assets was 9.43% at December 31, 2003 and 9.20% at December 31, 2002. As of December 31, 2003, total equity was 8.18% of assets compared to 8.02% of assets at the prior year end. The ability of the Company to pay dividends to its shareholders is dependent upon the earnings and capital adequacy of its subsidiary bank, which affects the Bank’s dividends to the Company. The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends. In order to maintain acceptable capital ratios in the subsidiary bank, certain of its retained earnings are not available for the payment of dividends. Retained earnings available for the payment of dividends to the Company total approximately $10,820,000, $6,092,000 and $7,015,000 as of December 31, 2003, 2002 and 2001, respectively.

The Company and the Bank are subject to the Federal Deposit Insurance Corporation Improvement Act of 1991 and the Bank is subject to Prompt Corrective Action Rules as determined and enforced by the Federal Reserve. These regulations establish minimum capital requirements that member banks must maintain.

As of December 31, 2003, risk-based capital standards require 8% of risk-weighted assets. At least half of that 8% must consist of Tier I core capital (common stockholders’ equity, non-cumulative perpetual preferred stock and minority interest in the equity accounts of consolidated subsidiaries), and the remainder may be Tier II supplementary capital (perpetual debt, intermediate-term preferred stock, cumulative perpetual, long-term and convertible preferred stock, and loan loss reserve up to a maximum of 1.25% of risk-weighted assets). Total risk-weighted assets are determined by weighting the assets according to their risk characteristics. Certain off-balance sheet items (such as standby letters of credit and firm loan commitments) are multiplied by “credit conversion factors” to translate them into balance sheet equivalents before assigning them risk weightings. Any bank having a capital ratio less than the 8% minimum required level must, within 60 days, submit to the Federal Reserve a plan describing the means and schedule by which the Bank shall achieve the applicable minimum capital ratios.

The Bank is an insured state bank, incorporated under the laws of the state of Iowa. As such, the Bank is subject to regulation, supervision and periodic examination by the Superintendent of Banking of the State of Iowa (the “Superintendent”). Among the requirements and restrictions imposed upon state banks by the Superintendent are the requirements to maintain reserves against deposits, restrictions on the nature and amount of loans, which may be made by state banks, and restrictions relating to investments, opening of bank offices and other activities of state banks. Changes in the capital structure of state banks are also approved by the Superintendent. One of the most significant standards of operation of state banks is the six and one-half percent (6 1/2%) primary capital to total assets ratio generally required by the Superintendent. In certain instances, the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement on the Bank. The Superintendent defines the term “primary capital” to mean the sum of stockholders’ equity and the allowance for loan losses less any intangible assets. In determining the primary capital ratio, the Superintendent uses the total assets as of the date of computation. At December 31, 2003, the primary capital to total assets ratio of the Bank exceeded the ratio required by the Superintendent.

Page 41 of 92

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The actual amounts and capital ratios as of December 31, 2003 and the minimum regulatory requirements for the Company and the Bank are presented below (amounts in thousands):

				Actual					For Capital Adequacy Purposes			To Be Well Capitalized Under Prompt Corrective Action Provisions

				Amount		Ratio			Ratio			Ratio

As of December 31, 2003:
	Company:
			Total risk based capital	$	116,035		14.56	%		8.00	%		10.00	%
			Tier 1 risk based capital		106,042		13.31			4.00			6.00
			Leverage ratio		106,042		8.87			3.00			5.00
	Bank:
		Total risk based capital			112,641		14.15			8.00			10.00
		Tier 1 risk based capital			102,661		12.90			4.00			6.00
		Leverage ratio			102,661		8.60			3.00			5.00

The Bank is classified as “well capitalized” by FDIC capital guidelines.

On a consolidated basis, 2003 cash flows from operations provided $22,145,000 and net increases in deposits provided $66,446,000. These cash flows were invested in net loans of $94,645,000, and net securities of $25,693,000. Also, federal funds sold decreased by $19,281,000 to assist in the funding of the loans and investments growth. In addition, $2,952,000 was used to purchase property and equipment.

At December 31, 2003, the Bank had total outstanding loan commitments and unused portions of lines of credit totaling $139,422,000. Management believes that its liquidity levels are sufficient at this time, but the Bank may increase its liquidity by limiting the growth of its assets by selling more loans in the secondary market or selling portions of loans to other banks through participation agreements. It may also obtain additional funds from the Federal Home Loan Bank (FHLB). The Bank as of December 31, 2003 can obtain an additional $139 million from the FHLB based on the current real estate mortgage loans held. In addition, the Bank has arranged $111 million of credit lines at three banks. The borrowings would be secured by the Bank’s investment securities. As a further source of liquidity, $69 million of additional securities are available to be pledged or liquidated.

While the Bank has off-balance sheet commitments to fund additional borrowings of customers, it does not use other off-balance-sheet financial instruments, including interest rate swaps, as part of its asset and liability management. Contractual commitments to fund loans are met from the proceeds of federal funds sold or investment securities and additional borrowings. Many of the contractual commitments to extend credit will not be funded because they represent the credit limits on credit cards and home equity lines of credits.

Page 42 of 92

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Related Party Transactions

The Bank’s primary transactions with related parties are the loan and deposit relationships it maintains with officers, directors and entities related to these individuals. The Bank makes loans to related parties under substantially the same interest rates, terms and collateral as those prevailing for comparable transactions with unrelated persons. In addition, these parties may maintain deposit account relationships with the Bank that also are on the same terms as with unrelated persons. As of December 31, 2003 and 2002, loan balances to related individuals and businesses totaled $32,454,000 and $27,813,000, respectively. Deposits from related parties totaled $5,800,000 and $6,599,000 as of December 31, 2003 and 2002, respectively.

Commitments and Trends

The Company and the Bank have no material commitments or plans that will materially affect liquidity or capital resources. Property and equipment may be acquired in cash purchases, or they may be financed if favorable terms are available.

Market Risk Exposures

The Company’s primary market risk exposure is to changes in interest rates. 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 rates increase over an extended period of time. Inversely, the Company’s yields and cost of funds will decrease when market rates decline. The Company is able to manage these swings to some extent by attempting to control the maturity or rate adjustments of its interest-earning assets and interest-bearing liabilities over given periods of time.

The Bank maintains an asset/liability committee, which meets at least quarterly to review the interest rate sensitivity position and to review various strategies as to interest rate risk management. 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.

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 passbook or transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.

Based on the data following, net interest income should decline with instantaneous increases in interest rates while net interest income should increase with instantaneous declines in interest rates. Generally, during periods of increasing interest rates, the Company’s interest rate sensitive liabilities would re-price faster than its interest rate sensitive assets causing a decline in the Company’s interest rate spread and margin. This would tend to reduce net interest income because the resulting increase in the Company’s cost of funds would not be immediately offset by an increase in its yield on earning assets. In times of decreasing interest rates, fixed rate assets could increase in value and the lag in re-pricing of interest rate sensitive assets could be expected to have a positive effect on the Company’s net interest income.

Page 43 of 92

Item 7A. Quantitative and Qualitative Disclosures About Market Risk (Continued)

The following table, which presents principal cash flows and related weighted average interest rates by expected maturity dates, provides information about the Company’s loans, investment securities and deposits that are sensitive to changes in interest rates.

