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EX-32 - EXHIBIT 32 - HILLS BANCORPORATIONexhibit3263016.htm
EX-31 - EXHIBIT 31 - HILLS BANCORPORATIONexhibit3163016.htm

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

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

For the quarterly period ended June 30, 2016

Commission file number:  0-12668
Hills Bancorporation

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

131 MAIN STREET, HILLS, IOWA 52235

Telephone number: (319) 679-2291

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

þ Yes  o No

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

þ Yes  o No

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or smaller reporting company.  See definition of “large accelerated filer,” “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer  o
Accelerated Filer                     þ   
Non-accelerated filer    o
Small Reporting Company     o

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

o Yes  þ No

APPLICABLE ONLY TO CORPORATE ISSUERS:

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



 
SHARES OUTSTANDING
CLASS
July 31, 2016
 
 
Common Stock, no par value
9,278,711
 
 
 
 



HILLS BANCORPORATION
Index to Form 10-Q

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

Page 3




HILLS BANCORPORATION CONSOLIDATED BALANCE SHEETS (Amounts In Thousands, Except Share Amounts) 
 
June 30, 2016
 
December 31, 2015
ASSETS
(Unaudited)
 
Cash and cash equivalents
$
36,614

 
$
35,427

Investment securities available for sale at fair value (amortized cost June 30, 2016 $243,560; December 31, 2015 $261,991)
247,998

 
264,235

Stock of Federal Home Loan Bank
12,623

 
11,834

Loans held for sale
7,239

 
5,554

Loans, net of allowance for loan losses (June 30, 2016 $27,290; December 31, 2015 $26,510)
2,143,465

 
2,099,174

Property and equipment, net
34,769

 
33,522

Tax credit real estate investment
11,131

 
16,314

Accrued interest receivable
9,601

 
8,672

Deferred income taxes, net
12,170

 
11,695

Other real estate
470

 
439

Goodwill
2,500

 
2,500

Other assets
2,833

 
4,241

Total Assets
$
2,521,413

 
$
2,493,607

 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

 
 
 
 
Liabilities
 

 
 

Noninterest-bearing deposits
$
304,155

 
$
314,968

Interest-bearing deposits
1,591,853

 
1,575,734

Total deposits
$
1,896,008

 
$
1,890,702

Other borrowings
45,132

 
44,051

Federal Home Loan Bank borrowings
240,000

 
225,000

Accrued interest payable
844

 
846

Other liabilities
22,041

 
23,271

Total Liabilities
$
2,204,025

 
$
2,183,870

 
 
 
 
Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)
$
38,441

 
$
37,562

 
 
 
 
STOCKHOLDERS' EQUITY
 

 
 

Common stock, no par value; authorized 20,000,000 shares; issued June 30, 2016 10,207,552 shares; December 31, 2015 10,199,643 shares
$

 
$

Paid in capital
44,077

 
43,697

Retained earnings
304,094

 
294,487

Accumulated other comprehensive loss
(1,342
)
 
(1,195
)
Treasury stock at cost (June 30, 2016 926,268 shares; December 31, 2015 877,589 shares)
(29,441
)
 
(27,252
)
Total Stockholders' Equity
$
317,388

 
$
309,737

Less maximum cash obligation related to ESOP shares
38,441

 
37,562

Total Stockholders' Equity Less Maximum Cash Obligations Related to ESOP Shares
$
278,947

 
$
272,175

Total Liabilities & Stockholders' Equity
$
2,521,413

 
$
2,493,607


See Notes to Consolidated Financial Statements.

Page 4


HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(Amounts In Thousands, Except Per Share Amounts)
 
Three Months Ended June 30,
 
Six Months Ended 
 June 30,
 
2016
 
2015
 
2016
 
2015
Interest income:
 
 
 
 
 
 
 
Loans, including fees
$
22,820

 
$
21,900

 
$
45,348

 
$
42,980

Investment securities:
 

 
 

 
 
 
 
Taxable
362

 
300

 
718

 
586

Nontaxable
800

 
817

 
1,628

 
1,660

Federal funds sold
74

 
10

 
118

 
15

Total interest income
$
24,056

 
$
23,027

 
$
47,812

 
$
45,241

Interest expense:
 

 
 

 
 
 
 

Deposits
$
1,904

 
$
2,110

 
$
3,825

 
$
4,274

Short-term borrowings
27

 
42

 
57

 
59

FHLB borrowings
2,157

 
1,507

 
4,289

 
2,961

Total interest expense
$
4,088

 
$
3,659

 
$
8,171

 
$
7,294

Net interest income
$
19,968

 
$
19,368

 
$
39,641

 
$
37,947

Provision for loan losses
(721
)
 
517

 
(172
)
 
455

Net interest income after provision for loan losses
$
20,689

 
$
18,851

 
$
39,813

 
$
37,492

Noninterest income:
 

 
 

 
 
 
 
Net gain on sale of loans
$
546

 
$
440

 
$
835

 
$
748

Trust fees
1,726

 
1,679

 
3,454

 
3,248

Service charges and fees
2,218

 
2,081

 
4,273

 
4,027

Rental revenue on tax credit real estate

 
393

 

 
904

Net gain on sale of other real estate owned and other repossessed assets

 
110

 
34

 
117

Other noninterest income
378

 
803

 
1,145

 
1,452

 
$
4,868

 
$
5,506

 
$
9,741

 
$
10,496

 
 
 
 
 
 
 
 
Noninterest expenses:
 

 
 

 
 
 
 

Salaries and employee benefits
$
7,475

 
$
6,924

 
$
14,459

 
$
13,575

Occupancy
983

 
953

 
1,984

 
1,968

Furniture and equipment
1,357

 
1,309

 
2,761

 
2,607

Office supplies and postage
445

 
413

 
846

 
854

Advertising and business development
840

 
919

 
1,626

 
1,693

Outside services
1,765

 
1,619

 
3,541

 
3,433

Rental expenses on tax credit real estate

 
559

 

 
1,161

FDIC insurance assessment
320

 
284

 
623

 
573

Other noninterest expense
678

 
524

 
1,075

 
839

 
$
13,863

 
$
13,504

 
$
26,915

 
$
26,703

Income before income taxes
$
11,694

 
$
10,853

 
$
22,639

 
$
21,285

Income taxes
3,727

 
3,383

 
6,972

 
6,435

Net income
$
7,967

 
$
7,470

 
$
15,667

 
$
14,850

 
 
 
 
 
 
 
 
Earnings per share:
 

 
 

 
 
 
 
Basic
$
0.86

 
$
0.80

 
$
1.69

 
$
1.59

Diluted
$
0.85

 
$
0.80

 
$
1.68

 
$
1.59

 
See Notes to Consolidated Financial Statements.