			2004			2005			2006			2007			2008			Thereafter			Total			Fair Value

			(Amounts In Thousands)
Assets:
	Loans, fixed:
		Balance	$	94,619		$	26,387		$	50,804		$	69,245		$	113,128		$	44,500		$	398,683		$	441,178
		Average interest rate		6.59	%		7.12	%		6.59	%		6.43	%		6.01	%		5.89	%		6.35	%

	Loans, variable:
		Balance	$	52,340		$	3,563		$	1,962		$	5,052		$	35,061		$	384,118		$	482,096		$	482,096
		Average interest rate		6.51	%		5.75	%		6.35	%		5.60	%		4.46	%		5.96	%		5.91	%

Investments (1):
		Balance	$	65,445		$	54,905		$	50,634		$	39,605		$	16,050		$	22,751		$	249,390		$	249,501
		Average interest rate		3.88	%		4.14	%		3.12	%		3.14	%		3.73	%		4.91	%		3.75	%

Liabilities:
	Liquid deposits (2):
		Balance	$	359,017		$	—		$	—		$	—		$	—		$	—		$	359,017		$	359,017
		Average interest rate		0.61	%																	0.61	%

Deposits, certificates:
		Balance	$	221,257		$	56,699		$	47,309		$	47,851		$	20,428		$	—		$	393,544		$	391,798
		Average interest rate		2.89	%		2.81	%		4.08	%		4.29	%		3.57	%					3.23	%

(1)	Includes all available-for-sale investments, held-to-maturity investments, federal funds and Federal Home Loan Bank stock.

(2)	Includes passbook accounts, NOW accounts, Super NOW accounts and money market funds.

Item 8. Financial Statements and Supplementary Data

The financial statements and supplementary data are included on Pages 45 through 77.

Page 44 of 92

INDEPENDENT AUDITOR’S REPORT

To the Board of Directors
Hills Bancorporation
Hills, Iowa

We have audited the accompanying consolidated balance sheet of Hills Bancorporation and subsidiary as of December 31, 2003, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the 2003 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hills Bancorporation and subsidiary as of December 31, 2003, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

January 30, 2004

Page 45 of 92

INDEPENDENT AUDITOR’S REPORT

To the Board of Directors
Hills Bancorporation
Hills, Iowa

We have audited the accompanying consolidated balance sheet of Hills Bancorporation and subsidiary as of December 31, 2002 and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for the years ended December 31, 2002 and 2001. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hills Bancorporation and subsidiary as of December 31, 2002, and the results of their operations and their cash flows for the years ended December 31, 2002 and 2001 in conformity with accounting principles generally accepted in the United States of America.

Iowa City, Iowa
February 25, 2003

Page 46 of 92

HILLS BANCORPORATION

CONSOLIDATED BALANCE SHEETS
December 31, 2003 and 2002
(Amounts In Thousands, Except Shares)

			2003		2002

ASSETS
Cash and due from banks (Note 9)			$	24,194	$	32,647
Investment securities (Note 2):
	Available for sale (amortized cost 2003 $214,530 ; 2002 $190,313)			219,430		197,807
	Held to maturity (fair value 2003 $8,064 ; 2002 $8,303)			7,953		8,022
Stock of Federal Home Loan Bank				8,774		8,382
Federal funds sold				13,233		32,514
Loans held for sale				1,960		6,884
Loans, net (Notes 3, 6 and 10)				868,194		773,973
Property and equipment, net (Note 4)				22,210		21,500
Accrued interest receivable				7,303		7,278
Deferred income taxes (Note 8)				2,411		1,971
Goodwill				2,500		2,500
Other assets				5,061		5,069

			$	1,183,223	$	1,098,547


LIABILITIES AND STOCKHOLDERS’ EQUITY

Liabilities
	Noninterest-bearing deposits		$	116,206	$	107,833
	Interest-bearing deposits (Note 5)			752,561		694,488

		Total deposits		868,767		802,321
	Securities sold under agreements to repurchase (Note 6)			29,926		20,798
	Federal Home Loan Bank borrowings (“FHLB”) (Note 7)			167,574		167,606
	Accrued interest payable			1,735		2,134
	Other liabilities			3,592		4,653

				1,071,594		997,512

Commitments and Contingencies (Notes 8 and 14)

Redeemable Common Stock Held By Employee Stock
	Ownership Plan (ESOP) (Note 8)			14,864		12,951


Stockholders’ Equity (Note 10)
	Capital stock, no par value; authorized 10,000,000 shares; issued 2003 1,516,678 shares; 2002 1,501,054 shares			11,353		10,541
	Retained earnings			97,189		85,773
	Accumulated other comprehensive income			3,087		4,721

				111,629		101,035
	Less maximum cash obligation related to ESOP shares (Note 8)			14,864		12,951

				96,765		88,084

			$	1,183,223	$	1,098,547

See Notes to Consolidated Financial Statements.

Page 47 of 92

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands, Except Per Share Amounts)

				2003			2002		2001

Interest income:
	Loans, including fees			$	54,362		$	54,363	$	52,986
	Investment securities:
		Taxable			6,268			7,412		7,670
		Nontaxable			2,369			2,266		1,930
	Federal funds sold				382			520		1,132

			Total interest income		63,381			64,561		63,718

Interest expense:
	Deposits				16,926			22,294		26,634
	Securities sold under agreements to repurchase				389			375		617
	FHLB borrowings				9,090			8,472		7,184

			Total interest expense		26,405			31,141		34,435

			Net interest income		36,976			33,420		29,283
Provision for loan losses (Note 3)					424			2,449		924

			Net interest income after provision for loan losses		36,552			30,971		28,359

Other income:
	Net gain on sale of loans				4,278			1,991		1,165
	Trust fees				2,444			2,352		2,399
	Deposit account charges and fees				3,624			3,297		3,108
	Credit card processing fee income				698			191		232
	Other fees and charges				2,489			2,399		2,353
	Net losses on sale of investment securities				(177	)		—		—

					13,356			10,230		9,257

Other expenses:
	Salaries and employee benefits				15,879			13,667		11,863
	Occupancy				1,899			1,817		1,826
	Furniture and equipment				3,008			2,892		2,807
	Office supplies and postage				1,245			1,167		1,198
	Advertising and business development				1,769			1,390		1,273
	Credit card processing expense				957			398		384
	Other				3,884			3,284		3,508

					28,641			24,615		22,859

			Income before income taxes		21,267			16,586		14,757
Federal and state income taxes (Note 9)					6,998			5,122		4,613

			Net income	$	14,269		$	11,464	$	10,144


Earnings per share:
	Basic			$	9.44		$	7.65	$	6.78
	Diluted				9.42			7.58		6.72

See Notes to Consolidated Financial Statements.

Page 48 of 92

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)

			2003			2002		2001


Net income			$	14,269		$	11,464	$	10,144

Other comprehensive income (loss),
	Unrealized gains on securities:
		Unrealized holding gains (losses) arising during the year, net of income taxes 2003 $(960); 2002 $998; 2001 $1,366		(1,746	)		1,700		2,323

		Less: reclassification adjustment for losses included in net income, net of income taxes		112			—		—


Other comprehensive income (loss)				(1,634	)		1,700		2,323


Comprehensive income			$	12,635		$	13,164	$	12,467

See Notes to Consolidated Financial Statements.

Page 49 of 92

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands, Except Share Amounts)

		Capital Stock			Retained Earnings			Accumulated Other Comprehensive Income (Loss)				Maximum Cash Obligation Related To ESOP Shares				Total


Balance, December 31, 2000		$	10,197		$	69,179			$	698			$	(11,550	)	$	68,524
	Issuance of 3,233 shares of common stock		165			—				—				—			165
	Redemption of 158 shares of common stock		(8	)		—				—				—			(8	)
	Change related to ESOP shares		—			—				—				(644	)		(644	)
	Net income		—			10,144				—				—			10,144
	Income tax benefit related to stock based compensation		43			—				—				—			43
	Cash dividends ($1.60 per share)		—			(2,392	)			—				—			(2,392	)
	Other comprehensive income		—			—				2,323				—			2,323

Balance, December 31, 2001			10,397			76,931				3,021				(12,194	)		78,155
	Issuance of 2,891 shares of common stock		127			—				—				—			127
	Redemption of 395 shares of common stock		(30	)		—				—				—			(30	)
	Change related to ESOP shares		—			—				—				(757	)		(757	)
	Net income		—			11,464				—				—			11,464
	Income tax benefit related to stock based compensation		47			—				—				—			47
	Cash dividends ($1.75 per share)		—			(2,622	)			—				—			(2,622	)
	Other comprehensive income		—			—				1,700				—			1,700

Balance, December 31, 2002			10,541			85,773				4,721				(12,951	)		88,084

	Issuance of 15,624 shares of common stock		465			—				—				—			465
	Change related to ESOP shares		—			—				—				(1,913	)		(1,913	)
	Net income		—			14,269				—				—			14,269
	Income tax benefit related to stock based compensation		347			—				—				—			347
	Cash dividends ($1.90 per share)		—			(2,853	)			—				—			(2,853	)
	Other comprehensive income		—			—				(1,634	)			—			(1,634	)

Balance, December 31, 2003			11,353			97,189				3,087				(14,864	)		96,765

See Notes to Consolidated Financial Statements.

Page 50 of 92

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)

						2003			2002			2001

Cash Flows from Operating Activities
	Net income					$	14,269		$	11,464		$	10,144
	Adjustments to reconcile net income to net cash provided by operating activities:
		Depreciation					2,242			2,316			2,212
		Amortization					—			—			301
		Provision for loan losses					424			2,449			924
		Net losses on sale of investment securities					177			—			—
		Compensation paid by issuance of common stock					90			75			121
		Deferred income taxes					520			(1,096	)		47
		(Increase) decrease in accrued interest receivable					(25	)		(21	)		266
		Amortization of bond discount					976			431			171
		(Increase) decrease in other assets					8			(741	)		(359	)
		Increase (decrease) in accrued interest and other liabilities					(1,460	)		1,095			(49	)
		Loans originated for sale					(316,637	)		(176,195	)		(90,207	)
		Proceeds on sales of loans					325,839			176,877			87,063
		Net gain on sales of loans					(4,278	)		(1,991	)		(1,165	)

					Net cash provided by operating activities		22,145			14,663			9,469


Cash Flows from Investing Activities
	Proceeds from maturities of investment securities:
		Available for sale					73,529			59,140			47,282
		Held to maturity					3,639			3,819			3,668
	Proceeds from sales of available for sale securities						11,658			—			—
	Purchases of investment securities:
		Available for sale					(110,949	)		(84,943	)		(76,327	)
		Held to maturity					(3,570	)		—			—
	Federal funds sold, net						19,281			(3,086	)		(1,363	)
	Loans made to customers, net of collections						(94,645	)		(99,305	)		(52,434	)
	Purchases of property and equipment						(2,952	)		(2,819	)		(6,710	)

				Net cash used in investing activities			(104,009	)		(127,194	)		(85,884	)


Cash Flows from Financing Activities
	Net increase in deposits						66,446			82,303			67,312
	Net increase (decrease) in federal funds purchased and securities sold under agreements to repurchase						9,128			(1,611	)		5,848
	Borrowings from FHLB						—			30,000			17,000
	Payments on FHLB borrowings						(32	)		(31	)		(31	)
	Stock options exercised						375			52			44
	Income tax benefits related to stock based compensation						347			47			43
	Redemption of common stock						—			(30	)		(8	)
	Dividends paid						(2,853	)		(2,622	)		(2,392	)

			Net cash provided by financing activities				73,411			108,108			87,816

(Continued)

Page 51 of 92

HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)

				2003			2002			2001


Increase (decrease) in cash and due from banks				$	(8,453	)	$	(4,423	)	$	11,401

Cash and due from banks:
	Beginning				32,647			37,070			25,669

	Ending			$	24,194		$	32,647		$	37,070


Supplemental Disclosures
	Cash payments for:
		Interest paid to depositors		$	17,325		$	22,843		$	26,884
		Interest paid on other obligations			9,479			8,847			8,504
		Income taxes			7,817			5,245			4,974

Noncash financing activities:
		Increase in maximum cash obligation related to
			ESOP shares	$	1,913		$	757		$	644

See Notes to Consolidated Financial Statements.

Page 52 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of Activities and Significant Accounting Policies

Nature of activities: Hills Bancorporation (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 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, Cedar Rapids and Marion, Iowa.

The Bank competes with other financial institutions and nonfinancial institutions providing similar financial products. Although the loan activity of the Bank is diversified with commercial and agricultural loans, real estate loans, automobile, installment and other consumer loans, the Bank’s credit is concentrated in real estate loans.

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

Certain significant estimates: The allowance for loan losses, fair values of securities and other financial instruments, and stock-based compensation expense involves certain significant estimates made by management. These estimates are reviewed by management routinely and it is reasonably possible that circumstances that exist at December 31, 2003 may change in the near-term future and that the effect could be material to the consolidated financial statements.

Principles of consolidation: The consolidated financial statements include the accounts of the Company and its subsidiary. All significant intercompany balances and transactions have been eliminated in consolidation.

Revenue recognition: Interest income on loans and investment securities is recognized on the accrual method. Loan origination fees are recognized when the loans are sold. Trust fees, deposit account service charges and other fees are recognized when the services are provided or when customers use the services.

Investment securities: Held-to-maturity securities consist solely of debt securities, which the Company has the positive intent and ability to hold to maturity and are stated at amortized cost.

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 securities as of December 31, 2003 and 2002.

Stock of the Federal Home Loan Bank is carried at cost.

Premiums and discounts on debt securities are amortized over the contractual lives of those securities. The method of amortization results in a constant effective yield on those securities (the interest method). Realized gains and losses on investment securities are included in income, determined on the basis of the cost of the specific securities sold.

Page 53 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of Activities and Significant Accounting Policies (Continued)

Loans: Loans are stated at the amount of unpaid principal, reduced by the allowance for loan losses. Interest income is accrued on the unpaid balances as earned.

Loans held for sale are stated at the lower of aggregate cost or estimated fair value. Loans are sold on a non-recourse basis with servicing released and gains and losses are recognized based on the difference between sales proceeds and the carrying value of the loan.

The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance when management believes the collectability of principal is unlikely. The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. The allowance is increased by provisions charged to expense and is reduced by net charge-offs. The Bank makes continuous reviews of the loan portfolio and considers current economic conditions, historical loss experience, review of specific problem loans and other factors in determining the adequacy of the allowance.

Loans are considered impaired when, based on current information and events, it is probable the Bank will not be able to collect all amounts due. The portion of the allowance for loan losses applicable to impaired loans has been computed based on the present value of the estimated future cash flows of interest and principal discounted at the loans effective interest rate or on the fair value of the collateral for collateral dependent loans. The entire change in present value of expected cash flows of impaired loans or of collateral value is reported as bad debt expense in the same manner in which impairment initially was recognized or as a reduction in the amount of bad debt expense that otherwise would be reported. Interest income on impaired loans is recognized on the cash basis.

The accrual of interest income on loans is discontinued when, in the opinion of management, there is reasonable doubt as to the borrower’s ability to meet payments of interest or principal when they become due.

Loan fees and origination costs are reflected in the consolidated statements of income as collected or incurred. Compared to the net deferral method, this practice had no significant effect on income.

Transfers of financial assets: Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.

Credit related financial instruments: In the ordinary course of business, the Company has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded when they are funded.

Property and equipment: Property and equipment is stated at cost less accumulated depreciation. Depreciation is computed using primarily declining-balance methods over the estimated useful lives of 7-40 years for buildings and improvements and 3-10 years for furniture and equipment.