Page 5


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

 
Three Months Ended June 30,
 
Six Months Ended 
 June 30,
 
2016
 
2015
 
2016
 
2015
Net income
$
7,967

 
$
7,470

 
$
15,667

 
$
14,850

 
 
 
 
 
 
 
 
Other comprehensive income (loss)
 

 
 

 
 
 
 
Securities:
 

 
 

 
 
 
 
Net change in unrealized gain on securities available for sale
$
1,176

 
$
(1,721
)
 
$
2,194

 
$
(588
)
Reclassification adjustment for net gains realized in net income

 

 

 

Income taxes
(450
)
 
658

 
(840
)
 
225

Other comprehensive income on securities available for sale
$
726

 
$
(1,063
)
 
$
1,354

 
$
(363
)
Derivatives used in cash flow hedging relationships:
 

 
 

 
 
 
 
Net change in unrealized loss on derivatives
$
(678
)
 
$
840

 
$
(2,431
)
 
$
(252
)
Income taxes
260

 
(321
)
 
930

 
97

Other comprehensive loss on cash flow hedges
$
(418
)
 
$
519

 
$
(1,501
)
 
$
(155
)
 
 
 
 
 
 
 
 
Other comprehensive (loss) income, net of tax
$
308

 
$
(544
)
 
$
(147
)
 
$
(518
)
 
 
 
 
 
 
 
 
Comprehensive income
$
8,275

 
$
6,926

 
$
15,520

 
$
14,332

 
See Notes to Consolidated Financial Statements.

Page 6


HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited) (Amounts In Thousands, Except Share Amounts)
 
Paid In Capital
 
Retained Earnings
 
Accumulated Other
Comprehensive
Income (Loss)
 
Unearned ESOP
Shares
 
Treasury Stock
 
Maximum Cash
Obligation Related
To ESOP Shares
 
Total
Balance, December 31, 2014
$
42,925

 
$
271,924

 
$
(448
)
 
$
(504
)
 
$
(23,798
)
 
$
(34,571
)
 
$
255,528

Issuance of 2,844 shares of common stock
119

 

 

 

 

 

 
119

Issuance of 2,048 shares of common stock under the employee stock purchase plan
83

 

 

 

 

 

 
83

Unearned restricted stock compensation
79

 

 

 

 

 

 
79

Forfeiture of 682 shares of common stock
(22
)
 

 

 

 

 

 
(22
)
Share-based compensation
14

 

 

 

 

 

 
14

Income tax benefit related to share-based compensation
3

 

 

 

 

 

 
3

Change related to ESOP shares

 

 

 

 

 
(521
)
 
(521
)
Net income

 
14,850

 

 

 

 

 
14,850

Cash dividends ($0.625 per share)

 
(5,854
)
 

 

 

 

 
(5,854
)
Purchase of 20,031 shares of common stock

 

 

 

 
(839
)
 

 
(839
)
Other comprehensive income

 

 
(518
)
 

 

 

 
(518
)
Balance, June 30, 2015
$
43,201

 
$
280,920

 
$
(966
)
 
$
(504
)
 
$
(24,637
)
 
$
(35,092
)
 
$
262,922

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2015
$
43,697

 
$
294,487

 
$
(1,195
)
 
$

 
$
(27,252
)
 
$
(37,562
)
 
$
272,175

Issuance of 5,660 shares of common stock
256

 

 

 

 

 

 
256

Issuance of 2,249 shares of common stock under the employee stock purchase plan
98

 

 

 

 

 

 
98

Unearned restricted stock compensation
7

 

 

 

 

 

 
7

Share-based compensation
16

 

 

 

 

 

 
16

Income tax benefit related to share-based compensation
3

 

 

 

 

 

 
3

Change related to ESOP shares

 

 

 

 

 
(879
)
 
(879
)
Net income

 
15,667

 

 

 

 

 
15,667

Cash dividends ($0.65 per share)

 
(6,060
)
 

 

 

 

 
(6,060
)
Purchase of 48,679 shares of common stock

 

 

 

 
(2,189
)
 

 
(2,189
)
Other comprehensive loss

 

 
(147
)
 

 

 

 
(147
)
Balance, June 30, 2016
$
44,077

 
$
304,094

 
$
(1,342
)
 
$

 
$
(29,441
)
 
$
(38,441
)
 
$
278,947

 
See Notes to Consolidated Financial Statements.

Page 7


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

 
Six Months Ended 
 June 30,
 
2016
 
2015
Cash Flows from Operating Activities
 
 
 
Net income
$
15,667

 
$
14,850

Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
 

 
 

Depreciation
1,455

 
1,370

Provision for loan losses
(172
)
 
455

Share-based compensation
16

 
14

Forfeiture of common stock

 
(22
)
Compensation expensed through issuance of common stock
354

 
202

Excess tax benefits from share-based compensation
(3
)
 
(3
)
Provision for deferred income taxes
(385
)
 
(1,142
)
Net gain on sale of other real estate owned and other repossessed assets
(34
)
 
(117
)
Increase in accrued interest receivable
(929
)
 
(643
)
Amortization of premium on investment securities, net
297

 
336

Decrease in other assets
442

 
882

(Increase) decrease in accrued interest payable and other liabilities
(1,266
)
 
2,488

Loans originated for sale
(89,295
)
 
(90,671
)
Proceeds on sales of loans
88,445

 
88,697

Net gain on sales of loans
(835
)
 
(748
)
Net cash and cash equivalents provided by operating activities
$
13,757

 
$
15,948

 
 
 
 
Cash Flows from Investing Activities
 

 
 

Proceeds from maturities of investment securities available for sale
$
35,674

 
$
35,652

Purchases of investment securities available for sale
(18,329
)
 
(25,925
)
Loans made to customers, net of collections
(40,794
)
 
(41,072
)
Proceeds on sale of other real estate owned and other repossessed assets
133