Page 54 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of Activities and Significant Accounting Policies (Continued)

Deferred income taxes: Deferred income taxes are provided under the liability method whereby deferred tax assets are recognized for deductible temporary differences and net operating loss, and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

Goodwill: Goodwill represents the excess of cost over the fair value of the net assets acquired, and FASB Statement No. 142 provides for the elimination of the amortization of goodwill and other intangibles that are determined to have an indefinite life, and requires, at a minimum, annual impairment tests for intangibles that are determined to have an indefinite life. Effective January 1, 2002, the Company discontinued the amortization of goodwill, but makes an annual assessment for possible impairment. The change in this accounting policy reduced goodwill amortization by $261,000 for the years ended December 31, 2003 and 2002 compared to the year ended December 31, 2001. The carrying amount of goodwill as of December 31, 2003 and 2002 totaled $2,500,000 net of accumulated amortization of $1,398,000 and is included in other assets.

The table below reconciles reported earnings for the year ended December 31, 2001 to “adjusted” earnings, which excludes goodwill amortization.

	(Amount in thousands, except per share amounts)

	Reported Earnings			Goodwill Amortization			Adjusted Earnings


Income before income tax expense		$	14,757		$	261		$	15,018
Income tax expense			4,613			63			4,676

Net income		$	10,144		$	198		$	10,342

Basic earnings per share		$	6.78		$	0.13		$	6.91

Diluted earnings per share		$	6.72		$	0.13		$	6.85

Stock awards and options: Compensation expense for stock issued through the stock award plan is accounted for using the intrinsic value based method of accounting prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Under this method, compensation is measured as the difference between the estimated fair value of the stock at the date of award less the amount required to be paid for the stock. The difference, if any, is amortized straight line to expense over the vesting period of five years of service. No stock-based employee compensation cost is reflected in net income because all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Therefore, the options have no intrinsic value at the date of grant. See Note 8 for a tabular presentation of the reconciliation between net income, basic earnings per share and diluted earnings per share as reported in the financial statements and as the information would have been reported (pro forma) if the Company has chosen to implement the fair value based method for all options.

Common stock held by ESOP: The Company’s maximum cash obligation related to these shares is classified outside stockholders’ equity because the shares are not readily traded and could be put to the Company for cash.

Page 55 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of Activities and Significant Accounting Policies (Continued)

Trust assets: Trust assets, other than cash deposits, held by the Bank in fiduciary or agency capacities for its customers are not included in these statements since they are not assets of the Company.

Earnings per share: Basic per-share amounts are computed by dividing net income (the numerator) by the weighted-average number of common shares outstanding (the denominator). Diluted per share amounts assume the conversion, exercise or issuance of all potential common stock equivalents unless the effect is to reduce the loss or increase the income per common share from continuing operations.

Following is a reconciliation of the denominator:

	Year Ended December 31,

	2003		2002		2001


Weighted average number of shares		1,511,317		1,499,269		1,497,064
Potential number of dilutive shares		3,709		12,106		12,432

Total shares to compute diluted earnings per share		1,515,026		1,511,375		1,509,496

There are no potentially dilutive securities that have not been included in the determination of diluted shares.

Statement of cash flows: For purposes of reporting cash flows, cash and due from banks includes cash on hand and amounts due from banks (including cash items in process of clearing). Cash flows from loans originated by the Bank, deposits and federal funds sold and securities sold under agreements to repurchase are reported net.

Fair value of financial instruments: In cases where quoted market prices are not available, fair values of financial instruments are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Certain financial instruments and all nonfinancial instruments are excluded from fair value disclosure. Accordingly, the aggregate fair value amounts presented in Note 11 do not represent the underlying value of the Company.

The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:

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 believed to be significant. Unfunded loan commitments are not valued since the loans are generally priced at market at the time of funding.

Cash and due from banks and federal funds sold: The carrying amounts reported in the consolidated balance sheets for cash and short-term instruments approximate their fair values.

Page 56 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of Activities and Significant Accounting Policies (Continued)

Investment securities: Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.

Loans receivable: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans are determined using estimated future cash flows, discounted at the interest rates currently being offered for loans with similar terms to borrowers with similar credit quality.

Accrued interest receivable: The fair value of accrued interest receivable equals the amount receivable due to the current nature of the amounts receivable.

Deposit liabilities: The fair values of demand deposits equal their carrying amounts, which represent the amount payable on demand. The carrying amounts for variable-rate, fixed-term money market accounts and certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Short-term borrowings: The carrying amounts of federal funds sold and securities sold under agreements to repurchase approximate their fair values.

Long-term borrowings: The fair values of the Bank’s long-term borrowings (other than deposits) are estimated using discounted cash flow analyses, based on the Bank’s current incremental borrowing rates for similar types of borrowing arrangements.

Accrued interest payable: The carrying amount of accrued interest payable approximates its fair value.

Page 57 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 2. Investment Securities

Investment Securities Available For Sale:

Investment securities have been classified in the consolidated balance sheets according to management’s intent. The Company had no securities designated as trading in its portfolio at December 31, 2003 or 2002. The carrying amount of available-for-sale securities and their approximate fair values were as follows December 31 (in thousands):

The amortized cost and fair value of investment securities available for sale are as follows:

				Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Estimated Fair Value


December 31, 2003:
	U. S. Treasury			$	6,020	$	118	$	—		$	6,138
	U. S. Government agencies and corporations				150,155		2,635		(80	)		152,710
	State and political subdivisions				58,355		2,287		(60	)		60,582

			Total	$	214,530	$	5,040	$	(140	)	$	219,430


December 31, 2002:
	U. S. Treasury			$	6,035	$	330		—		$	6,365
	U. S. Government agencies and corporations				129,916		5,020		—			134,936
	State and political subdivisions				54,362		2,159		(15	)		56,506

		Total		$	190,313	$	7,509	$	(15	)	$	197,807

The amortized cost and estimated fair market value of available-for-sale securities classified according to their contractual maturities at December 31, 2003, were as follows (in thousands):

	Amortized Cost		Fair Value


Due in one year or less	$	37,212	$	37,909
Due after one year through five years		157,806		161,510
Due after five years through ten years		19,079		19,566
Due over ten years		433		445

Total	$	214,530	$	219,430

As of December 31, 2003, investment securities with a carrying value of $41,932,000 were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as required or permitted by law.

Page 58 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 2. Investment Securities (Continued)

Sales proceeds and gross realized gains and losses on available-for-sale securities were as follows for the years ended December 31 (in thousands):

	*2003*			*2002*		*2001*

Sales proceeds	$	11,658		$	—	$	—
Gross realized gains		—			—		—
Gross realized losses		(177	)		—		—

The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2003 (in thousands):

	Less than 12 months										12 months or more											Total

	#		Fair Value		Unrealized Loss			%			#		Fair Value			Unrealized Loss			%			#		Fair Value		Unrealized Loss				%

*Description*
*of Securities*

U.S. Government agencies and corporations		5	$	13,018	$	(80	)		0.61	%		0		$	—		$	—		0.00	%		5	$	13,018		$	(80	)		0.61	%

State and municipal bonds		31		6,093		(60	)		0.98			0			—			—		0.00			31		6,093			(60	)		0.98


Total temporarily impaired securities		36	$	19,111	$	(140	)		0.73	%		0		$	—		$	—		0.00	%		36	$	19,111		$	(140	)		0.73	%

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. The nature of the investments with gross unrealized losses as of December 31, 2003 was as follows: U.S. government agency backed securities; (5 positions issued and guaranteed by FNMA, FHLB, or FHLMC); and state and municipal bonds (26 A1 or better rated, general obligation bonds). Therefore, none of the impairments in the above table was due to the deterioration in the credit quality of any of the issues that might result in the non-collection of contractual principal and interest. The cause of the impairments is due to changes in interest rates.