 
360

Purchases of property and equipment
(2,702
)
 
(5,665
)
Income from tax credit real estate, net
307

 
440

Net cash and cash equivalents used in investing activities
$
(25,711
)
 
$
(36,210
)
 
 
 
 
Cash Flows from Financing Activities
 

 
 

Net increase (decrease) in deposits
$
5,306

 
$
(15,479
)
Net increase in other borrowings
1,081

 
11,226

Net increase in FHLB borrowings
15,000

 
30,000

Excess tax benefits related to share-based compensation
3

 
3

Purchase of treasury stock
(2,189
)
 
(839
)
Dividends paid
(6,060
)
 
(5,854
)
Net cash and cash equivalents provided by financing activities
$
13,141

 
$
19,057

 
(Continued)


Page 8


HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)
 
Six Months Ended 
 June 30,
 
2016
 
2015
Increase (decrease) in cash and cash equivalents
$
1,187

 
$
(1,205
)
Cash and cash equivalents:
 

 
 

Beginning of period
35,427

 
29,174

End of period
$
36,614

 
$
27,969

 
 
 
 
Supplemental Disclosures
 

 
 

Cash payments for:
 

 
 

Interest paid to depositors
$
3,827

 
$
4,351

Interest paid on other obligations
4,346

 
3,020

Income taxes paid
6,746

 
5,808

 
 
 
 
Noncash activities:
 

 
 

Increase in maximum cash obligation related to ESOP shares
$
879

 
$
521

Transfers to other real estate owned
130

 
36

Sale and financing of other real estate owned
135

 
266

 
See Notes to Consolidated Financial Statements.



Page 9


HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1.
Summary of Significant Accounting Policies

Basis of Presentation:

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

Operating results for the six month period ended June 30, 2016 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2016.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Form 10-K Annual Report of Hills Bancorporation and subsidiary (the “Company”) for the year ended December 31, 2015 filed with the Securities Exchange Commission on March 9, 2016.  The consolidated balance sheet as of December 31, 2015, has been derived from the audited consolidated financial statements for that period.

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

Effect of New Financial Accounting Standards:

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

In February 2015, the FASB issued ASU No. 2015-02 (Topic 810), Consolidation. The ASU modifies the evaluation of whether limited partnerships and similar legal entities are variable interest entities (VIE) or voting interest entities (VOE). The standard relaxes existing criteria for determining when fees paid to a decision maker or service provider do not represent a variable interest by focusing on whether those fees are "at market". The ASU eliminates both the consolidation model specific to limited partnerships and the current presumption that a general partner controls a limited partnership. For public companies, ASU 2015-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. The Company adopted the accounting standard for the period ending March 31, 2016 and have changed the accounting for its tax credit limited partnership investments to the equity method. The impact of the change was determined to not be material.
 
In April 2015, the FASB issued ASU No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30), Simplifying the Presentation of Debt Issuance Costs. ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this update. For public companies, ASU 2015-03 is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted. The Company adopted ASU 2015-03 for the period ending March 31, 2016. There was no material impact on the financial statements.

In April 2015, the FASB issued ASU No. 2015-05, Intangibles – Goodwill and Other Internal-Use Software (Subtopic 350-40), Customer's Accounting for Fees Paid in a Cloud Computing Arrangement.  ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes a software license. If it does, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. ASU 2015-05 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015.  The adoption of ASU 2015-05 by the Company did not have a material impact.

Page 10

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



In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 created Subtopic 321-10, Investments-Equity Securities which is applicable to all entities except those in industries that account for substantially all investments at fair value through earnings or the change in net assets. Under this new subtopic, equity securities are generally required to be measured at fair value with unrealized holding gains and losses reflected in net income. ASU 2016-01 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. The adoption of ASU 2016-01 by the Company is not expected to have a material impact.

In February 2016, the FASB issued ASU No. 2016-02 (Topic 842), Leases. The ASU provides guidance requiring lessees to recognize right-of-use assets and lease liabilities for all leases other than those that meet the definition of short-term leases. For short-term leases, lessees may elect an accounting policy by class of underlying asset under which these assets and liabilities are not recognized and lease payments are generally recognized over the lease term on a straight-line basis. Under this new ASU, lessees will recognize right-of use assets and lease liabilities for most leases currently accounted for as operating leases under generally accepted accounting principles. For public companies, ASU 2016-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The adoption of ASU 2016-02 by the Company is not expected to have a material impact.

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

In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718), Improvements to Employee Share-Based Payment Accounting. The ASU simplifies several aspects of the accounting for share-based payment transaction, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. For public companies, ASU 2016-09 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. The adoption of ASU 2016-09 by the Company is not expected to have a material impact.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments. The ASU changes the way entities recognize impairment of financial assets by requiring immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets. For public companies, ASU 2016-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company is currently reviewing the provisions of this standard to determine the impact on the Company's financial statements.


Page 11

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


Note 2.
Earnings Per Share

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

On March 24, 2015, the Company declared a payment of a 2-for-1 stock split of each issued and unissued share of the Company's common stock outstanding as of April 27, 2015. The additional shares were issued as a result of the stock split and were mailed to the shareholders as of May 4, 2015. All shares and earnings per share numbers have been restated for the stock split.

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

 
Three Months Ended June 30,
 
Six Months Ended 
 June 30,
 
2016
 
2015
 
2016
 
2015
Common shares outstanding at the beginning of the period
9,289,662

 
9,362,061

 
9,322,054

 
9,365,176

Weighted average number of net shares redeemed
(3,339
)
 
(7,153
)
 
(24,752
)
 
(6,075
)
Weighted average shares outstanding (basic)
9,286,323

 
9,354,908

 
9,297,302

 
9,359,101

Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method
6,481

 
5,448

 
6,259

 
5,159

Weighted average number of shares (diluted)
9,292,804

 
9,360,356

 
9,303,561

 
9,364,260

Net income (In thousands)
$
7,967

 
$
7,470

 
$
15,667

 
$
14,850

Earnings per share:
 

 
 

 
 

 
 

Basic
$
0.86

 
$
0.80

 
$
1.69

 
$
1.59

Diluted
$
0.85

 
$
0.80

 
$
1.68

 
$
1.59


Note 3.
Other Comprehensive Income (Loss)