Investment Securities Held to Maturity:

	Amortized Cost			Gross Unrealized Gains			Gross Unrealized (Losses)				Estimated Fair Value

	(Amounts in Thousands)
December 31, 2003:
State and political subdivisions		$	7,953		$	127		$	(16	)		$	8,064


December 31, 2002:
State and political subdivisions		$	8,022		$	281		$	—			$	8,303

Page 59 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 2. Investment Securities (Continued)

The amortization cost and estimated fair market value of securities held to maturity classified according to their contractual maturities at December 31, 2003, were as follows (in thousands):

		Amortized Cost		Fair Value

Due in one year or less		$	6,646	$	6,688
Due after one year through five years			1,207		1,263
Due after five years through ten years			100		113

	Total	$	7,953	$	8,064

	Less than 12 months										12 months or more											Total

*Description of Securities*	#		Fair Value		Unrealized Loss			%			#		Fair Value			Unrealized Loss			%			#		Fair Value		Unrealized Loss				%



State and municipal bonds		1	$	3,554	$	(16	)		0.45	%		0		$	—		$	—		0.00	%		1	$	3,554		$	(16	)		0.45	%

Total temporarily impaired securities		1	$	3,554	$	(16	)		0.45	%		0		$	—		$	—		0.00	%		1	$	3,554		$	(16	)		0.45	%

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. The nature of the investment with a gross unrealized loss as of December 31, 2003 was a local county capital note due June 1, 2004. The impairment in the above table was not due to the deterioration in the credit quality of the issue that might result in the non-collection of contractual principal and interest. The cause of the impairment is due to changes in interest rates.

Note 3. Loans

The composition of loans is as follows:

		December 31,

		2003		2002

		(Amounts In Thousands)

Agricultural		$	38,153	$	37,937
Commercial and financial			47,938		46,828
Real estate:
	Construction		66,644		47,201
	Mortgage		696,453		621,226
Loans to individuals			31,591		32,906

			880,779		786,098
Less allowance for loan losses			12,585		12,125

		$	868,194	$	773,973

Page 60 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 3. Loans (continued)

Changes in the allowance for loan losses are as follows:

		Year Ended December 31,

		2003			2002			2001

		(Amounts In Thousands)

Balance, beginning		$	12,125		$	9,950		$	10,428
	Provision charged to expenses		424			2,449			924
	Recoveries		1,680			1,514			1,139
	Loans charged off		(1,644	)		(1,788	)		(2,541	)

Balance, ending		$	12,585		$	12,125		$	9,950

Information about impaired and nonaccrual loans as of and for the years ended December 31, 2003, 2002 and 2001 are as follows:

		2003		2002			2001

		(Amounts In Thousands)

Loans receivable for which there is a related allowance for loan losses		$	3,793		$	4,588	$	4,417
Loans receivable for which there is no related allowance for loan losses			14,384			11,673		6,871

	Total impaired loans	$	18,177		$	16,261	$	11,288


Related allowance for credit losses on impaired loans		$	802		$	547	$	897
Average balance of impaired loans			17,883			12,739		11,200
Nonaccrual loans (included as impaired loans)			3,944			1,538		1,001
Loans past due ninety days or more and still accruing			2,296			2,516		2,921
Interest income recognized on impaired loans			1,202			962		962

Note 4. Property and Equipment

The major classes of property and equipment and the total accumulated depreciation are as follows:

		December 31,

		2003		2002

		(Amounts In Thousands)

Land		$	3,715	$	3,715
Buildings and improvements			17,743		17,041
Furniture and equipment			20,706		18,456

			42,164		39,212
Less accumulated depreciation			19,954		17,712

	Net	$	22,210	$	21,500

Page 61 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 5. Interest-Bearing Deposits

A summary of these deposits is as follows:

	December 31,

	2003		2002

	(Amounts In Thousands)

NOW and other demand	$	135,254	$	98,415
Savings		223,763		201,890
Time, $100,000 and over		61,966		60,536
Other time		331,578		333,647

	$	752,561	$	694,488

Time deposits have a maturity as follows:

	December 31,

	2003		2002

	(Amounts in thousands)
Due in one year or less	$	221,257	$	174,595
Due after one year through two years		56,699		132,282
Due after two years through three years		47,309		17,726
Due after three years through four years		47,851		36,336
Due over four years		20,428		33,244

	$	393,544	$	394,183

Note 6. Short-Term Borrowings

The following table sets forth selected information for short-term borrowings securities sold under agreements to repurchase with an original maturity of less than one year as of December 31 (in thousands):

	2003		2002

Repurchase agreements with customers, renewable daily, interest payable monthly, secured by U.S. Government agencies (1)	$	29,926	$	20,798

(1)

The weighted average interest rate on short-term borrowings outstanding as of December 31, 2003 and 2002 was 1.00% and 1.52%, respectively.

Customer repurchase agreements are used by the Bank to acquire funds from customers where the customer is required or desires to have their funds supported by collateral consisting of government, government agency or other types of securities. The repurchase agreement is a promise to sell these securities to a customer at a certain price and repurchase them at a future date at that same price plus interest accrued at an agreed upon rate. The Bank uses customer repurchase agreements in its liquidity plan as well as an accommodation to customers. At December 31, 2003, $29.9 million of securities sold under repurchase agreements with an interest rate of 1.00%, maturing in 2004, were collateralized by U.S. Government agencies having an estimated fair value of $30.6 million and a amortized cost of $29.7 million.

Page 62 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 7. Federal Home Loan Bank Borrowings

As of December 31, 2003 and 2002, the borrowings were as follows:

	2003		2002

(Effective interest rates as of December 31, 2003)	(Amounts In Thousands)

Due 2005, 3.80%	$	4,350	$	4,350
Due 2006, 4.08%		22,750		22,750
Due 2007, 4.48%		20,000		20,000
Due 2008, 5.22% to 6.00%		40,474		40,506
Due 2009, 5.66% to 6.22%		40,000		40,000
Due 2010, 5.77% to 6.61%		40,000		40,000

	$	167,574	$	167,606

$120,000,000 of the borrowings is callable at various dates now through 2005.

The borrowings are collateralized by 1-4 family mortgage loans with an aggregate face amount of $201,089,000. As of December 31, 2003, the Company held Federal Home Loan Bank stock with a cost of $8,774,000.

Note 8. Employee Benefit Plans

The Company has an Employee Stock Ownership Plan (the “ESOP”) to which it makes discretionary cash contributions. The Company’s contribution to the ESOP totaled $108,000, $93,000 and $79,000 for the years ended December 31, 2003, 2002 and 2000, respectively.

In the event a terminated plan participant desires to sell his or her shares of the Company stock, or for certain employees who elect to diversify their account balances, the Company may be required to purchase the shares from the participant at their fair value. To the extent that shares of common stock held by the ESOP are not readily traded, a sponsor must reflect the maximum cash obligation related to those securities outside of stockholders’ equity to liabilities. As of December 31, 2003 and 2002, the shares held by the ESOP, fair value and maximum cash obligation were as follows:

	2003		2002


Shares held by the ESOP		147,172		147,172

Fair value per share	$	101.00	$	88.00

Maximum cash obligation	$	14,864,000	$	12,951,000

Page 63 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 8. Employee Benefit Plans (Continued)

The Company has a profit-sharing plan with a 401(k) feature, which provides for discretionary annual contributions in amounts to be determined by the Board of Directors. The profit-sharing contribution totaled $862,000, $741,000 and $636,000 for the years ended December 31, 2003, 2002 and 2001, respectively.

The Company has a Stock Option and Incentive Plan for certain key employees and directors whereby shares of common stock have been reserved for awards in the form of stock options or restricted stock awards. Under the plan, the aggregate number of options and shares granted cannot exceed 66,000 shares. A Stock Option Committee may grant options at prices equal to the fair value of the stock at the date of the grant. Options expire 10 years from the date of the grant. Directors may exercise options immediately and officers’ rights under the plan vest over a five-year period from the date of the grant. No compensation expense has been charged to expense using the intrinsic value based method as prescribed by APB No. 25.