The following table summarizes the balances of each component of accumulated other comprehensive income (AOCI), included in stockholders’ equity, at June 30, 2016 and December 31, 2015:

 
June 30,
2016

December 31, 2015
 
(amounts in thousands)
Net unrealized gain on available-for-sale securities
$
4,438

 
$
2,244

Net unrealized loss on derivatives used for cash flow hedges
(6,611
)
 
(4,180
)
Tax effect
$
831

 
$
741

Net-of-tax amount
$
(1,342
)
 
$
(1,195
)
 





Page 12

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

Note 4.
Securities

The carrying values of investment securities at June 30, 2016 and December 31, 2015 are summarized in the following table (dollars in thousands):

 
June 30, 2016
 
December 31, 2015
 
Amount
 
Percent
 
Amount
 
Percent
Securities available for sale
 
 
 
 
 
 
 
U.S. Treasury
$
25,342

 
10.22
%
 
$
24,978

 
9.45
%
Other securities (FHLB, FHLMC and FNMA)
63,315

 
25.53

 
65,328

 
24.72

State and political subdivisions
159,341

 
64.25

 
173,929

 
65.83

Total securities available for sale
$
247,998

 
100.00
%
 
$
264,235

 
100.00
%

Investment securities have been classified in the consolidated balance sheets according to management’s intent.  Available-for-sale securities consist of debt securities not classified as trading or held to maturity.  Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity.  There were no trading or held to maturity securities as of June 30, 2016 or December 31, 2015. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of June 30, 2016 and December 31, 2015 (in thousands):

 
Amortized Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
(Losses)
 
Estimated Fair
Value
June 30, 2016:
 
 
 
 
 
 
 
U.S. Treasury
$
24,917

 
$
425

 
$

 
$
25,342

Other securities (FHLB, FHLMC and FNMA)
62,748

 
568

 
(1
)
 
63,315

State and political subdivisions
155,895

 
3,469

 
(23
)
 
159,341

Total
$
243,560

 
$
4,462

 
$
(24
)
 
$
247,998

December 31, 2015:
 

 
 

 
 

 
 

U.S. Treasury
$
24,893

 
$
92

 
$
(7
)
 
$
24,978

Other securities (FHLB, FHLMC and FNMA)
65,400

 
81

 
(153
)
 
65,328

State and political subdivisions
171,698

 
2,375

 
(144
)
 
173,929

Total
$
261,991

 
$
2,548

 
$
(304
)
 
$
264,235


The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at June 30, 2016, were as follows (in thousands):
 
 
Amortized
Cost
 
Fair Value
Due in one year or less
$
35,094

 
$
35,245

Due after one year through five years
144,645

 
147,041

Due after five years through ten years
62,485

 
64,374

Due over ten years
1,336

 
1,338

Total
$
243,560

 
$
247,998


As of June 30, 2016 investment securities with a carrying value of $70.16 million were pledged to collateralize repurchase agreements, derivative financial instruments, and other borrowings.


Page 13

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

The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2016 and December 31, 2015 (in thousands):

 
Less than 12 months
 
12 months or more
 
Total
June 30, 2016
Description of Securities
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
U.S. Treasury

 
$

 
$

 
%
 

 
$

 
$

 
%
 

 
$

 
$

 
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other securities (FHLB, FHLMC and FNMA)
1

 
1,802

 
(1
)
 
0.06

 

 

 

 

 
1

 
1,802

 
(1
)
 
0.06

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and political subdivisions
11

 
2,735

 
(6
)
 
0.22

 
15

 
2,558

 
(17
)
 
0.66

 
26

 
5,293

 
(23
)
 
0.43

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total temporarily impaired securities
12

 
$
4,537

 
$
(7
)
 
0.15
%
 
15

 
$
2,558

 
$
(17
)
 
0.66
%
 
27

 
$
7,095

 
$
(24
)
 
0.34
%

 
Less than 12 months
 
12 months or more
 
Total
December 31, 2015
Description of Securities
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
 
#
 
Fair Value
 
Unrealized
Loss
 
%
U.S. Treasury
3

 
$
7,455

 
$
(7
)
 
0.09
%
 

 
$

 
$

 
%
 
3

 
$
7,455

 
$
(7
)
 
0.09
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other securities (FHLB, FHLMC and FNMA)
15

 
36,830

 
(153
)
 
0.42

 

 

 

 

 
15

 
36,830

 
(153
)
 
0.42

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and political subdivisions
56

 
13,557

 
(70
)
 
0.52

 
27

 
5,633

 
(74
)
 
1.31

 
83

 
19,190

 
(144
)
 
0.75

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total temporarily impaired securities
74

 
$
57,842

 
$
(230
)
 
0.40
%
 
27

 
$
5,633

 
$
(74
)
 
1.31
%
 
101

 
$
63,475

 
$
(304
)
 
0.48
%

The Company considered the following information in reaching the conclusion that the impairments disclosed in the table above are temporary and not other-than-temporary impairments.  None of the unrealized losses in the above table was due to the deterioration in the credit quality of any of the issues that might result in the non-collection of contractual principal and interest.  The unrealized losses are due to changes in interest rates.  The Company has not recognized any unrealized loss in income because management does not have the intent to sell the securities included in the previous table.  Management has concluded that it is more likely than not that the Company will not be required to sell these securities prior to recovery of the amortized cost basis.