The following table illustrates the effect on net income and earnings per share had compensation cost for all of the stock-based compensation plans been determined based on the grant date values of awards (the method described in FASB Statement No. 123, Accounting for Stock-Based Compensation):

		Years Ended December 31,

		2003			2002			2001


Net income:
	As reported	$	14,269		$	11,464		$	10,144

	Deduct total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(25	)		(18	)		(13	)


	Pro forma	$	14,244		$	11,446		$	10,131


Basic earnings per share:
	As reported	$	9.44		$	7.65		$	6.79
	Pro forma	$	9.42		$	7.64		$	6.77

Diluted earnings per share:
	As reported	$	9.42		$	7.58		$	6.72
	Pro forma	$	9.40		$	7.57		$	6.71

Page 64 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 8. Employee Benefit Plans (Continued)

A summary of the stock options is as follows:

	Number Of Shares			Weighted Average Exercise Price

Balance, December 31, 2000		20,462			$	27.15
Granted		10,400				77.00
Exercised		(1,683	)			26.17

Balance, December 31, 2001		29,179			$	44.98
Granted		636				73.81
Exercised		(2,000	)			26.17

Balance, December 31, 2002		27,815			$	46.99
Granted		6,200				90.10
Exercised		(14,724	)			25.47

Balance, December 31, 2003		19,291			$	77.27

The weighted average fair value of options granted in 2003 and 2002 and 2001 was $16.20 per share, $20.13 per share, and $15.00 per share, respectively.

The fair value of stock options granted was determined utilizing the Black Scholes Valuation model. Significant assumptions include:

	2003			2002			2001


Risk-free interest rate		4.57	%		4.84	%		4.40	%
Expected option life		10 years			10 years			10 years
Expected volatility		6.69	%		2.00	%		10.77	%
Expected dividends		2.16	%		2.13	%		2.20	%

Other pertinent information related to the options outstanding at December 31, 2003 is as follows:

Exercise Price			Number Outstanding		Remaining Contractual Life	Number Exercisable


	$	41.00		2,055	39 Months		2,055
		77.00		10,400	89 Months		—
		73.00		378	92 Months		—
		75.00		258	96 Months		—
		88.00		5,200	108 Months		—
		101.00		1,000	120 Months		—

				19,291			2,055

As of December 31, 2003, 45,976 shares were available for stock options and awards. The committee is also authorized to grant awards of restricted common stock, and it authorized the issuance of 900, 891 and 1,550 shares of common stock to a group of employees in 2003, 2002 and 2001, respectively. The vesting period for these awards is five years and the Bank amortizes the expense on a straight line basis during the vesting period. The expense relating to these awards for the years ended December 31, 2003, 2002 and 2001 was $61,000, $50,000 and $44,000, respectively.

Page 65 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 9. Income Taxes

Income taxes for the years ended December 31, 2003, 2002 and 2001 are summarized as follows:

		2003		2002			2001

		(Amounts In Thousands)

Current:
	Federal	$	5,465	$	5,258		$	3,819
	State		1,013		960			747
Deferred:
	Federal		453		(949	)		41
	State		67		(147	)		6

		$	6,998	$	5,122		$	4,613

Deferred income tax liabilities and assets arose from the following temporary differences:

			December 31,

			2003		2002

			(Amounts In Thousands)
Deferred income tax assets:
	Allowance for loan losses		$	4,694	$	4,515
	Deferred compensation			761		624
	Certain accrued expenses			224		301
	Other			56		150

		Gross deferred tax assets		5,735		5,590

Deferred income tax liabilities:
	Property and equipment			1,146		716
	FHLB dividends			130		130
	Unrealized gains on investment securities			1,813		2,773
	Other			235		—

		Gross deferred tax liabilities		3,324		3,619

		Net deferred income tax asset	$	2,411	$	1,971

Page 66 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 9. Income Taxes (Continued)

The net change in the deferred income taxes for the years ended December 31, 2003, 2002 and 2001 is reflected in the financial statements as follows:

	Year Ended December 31,

	2003			2002			2001

	(Amounts In Thousands)

Consolidated statements of income	$	520		$	(1,096	)	$	47
Consolidated statements of stockholders’ equity		(960	)		998			1,366

	$	(440	)	$	(98	)	$	1,413

The income tax provisions for the years ended December 31, 2003, 2002 and 2001 are less than the amounts computed by applying the maximum effective federal income tax rate to the income before income taxes because of the following items:

	2003						2002						2001

	Amount			% Of Pretax Income			Amount			% Of Pretax Income			Amount			% Of Pretax Income

	(Amounts In Thousands)

Expected provision	$	7,443			35.0	%	$	5,805			35.0	%	$	5,165			35.0	%
Tax-exempt interest		(875	)		(4.1	)		(875	)		(5.3	)		(745	)		(5.0	)
Interest expense limitation		110			0.5			128			0.8			143			1.0
State income taxes, net of federal income tax benefit		702			3.3			547			3.3			493			3.3
Income tax credits		(234	)		(1.1	)		(345	)		(2.1	)		(345	)		(2.3	)
Other		(148	)		(0.7	)		(138	)		(0.8	)		(98	)		(0.7	)

	$	6,998			32.9	%	$	5,122			30.9	%	$	4,613			31.3	%

Page 67 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 10.

Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and Cash Restrictions

The Company and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial results. Under capital adequacy guidelines and the regulatory frameworks for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classifications of the Company and the Bank are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by the regulations to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the tables that follow) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes that, as of December 31, 2003 and 2002, the Company and the Bank met all capital adequacy requirements to which they are subject.

As of December 31, 2003, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table that follows. There are no conditions or events since that notification that management believes have changes the institution’s category.

The actual amounts and capital ratios as of December 31, 2003 and 2002, with the minimum regulatory requirements for the Company and Bank are presented below (amounts in thousands):

			Actual					For Capital Adequacy Purposes			To Be Well Capitalized Under Prompt Corrective Action Provisions

			Amount		Ratio			Ratio			Ratio

As of December 31, 2003:
	Company:
		Total risk based capital	$	116,035		14.56	%		8.00	%		10.00	%
		Tier 1 risk based capital		106,042		13.31			4.00			6.00
		Leverage ratio		106,042		8.87			3.00			5.00
	Bank:
		Total risk based capital		112,641		14.15			8.00			10.00
		Tier 1 risk based capital		102,661		12.90			4.00			6.00
		Leverage ratio		102,661		8.60			3.00			5.00

Page 68 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 10.

Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and Cash Restrictions (continued)

			Actual					For Capital Adequacy Purposes			To Be Well Capitalized Under Prompt Corrective Action Provisions

			Amount		Ratio			Ratio			Ratio

As of December 31, 2002:
	Company:
		Total risk based capital	$	102,921		14.19	%		8.00	%		10.00	%
		Tier 1 risk based capital		93,814		12.93			4.00			6.00
		Leverage ratio		93,814		8.64			3.00			5.00
	Bank:
		Total risk based capital		100,288		13.84			8.00			10.00
		Tier 1 risk based capital		91,189		12.58			4.00			6.00
		Leverage ratio		91,189		8.41			3.00			5.00

The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by the Bank. The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends. To maintain acceptable capital ratios in the Bank, certain of its retained earnings are not available for the payment of dividends. To maintain a ratio of capital to assets of 8%, retained earnings of $10,820,000 as of December 31, 2003 are available for the payment of dividends to the Company.

The Bank is required to maintain reserve balances in cash or with the Federal Reserve Bank. Reserve balances totaled $2,092,000 and $1,405,000 as of December 31, 2003 and 2002, respectively.