Page 14

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

Note 5.
Loans

Classes of loans are as follows:

 
June 30,
2016
 
December 31,
2015
 
(Amounts In Thousands)
Agricultural
$
89,129

 
$
101,588

Commercial and financial
170,346

 
184,199

Real estate:
 
 
 
Construction, 1 to 4 family residential
57,720

 
51,346

Construction, land development and commercial
117,738

 
83,121

Mortgage, farmland
191,194

 
187,856

Mortgage, 1 to 4 family first liens
743,450

 
727,160

Mortgage, 1 to 4 family junior liens
119,288

 
117,873

Mortgage, multi-family
285,588

 
271,974

Mortgage, commercial
319,825

 
323,409

Loans to individuals
24,485

 
24,019

Obligations of state and political subdivisions
51,199

 
52,371

 
$
2,169,962

 
$
2,124,916

Net unamortized fees and costs
793

 
768

 
$
2,170,755

 
$
2,125,684

Less allowance for loan losses
27,290

 
26,510

 
$
2,143,465

 
$
2,099,174



Page 15

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

Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the three and six months ended June 30, 2016 were as follows:

 
Three Months Ended June 30, 2016
 
Agricultural
 
Commercial and
Financial
 
Real Estate:
Construction and
land development
 
Real Estate:
Mortgage,
farmland
 
Real Estate:
Mortgage, 1 to 4
family
 
Real Estate:
Mortgage, multi-
family and
commercial
 
Other
 
Total
 
(Amounts In Thousands)
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,954

 
$
4,311

 
$
2,759

 
$
3,944

 
$
8,036

 
$
4,190

 
$
936

 
$
27,130

Charge-offs
(25
)
 
(79
)
 

 

 
(184
)
 

 
(108
)
 
(396
)
Recoveries
30

 
367

 
555

 

 
279

 
8

 
38

 
1,277

Provision
38

 
(588
)
 
(416
)
 
(17
)
 
95

 
3

 
164

 
(721
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
2,997

 
$
4,011

 
$
2,898

 
$
3,927

 
$
8,226

 
$
4,201

 
$
1,030

 
$
27,290



Six Months Ended June 30, 2016
 
Agricultural
 
Commercial and
Financial
 
Real Estate:
Construction and
land development
 
Real Estate:
Mortgage,
farmland
 
Real Estate:
Mortgage, 1 to 4
family
 
Real Estate:
Mortgage, multi-
family and
commercial
 
Other
 
Total
 
(Amounts In Thousands)
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
3,082

 
$
4,517

 
$
2,280

 
$
3,342

 
$
8,172

 
$
4,223

 
$
894

 
$
26,510

Charge-offs
(25
)
 
(134
)
 

 
(10
)
 
(528
)
 
(66
)
 
(277
)
 
(1,040
)
Recoveries
172

 
620

 
607

 

 
492

 
19

 
82

 
1,992

Provision
(232
)
 
(992
)
 
11

 
595

 
90

 
25

 
331

 
(172
)
 


 


 


 


 


 


 


 


Ending balance
$
2,997

 
$
4,011

 
$
2,898

 
$
3,927

 
$
8,226

 
$
4,201

 
$
1,030

 
$
27,290

 

 

 

 

 

 

 

 

Ending balance, individually evaluated for impairment
$
837

 
$
217

 
$
13

 
$
638

 
$
246

 
$
75

 
$
70

 
$
2,096

 

 

 

 

 

 

 

 

Ending balance, collectively evaluated for impairment
$
2,160

 
$
3,794

 
$
2,885

 
$
3,289

 
$
7,980

 
$
4,126

 
$
960

 
$
25,194

 


 


 


 


 


 


 


 


Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
89,129

 
$
170,346

 
$
175,458

 
$
191,194

 
$
862,738

 
$
605,413

 
$
75,684

 
$
2,169,962

 


 


 


 


 


 


 


 


Ending balance, individually evaluated for impairment
$
12,577

 
$
2,303

 
$
698

 
$
8,514

 
$
5,646

 
$
4,043

 
$
70

 
$
33,851

 

 

 

 

 

 

 

 

Ending balance, collectively evaluated for impairment
$
76,552

 
$
168,043

 
$
174,760

 
$
182,680

 
$
857,092

 
$
601,370

 
$
75,614

 
$
2,136,111


Page 16

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

Changes in the allowance for loan losses for the three and six months ended June 30, 2015 were as follows:

 
Three Months Ended June 30, 2015
 
Agricultural
 
Commercial and
Financial
 
Real Estate:
Construction and
land development
 
Real Estate:
Mortgage,
farmland
 
Real Estate:
Mortgage, 1 to 4
family
 
Real Estate:
Mortgage, multi-
family and
commercial
 
Other
 
Total
 
(Amounts In Thousands)
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,544

 
$
4,358

 
$
2,250

 
$
2,777

 
$
7,456

 
$
4,125

 
$
850

 
$
24,360

Charge-offs
(214
)
 
(250
)
 
(63
)
 

 
(321
)
 
(1
)
 
(102
)
 
(951
)
Recoveries
1

 
334

 
153

 

 
146

 
1,200

 
40

 
1,874

Provision
452

 
256

 
685

 
48

 
115

 
(1,213
)
 
174

 
517

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
2,783

 
$
4,698

 
$
3,025

 
$
2,825

 
$
7,396

 
$
4,111

 
$
962

 
$
25,800


 
Six Months Ended June 30, 2015
 
Agricultural
 
Commercial and
Financial
 
Real Estate:
Construction and
land development
 
Real Estate:
Mortgage,
farmland
 
Real Estate:
Mortgage,
1 to 4 family
 
Real Estate:
Mortgage, multi-
family and
commercial
 
Other
 
Total
 
(Amounts In Thousands)
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
$
2,515

 
$
4,231

 
$
2,241

 
$
2,672

 
$
7,419

 
$
4,195

 
$
747

 
$
24,020

Charge-offs
(257
)
 
(316
)
 
(147
)
 

 
(668
)
 
(180
)
 
(150
)
 
(1,718
)
Recoveries
83

 
735

 
304

 
6

 
559

 
1,270

 
86

 
3,043

Provision
442

 
48

 
627

 
147

 
86

 
(1,174
)
 
279

 
455

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
2,783

 
$
4,698

 
$
3,025

 
$
2,825

 
$
7,396

 
$
4,111

 
$
962

 
$
25,800

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance, individually evaluated for impairment
$
2

 
$
507

 
$
11

 
$

 
$
76

 
$
55

 
$
15

 
$
666

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance, collectively evaluated for impairment
$
2,781

 
$
4,191

 
$
3,014

 
$
2,825

 
$
7,320

 
$
4,056

 
$
947

 
$
25,134

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance
$
91,095

 
$
172,854

 
$
151,533

 
$
173,529

 
$
808,273

 
$
553,924

 
$
75,818

 
$
2,027,026

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance, individually evaluated for impairment
$
1,593

 
$
2,481

 
$
656

 
$
2,314

 
$
3,707

 
$
3,407

 
$
15

 
$
14,173

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ending balance, collectively evaluated for impairment
$
89,502

 
$
170,373

 
$
150,877

 
$
171,215

 
$
804,566

 
$
550,517

 
$
75,803

 
$
2,012,853




Page 17

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

The following table presents the credit quality indicators by type of loans in each category as of June 30, 2016 and December 31, 2015, respectively (amounts in thousands):

 
Agricultural
 
Commercial and
Financial
 
Real Estate:
Construction, 1 to 4
family residential
 
Real Estate:
Construction, land
development and
commercial
June 30, 2016
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
1,957

 
$
3,369

 
$

 
$
252

Good
15,716

 
34,040

 
1,593

 
12,054

Satisfactory
35,194

 
96,432

 
39,300

 
78,402

Monitor
9,666

 
19,601

 
11,156

 
20,369

Special Mention
12,794

 
11,874

 
5,065

 
6,220

Substandard
13,802

 
5,030

 
606

 
441

Total
$
89,129

 
$
170,346

 
$
57,720

 
$
117,738


 
Real Estate:
Mortgage,
farmland
 
Real Estate:
Mortgage, 1 to 4
family first liens
 
Real Estate: Mortgage,
1 to 4 family junior
liens
 
Real Estate:
Mortgage, multi-
family
June 30, 2016
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
2,429

 
$
547

 
$

 
$
6,466

Good
45,441

 
15,155

 
2,492

 
65,693

Satisfactory
98,720

 
640,462

 
109,301

 
179,886

Monitor
28,893

 
49,621

 
3,937

 
31,001

Special Mention
6,584

 
17,269

 
1,846

 
1,983

Substandard
9,127

 
20,396

 
1,712

 
559

Total
$
191,194

 
$
743,450

 
$
119,288

 
$
285,588


 
Real Estate:
Mortgage,
commercial
 
Loans to
individuals
 
Obligations of state and
political subdivisions
 
Total
June 30, 2016
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
15,478

 
$

 
$
2,326

 
$
32,824

Good
87,299

 
83

 
36,118

 
315,684

Satisfactory
186,309

 
23,753

 
12,249

 
1,500,008

Monitor
21,841

 
226

 
506

 
196,817

Special Mention
4,786

 
213

 

 
68,634

Substandard
4,112

 
210

 

 
55,995

Total
$
319,825

 
$
24,485

 
$
51,199

 
$
2,169,962

 

Page 18

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

 
Agricultural
 
Commercial and
Financial
 
Real Estate:
Construction, 1 to 4
family residential
 
Real Estate:
Construction, land
development and
commercial
December 31, 2015
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
1,786

 
$
3,298

 
$

 
$
260

Good
15,959

 
38,764

 
1,898

 
11,570

Satisfactory
36,819

 
102,188

 
34,357

 
52,731

Monitor
18,064

 
27,181

 
8,684

 
11,550

Special Mention
25,356

 
8,231

 
5,842

 
6,542

Substandard
3,604

 
4,537

 
565

 
468

Total
$
101,588

 
$
184,199

 
$
51,346

 
$
83,121


 
Real Estate:
Mortgage,
farmland
 
Real Estate:
Mortgage, 1 to 4
family first liens
 
Real Estate: Mortgage,
1 to 4 family junior
liens
 
Real Estate:
Mortgage, multi-
family
December 31, 2015
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
2,559

 
$
426

 
$

 
$
6,651

Good
31,186

 
15,773

 
2,992

 
64,002

Satisfactory
112,038

 
620,731

 
107,091

 
166,193

Monitor
27,304

 
55,499

 
4,198

 
29,732

Special Mention
11,181

 
16,237

 
1,846

 
4,873

Substandard
3,588

 
18,494

 
1,746

 
523

Total
$
187,856

 
$
727,160

 
$
117,873

 
$
271,974


 
Real Estate:
Mortgage,
commercial
 
Loans to
individuals
 
Obligations of state and
political subdivisions
 
Total
December 31, 2015
 
 
 
 
 
 
 
Grade:
 
 
 
 
 
 
 
Excellent
$
12,484

 
$

 
$
2,365

 
$
29,829

Good
81,305

 
70

 
37,045

 
300,564

Satisfactory
187,728

 
23,197

 
12,425

 
1,455,498

Monitor
32,141

 
285

 
518

 
215,156

Special Mention
6,183

 
198

 

 
86,489

Substandard
3,568

 
269

 
18

 
37,380

Total
$
323,409

 
$
24,019

 
$
52,371

 
$
2,124,916



Page 19

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

The below are descriptions of the credit quality indicators:

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

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

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

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

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

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





Page 20

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

Past due loans as of June 30, 2016 and December 31, 2015 were as follows:

 
30 - 59 Days
Past Due
 
60 - 89 Days
Past Due
 
90 Days
or More
Past Due
 
Total Past
Due
 
Current
 
Total
Loans
Receivable
 
Accruing Loans
Past Due 90
Days or More
 
(Amounts In Thousands)
June 30, 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
Agricultural
$
2,041

 
$
94

 
$
1,446

 
$
3,581

 
$
85,548

 
$
89,129

 
$
359

Commercial and financial
755

 
810

 
1,154

 
2,719

 
167,627

 
170,346

 

Real estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential
347

 
405

 
173

 
925

 
56,795

 
57,720

 

Construction, land development and commercial
45

 
199

 
85

 
329

 
117,409

 
117,738

 

Mortgage, farmland
338

 
195

 
200

 
733

 
190,461

 
191,194

 
200

Mortgage, 1 to 4 family first liens
228

 
2,007

 
1,703

 
3,938

 
739,512

 
743,450

 
175

Mortgage, 1 to 4 family junior liens
39

 
8

 
137

 
184

 
119,104

 
119,288

 

Mortgage, multi-family
132

 

 
40

 
172

 
285,416

 
285,588

 

Mortgage, commercial
253

 
335

 
173

 
761

 
319,064

 
319,825

 

Loans to individuals
79

 
62

 

 
141

 
24,344

 
24,485

 

Obligations of state and political subdivisions

 

 

 

 
51,199

 
51,199

 

 
$
4,257

 
$
4,115

 
$
5,111

 
$
13,483

 
$
2,156,479

 
$
2,169,962

 
$
734

 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2015
 

 
 

 
 

 
 

 
 

 
 

 
 