Page 69 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 11. Related Party Transactions

Certain directors of the Company and the Bank and companies with which the directors are affiliated and certain principal officers are customers of, and have banking transactions with, the Bank in the ordinary course of business. Such indebtedness has been incurred on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons.

The following is an analysis of the changes in the loans to related parties during the years ended December 31, 2003 and 2002:

	Year Ended December 31,

	2003			2002

	(Amounts In Thousands)

Balance, beginning	$	27,813		$	24,440
Advances		10,570			15,607
Collections		(5,929	)		(12,234	)

Balance, ending	$	32,454		$	27,813

Deposits from related parties are accepted subject to the same interest rates and terms as those from nonrelated parties.

Page 70 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 12. Fair Value of Financial Instruments

The carrying value and estimated fair values of the Company’s financial instruments as of December 31, 2003 and 2002 are as follows:

2003

2002

Carrying
Amount

Estimated
Fair Value

Carrying
Amount

Estimated
Fair Value

(Amounts In Thousands)

Cash and due from banks

24,194

32,647

Federal funds sold

13,233

32,514

Investment securities

236,157

236,268

214,211

214,492

Loans

870,154

923,274

780,857

839,398

Accrued interest receivable

7,303

7,278

Deposits

868,767

867,021

802,321

783,784

Federal funds purchased and securities sold under agreements to repurchase

29,926

20,798

Borrowings from Federal Home Loan Bank

167,574

168,718

167,606

169,085

Accrued interest payable

1,735

2,134

	Face Amount				Face Amount


Off-balance sheet instruments:
Loan commitments	$	139,422	$	—	$	112,260	$	—
Letters of credit		12,063		—		12,650		—

Page 71 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 13. Parent Company Only Financial Information

Following is condensed financial information of the Company (parent company only):

CONDENSED BALANCE SHEETS
December 31, 2003 and 2002
(Amounts In Thousands)

				2003		2002

ASSETS

Cash				$	2,343	$	1,856
Investment securities available for sale					507		514
Investment in subsidiary bank					108,248		98,410
Other assets					950		564

			Total assets	$	112,048	$	101,344


LIABILITIES AND STOCKHOLDERS’ EQUITY

Liabilities				$	419	$	309

Redeemable common stock held by ESOP					14,864		12,951

Stockholders’ equity:
	Capital stock				11,353		10,541
	Retained earnings				97,189		85,773
	Accumulated other comprehensive income				3,087		4,721

					111,629		101,035
	Less maximum cash obligation related to ESOP shares				14,864		12,951

		Total stockholders’ equity			96,765		88,084

		Total liabilities and stockholders’ equity		$	112,048	$	101,344

Page 72 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 13. Parent Company Only Financial Information (Continued)

CONDENSED STATEMENTS OF INCOME
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)

		2003			2002			2001


Interest on investment securities		$	17		$	25		$	32
Dividends received from subsidiary			2,856			2,623			2,392
Other expenses			(112	)		(80	)		(112	)

	Income before income tax benefit and equity in subsidiary’s undistributed income		2,761			2,568			2,312
Income tax benefit			36			23			29

			2,797			2,591			2,341
Equity in subsidiary’s undistributed income			11,472			8,873			7,803

	Net income	$	14,269		$	11,464		$	10,144

Page 73 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 13. Parent Company Only Financial Information (Continued)

CONDENSED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)

				2003			2002			2001

Cash flows from operating activities:
	Net income			$	14,269		$	11,464		$	10,144
	Noncash items included in net income:
		Undistributed income of subsidiary			(11,472	)		(8,873	)		(7,803	)
		(Increase) decrease in other assets			(379	)		8			(43	)
		Increase (decrease) in liabilities			110			73			(13	)

			Net cash provided by operating activities		2,528			2,672			2,285

Cash flows from investing activities:
	Proceeds from maturities of investment securities				—			250			250
	Purchase of investment securities				—			(243	)		(271	)

			Net cash provided (used in) by investing activities		—			7			(21	)

Cash flows from financing activities:
	Common stock issued				465			97			157
	Income tax benefits related to stock based compensation				347			47			43
	Dividends paid				(2,853	)		(2,622	)		(2,392	)

			Net cash (used in) financing activities		(2,041	)		(2,478	)		(2,192	)

			Increase in cash		487			201			72
Cash balance:
	Beginning				1,856			1,655			1,583

	Ending			$	2,343		$	1,856		$	1,655

Page 74 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 14. 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 $21,801,000. The concentrations of credit by type of loan are set forth in Note 3. 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 County, Iowa.

Contingencies: In the normal course of business, the Company and Bank are involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the accompanying financial statements.

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 December 31, 2003 and 2002 is as follows:

		2003		2002

		(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
	Home equity loans	$	8,643	$	6,923
	Credit card participations		17,946		15,057
	Commercial, real estate and home construction		72,860		51,272
	Commercial lines		39,973		39,008
Outstanding letters of credit			12,063		12,650

Page 75 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 14. Commitments and Contingencies (Continued)

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, crops, livestock, inventory, property and equipment, residential real estate and income-producing commercial properties. Credit card participations are the unused portion of the holders’ credit limits. Such amounts represent the maximum amount of additional unsecured borrowings.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements and, generally, have terms of one year, or less. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Bank holds collateral, which may include accounts receivable, inventory, property, equipment, and income-producing properties, supporting those commitments if deemed necessary. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Bank would be required to fund the commitment. The maximum potential amount of future payments the Bank could be required to make is represented by the contractual amount shown in the summary above. If the commitment is funded the Bank would be entitled to seek recovery from the customer. At December 31, 2003 and 2002 no amounts have been recorded as liabilities for the Bank’s potential obligations under these guarantees.

Page 76 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 15. Quarterly Results of Operations (unaudited, amounts in thousands, except per share amounts)

		Quarter Ended

		March		June			September			December		Year

2003:
	Interest income	$	15,814	$	15,926		$	15,855		$	15,786	$	63,381
	Interest expense		6,895		6,715			6,501			6,294		26,405

	Net interest income	$	8,919	$	9,211		$	9,354		$	9,492	$	36,976
	Provision for loan losses		484		(35	)		(326	)		301		424
	Other income		3,169		3,845			3,878			2,464		13,356
	Other expense		6,565		6,927			7,046			8,103		28,641

	Income before income taxes	$	5,039	$	6,164		$	6,512		$	3,552	$	21,267
	Income taxes		1,658		2,037			2,193			1,110		6,998

	Net income	$	3,381	$	4,127		$	4,319		$	2,442	$	14,269


	Basic earnings per share	$	2.25	$	2.73		$	2.85		$	1.61	$	9.44
	Diluted earnings per share		2.24		2.72			2.85			1.61		9.42

2002:
	Interest income	$	15,521	$	15,928		$	16,510		$	16,602	$	64,561
	Interest expense		7,990		7,879			7,948			7,416		31,141

	Net interest income	$	7,531	$	8,049		$	8,562		$	9,186	$	33,420
	Provision for loan losses		236		251			244			1,718		2,449
	Other income		2,397		2,205			2,504			3,124		10,230
	Other expense		5,881		6,179			6,079			6,384		24,615

	Income before income taxes	$	3,811	$	3,824		$	4,743		$	4,208	$	16,586
	Income taxes		1,188		1,151			1,507			1,276		5,122

	Net income	$	2,623	$	2,673		$	3,236		$	2,932	$	11,464


	Basic earnings per share	$	1.75	$	1.78		$	2.15		$	1.97	$	7.65
	Diluted earnings per share		1.74		1.76			2.14			1.94		7.58

Page 77 of 92

PART II

Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure

On May 13, 2003, upon the recommendation and approval of its Audit Committee, the Company terminated its relationship with McGladrey & Pullen LLP (“McGladrey & Pullen”) as its independent auditor and appointed the firm of KPMG LLP (“KPMG”) to be the Company’s Auditor for the 2003 fiscal year. There were no disagreements with KPMG on any matter of accounting principles or practices, financial statement disclosures, or auditing scope or procedure. KPMG has not audited any of the Company’s financial statements for year-ends prior to December 31, 2002 and therefore is unable to express an opinion on any prior years’ financial information.