Agricultural
$
3,064

 
$
961

 
$

 
$
4,025

 
$
97,563

 
$
101,588

 
$

Commercial and financial
854

 
71

 
1,312

 
2,237

 
181,962

 
184,199

 

Real estate:
 
 
 
 
 
 
 

 
 
 
 

 
 

Construction, 1 to 4 family residential

 

 
214

 
214

 
51,132

 
51,346

 

Construction, land development and commercial

 

 
88

 
88

 
$
83,033

 
83,121

 

Mortgage, farmland
320

 
88

 

 
408

 
187,448

 
187,856

 

Mortgage, 1 to 4 family first liens
4,526

 
1,192

 
2,085

 
7,803

 
$
719,357

 
727,160

 
406

Mortgage, 1 to 4 family junior liens
250

 
13

 
110

 
373

 
117,500

 
117,873

 

Mortgage, multi-family
135

 

 
113

 
248

 
$
271,726

 
271,974

 

Mortgage, commercial
1,033

 

 
331

 
1,364

 
322,045

 
323,409

 
61

Loans to individuals
158

 
40

 

 
198

 
$
23,821

 
24,019

 

Obligations of state and political subdivisions

 

 

 

 
52,371

 
52,371

 

 
$
10,340

 
$
2,365

 
$
4,253

 
$
16,958

 
$
2,107,958

 
$
2,124,916

 
$
467

 

Page 21

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

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

Certain impaired loan information by loan type at June 30, 2016 and December 31, 2015, was as follows:

 
June 30, 2016
 
December 31, 2015
 
Non-accrual
loans (1)
 
Accruing loans
past due 90 days
or more
 
TDR loans
 
Non-
accrual
loans (1)
 
Accruing loans
past due 90 days
or more
 
TDR loans
 
(Amounts In Thousands)
 
(Amounts In Thousands)
Agricultural
$
1,670

 
$
359

 
$
96

 
$

 
$

 
$
1,710

Commercial and financial
1,516

 

 
787

 
1,498

 

 
612

Real estate:
 

 
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
173

 

 
266

 
214

 

 
473

Construction, land development and commercial
140

 

 
120

 
145

 

 
122

Mortgage, farmland
1,272

 
200

 
1,626

 

 

 
2,233

Mortgage, 1 to 4 family first liens
3,914

 
175

 
1,342

 
3,845

 
406

 
1,369

Mortgage, 1 to 4 family junior liens
188

 

 
26

 
279

 

 
27

Mortgage, multi-family
358

 

 

 
449

 

 

Mortgage, commercial
1,089

 

 
2,596

 
985

 
61

 
1,733

 
$
10,320

 
$
734

 
$
6,859

 
$
7,415

 
$
467

 
$
8,279


(1)
There were $5.02 million and $2.31 million of TDR loans included within nonaccrual loans as of June 30, 2016 and December 31, 2015, respectively.

Loans 90 days or more past due that are still accruing interest increased $0.27 million from December 31, 2015 to June 30, 2016 due to an increase in the balances of loans past due greater than 90 days. As of June 30, 2016 there were 6 accruing loans past due 90 days or more. The average accruing loans past due as of June 30, 2016 are $0.12 million. The average accruing loans past due 90 days or more as of December 31, 2015 was $0.09 million. The accruing loans past due 90 days or more balances are believed to be adequately collateralized and the Company expects to collect all principal and interest as contractually due under these loans.

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


Page 22

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

Below is a summary of information for TDR loans as of June 30, 2016 and December 31, 2015:

 
June 30, 2016
 
December 31, 2015
 
Number
of
contracts
 
Recorded
investment
 
Commitments
outstanding
 
Number
of
contracts
 
Recorded
investment
 
Commitments
outstanding
 
 
 
(Amounts In Thousands)
 
 
 
(Amounts In Thousands)
Agricultural
4

 
$
1,523

 
$
65

 
7

 
$
1,710

 
$
32

Commercial and financial
12

 
1,946

 
252

 
8

 
1,818

 
241

Real estate:
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential
2

 
438

 

 
3

 
646

 
138

Construction, land development and commercial
1

 
120

 

 
1

 
122

 

Mortgage, farmland
7

 
2,897

 

 
5

 
2,233

 

Mortgage, 1 to 4 family first liens
13

 
1,539

 

 
13

 
1,575

 

Mortgage, 1 to 4 family junior liens
2

 
30

 

 
2

 
36

 

Mortgage, multi-family

 

 

 
1

 
71

 

Mortgage, commercial
14

 
3,385

 

 
10

 
2,381

 

Loans to individuals

 

 

 

 

 

 
55

 
$
11,878

 
$
317

 
50

 
$
10,592

 
$
411


The following is a summary of TDR loans that were modified during the three and six months ended June 30, 2016:

 
Three Months Ended June 30, 2016
 
Six Months Ended June 30, 2016
 
Number
of
contracts
 
Pre-modification
recorded
investment
 
Post-modification
recorded
investment
 
Number
of
contracts
 
Pre-modification
recorded
investment
 
Post-modification
recorded
investment
 
 
 
(Amounts In Thousands)
 
 
 
(Amounts In Thousands)
Agricultural
1

 
$
562

 
$
562

 
1

 
$
562

 
$
562

Commercial and financial

 

 

 
4

 
349

 
349

Real estate:
 

 
 

 
 

 
 

 
 

 
 
Construction, 1 to 4 family residential

 

 

 
2

 
543

 
543

Construction, land development and commercial

 

 

 

 

 

Mortgage, farmland

 

 

 
1

 
132

 
132

Mortgage, 1 to 4 family first lien

 

 

 

 

 

Mortgage, 1 to 4 family junior liens

 

 

 

 

 

Mortgage, multi-family
1

 
539

 
539

 
1

 
539

 
539

Mortgage, commercial

 

 

 
3

 
629

 
629

 
2

 
$
1,101

 
$
1,101

 
12

 
$
2,754

 
$
2,754



Page 23

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

The Company had commitments to lend $0.32 million in additional borrowings to restructured loan customers as of June 30, 2016.  The Company had commitments to lend $0.41 million in additional borrowings to restructured loan customers as of December 31, 2015.  These commitments were in the normal course of business.  The additional borrowings were not used to facilitate payments on these loans.

There were $0.20 million and $0.00 million of TDR loans that were in payment default (defined as past due 90 days or more) during the quarter ended June 30, 2016 and year ended December 31, 2015.