McGladrey & Pullen’s audit reports on the Company’s consolidated financial statements for each of the fiscal years ended December 31, 2002 and 2001 did not contain an adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.

During the two fiscal years ended December 31, 2002 and 2001 and the subsequent interim preceding the decision to change independent auditors, there were no disagreements with McGladrey & Pullen on any matter of accounting principles or practices, financial statement disclosures, or auditing scope or procedure which, if not resolved to McGladrey & Pullen’s satisfaction would have caused them to make reference to the subject matter of the disagreement in connection with the audit reports on the Company’s consolidated financial statements for such year, and there were no reportable events as defined in Item 304 (a)(1)(v) of Regulation S-K.

In the years ended December 31, 2002 and 2001 and up to May 13, 2003, the date of KPMG’s engagement, the Company did not consult KPMG with respect to the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Company’s consolidated financial statements, or any other matters or reportable events as set forth in Items 304 (a)(2)(i) and (ii) of Regulation S-K.

Item 9A. Controls and Procedures

As of the end of the period covered by this report, 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 operations of the Company’s disclosure controls and procedures, and as defined in Exchange Act Rule 15d-15(e). 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 in enabling the Company’s periodic SEC filings within the required time period. There have been no changes in the Company’s internal controls over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Page 78 of 92

PART III

Item 10. Directors and Executive Officers of the Registrant

The information required by Item 10 of Part III is presented under the items entitled “Certain Information Regarding Directors and Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s Definitive Proxy Statement dated March 22, 2004 for the Annual Meeting of Stockholders on April 19, 2004. Such information is incorporated herein by reference.

No current member of the Audit Committee is a financial expert. The Company hopes to add a financial expert as a member of the Board of Directors and the Audit Committee in the near future.

The Company has a Code of Ethics in place for the Chief Executive Officer and Chief Financial Officer. A copy of the Company’s Code of Ethics will be provided free of charge, upon written request to:

	James G. Pratt
	Treasurer
	Hills Bancorporation
	131 Main Street
	Hills, Iowa 52235

Item 11. Executive Compensation

The information required by Item 11 of the Part III is presented under the item entitled “Executive Compensation and Benefits” in the Company’s Definitive Proxy Statement for the Annual Meeting of Stockholders on April 19, 2004. Such information is incorporated herein by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholders Matters

The information required by Item 12 of Part III is presented under the item entitled “Security Ownership of Principal Stockholders and Management” and “Report on Executive Compensation,” in the Company’s Definitive Proxy Statement for the Annual Meeting of Stockholders on April 19, 2004. Such information is incorporated herein by reference.

Item 13. Certain Relationships and Related Transactions

The information required by Item 13 of Part III is presented under the item entitled “Loans to and Certain Other Transactions with Executive Officers and Directors” in the Company’s Definitive Proxy Statement for the Annual Meeting of Stockholders on April 19, 2004. Such information is incorporated herein by reference.

Item 14. Principal Accountant Fees and Services

Information required by this item is contained in the Registrant’s Proxy Statement dated March 22, 2004, under the heading “Independent Auditors – Change of Auditors in 2003,” which section is incorporated herein by this reference.

Page 79 of 92

PART IV

Item 15. Exhibits, Financial Statements, Schedules and Reports on Form 8-K

				Form 10-K Reference

(a)	1.	Financial Statements

		Independent auditor’s reports on the financial statements		45 - 46
		Consolidated balance sheets as of December 31, 2003 and 2002		47
		Consolidated statements of income for the years ended December 31, 2003, 2002, and 2001		48
		Consolidated statements of comprehensive income for the years ended December 31, 2003, 2002 and 2001		49
		Consolidated statements of stockholders’ equity for the years ended December 31, 2003, 2002 and 2001		50
		Consolidated statements of cash flows for the years ended December 31, 2003,2002 and 2001		51 - 52
		Notes to financial statements		53 - 77

	2.	Financial Statements Schedules

		All schedules are omitted because they are not applicable or not required, or because the required information is included in the consolidated financial statements or notes thereto.

(a)	3.	Exhibits

	3.1	Articles of Incorporation filed as Exhibit 3 of Form 10-K for the year ended December 31, 1993 are incorporated by reference.

	3.2	By-Laws filed as Exhibit 3 of Form 10-K for the year ended December 31, 1993 are incorporated by reference.

	10.1	Material Contract (Employee Stock Ownership Plan) filed as Exhibit 10(a) in Form 10-K for the year ended December 31, 1993 is incorporated by reference.

	10.2	Material Contract (1993 Stock Incentive Plan) filed as Exhibit 10(b) in Form 10-K for the year ended December 31, 1993 is incorporated by reference.

	10.3	Material Contract (1995 Deferred Compensation Plans) filed as Exhibit 10(c) in Form 10-K for the year ended December 31, 1995 is incorporated by reference.

	10.4	Material Contract (2000 Stock Option and Incentive Plan) filed as Exhibit 10(d) in Form 10-K for the year ended December 31, 2001 is incorporated by reference.

	11	Statement regarding Computation of Basic and Diluted Earnings Per Share on Page 83.

	16	Letter Regarding Change in Certifying Accountant on Page 84.

	21	Subsidiary of the Registrant is Attached on Page 85.

	23	Consents of Accountants is Attached on Pages 86 - 87.
			KPMG LLP
			McGladrey & Pullen LLP

	31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 on Pages 88 - 91.

	32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002 on Page 92.

(b)		Reports on Form 8-K:

		The Registrant filed no reports on Form 8-K for the three months ended December 31, 2003.

Page 80 of 92

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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: March 9, 2004	By: /s/ Dwight O. Seegmiller

	Dwight O. Seegmiller, Director and President

Date: March 9, 2004	By: /s/ James G. Pratt

	James G. Pratt, Treasurer and Chief Accounting Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

	DIRECTORS OF THE REGISTRANT

Date: March 9, 2004	By: /s/ Willis M. Bywater

	Willis M. Bywater, Director

Date: March 9, 2004	By: /s/ Thomas J. Gill

	Thomas J. Gill, Director

Date: March 9, 2004	By: /s/ Donald H. Gringer

	Donald H. Gringer, Director

Date: March 9, 2004	By: /s/ Michael E. Hodge

	Michael E. Hodge, Director

Date: March 9, 2004	By: /s/ Richard W. Oberman

	Richard W. Oberman, Director

Date: March 9, 2004	By: /s/ Theodore H. Pacha

	Theodore H. Pacha, Director

Date: March 9, 2004	By: /s/ Ann M. Rhodes

	Ann M. Rhodes, Director

Date: March 9, 2004	By: /s/ Ronald E. Stutsman

	Ronald E. Stutsman, Director

Date: March 9, 2004	By: /s/ Sheldon E. Yoder

	Sheldon E. Yoder, Director

Page 81 of 92

HILLS BANCORPORATION
ANNUAL REPORT OF FORM 10-K FOR THE
FISCAL YEAR ENDED DECEMBER 31, 2003

Exhibit Number	Description		Page Number In The Sequential Numbering System For 2003 Form 10-K


11	Statement Re Computation of Basic and Diluted Earnings Per Share		83 of 92

16	Letter Regarding Change in Certifying Accountant		84 of 92

21	Subsidiary of the Registrant		85 of 92

23	Consent of Independent Certified Public Accountants

		KPMG LLP	86 of 92
		McGladrey & Pullen LLP	87 of 92

31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002		88 - 91 of 92

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002		92 of 92

Page 82 of 92