Page 24

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

Information regarding impaired loans as of and for the three and six months ended June 30, 2016 is as follows:
 
June 30, 2016
 
Three Months Ended 
 June 30, 2016
 
Six Months Ended 
 June 30, 2016
 
Recorded
Investment
 
Unpaid
Principal
Balance
 
Related
Allowance
 
Average Recorded
Investment
 
Interest Income
Recognized
 
Average Recorded
Investment
 
Interest Income
Recognized
With no related allowance recorded:
(Amounts In Thousands)
Agricultural
$
50

 
$
195

 
$

 
$
91

 
$
1

 
$
97

 
$
1

Commercial and financial
1,693

 
2,325

 

 
1,722

 
6

 
1,743

 
12

Real estate:
 

 
 

 
 

 
 

 
 
 
 

 
 
Construction, 1 to 4 family residential
265

 
265

 

 
265

 
3

 
265

 
6

Construction, land development and commercial
205

 
292

 

 
205

 
1

 
208

 
3

Mortgage, farmland
1,089

 
1,206

 

 
1,090

 
13

 
1,095

 
26

Mortgage, 1 to 4 family first liens
4,029

 
4,983

 

 
4,075

 
13

 
4,136

 
27

Mortgage, 1 to 4 family junior liens
141

 
444

 

 
146

 

 
153

 

Mortgage, multi-family
146

 
258

 

 
149

 

 
187

 

Mortgage, commercial
2,823

 
4,176

 

 
2,853

 
25

 
2,893

 
50

Loans to individuals

 
20

 

 

 

 

 

 
$
10,441

 
$
14,164

 
$

 
$
10,596

 
$
62

 
$
10,777

 
$
125

 
 
 
 
 
 
 
 
 
 
 
 
 
 
With an allowance recorded:
 

 
 

 
 

 
 

 
 

 
 
 
 
Agricultural
$
12,527

 
$
12,564

 
$
837

 
$
12,560

 
$
140

 
$
12,598

 
$
282

Commercial and financial
610

 
623

 
217

 
643

 
5

 
696

 
11

Real estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential
173

 
184

 
2

 
173

 

 
173

 

Construction, land development and commercial
55

 
57

 
11

 
55

 

 
56

 

Mortgage, farmland
7,425

 
7,430

 
638

 
7,498

 
82

 
7,505

 
164

Mortgage, 1 to 4 family first liens
1,402

 
1,537

 
232

 
1,423

 
5

 
1,434

 
9

Mortgage, 1 to 4 family junior liens
74

 
232

 
14

 
76

 

 
78

 
1

Mortgage, multi-family
212

 
220

 
41

 
214

 

 
216

 

Mortgage, commercial
862

 
896

 
34

 
868

 
9

 
875

 
17

Loans to individuals
70

 
70

 
70

 
69

 
2

 
83

 
4

 
$
23,410

 
$
23,813

 
$
2,096

 
$
23,579

 
$
243

 
$
23,714

 
$
488

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total:
 

 
 

 
 

 
 

 
 

 
 
 
 
Agricultural
$
12,577

 
$
12,759

 
$
837

 
$
12,651

 
$
141

 
$
12,695

 
$
283

Commercial and financial
2,303

 
2,948

 
217

 
2,365

 
11

 
2,439

 
23

Real estate:
 

 
 

 
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
438

 
449

 
2

 
438

 
3

 
438

 
6

Construction, land development and commercial
260

 
349

 
11

 
260

 
1

 
264

 
3

Mortgage, farmland
8,514

 
8,636

 
638

 
8,588

 
95

 
8,600

 
190

Mortgage, 1 to 4 family first liens
5,431

 
6,520

 
232

 
5,498

 
18

 
5,570

 
36

Mortgage, 1 to 4 family junior liens
215

 
676

 
14

 
222

 

 
231

 
1

Mortgage, multi-family
358

 
478

 
41

 
363

 

 
403

 

Mortgage, commercial
3,685

 
5,072

 
34

 
3,721

 
34

 
3,768

 
67

Loans to individuals
70

 
90

 
70

 
69

 
2

 
83

 
4

 
$
33,851

 
$
37,977

 
$
2,096

 
$
34,175

 
$
305

 
$
34,491

 
$
613


Page 25

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

Information regarding impaired loans as of December 31, 2015 is as follows:

 
Recorded
Investment
 
Unpaid Principal
Balance
 
Related
Allowance
With no related allowance recorded:
(Amounts In Thousands)
Agricultural
$
1,609

 
$
1,773

 
$

Commercial and financial
1,263

 
1,981

 

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
238

 
238

 

Construction, land development and commercial
210

 
314

 

Mortgage, farmland
2,233

 
2,351

 

Mortgage, 1 to 4 family first liens
3,558

 
4,419

 

Mortgage, 1 to 4 family junior liens
189

 
500

 

Mortgage, multi-family
157

 
226

 

Mortgage, commercial
1,831

 
3,018

 

Loans to individuals

 
20

 

 
$
11,288

 
$
14,840

 
$

 
 
 
 
 
 
With an allowance recorded:
 

 
 

 
 

Agricultural
$
101

 
$
101

 
$
1

Commercial and financial
847

 
847

 
324

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
449

 
461

 
9

Construction, land development and commercial
57

 
58

 
13

Mortgage, farmland

 

 

Mortgage, 1 to 4 family first liens
2,062

 
2,156

 
306

Mortgage, 1 to 4 family junior liens
117

 
270

 
20

Mortgage, multi-family
292

 
332

 
58

Mortgage, commercial
948

 
1,030

 
52

Loans to individuals
100

 
100

 
100

 
$
4,973

 
$
5,355

 
$
883

 
 
 
 
 
 
Total:
 

 
 

 
 

Agricultural
$
1,710

 
$
1,874

 
$
1

Commercial and financial
2,110

 
2,828

 
324

Real estate:
 

 
 

 
 

Construction, 1 to 4 family residential
687

 
699

 
9

Construction, land development and commercial
267

 
372

 
13

Mortgage, farmland
2,233

 
2,351

 

Mortgage, 1 to 4 family first liens
5,620

 
6,575

 
306

Mortgage, 1 to 4 family junior liens
306

 
770

 
20

Mortgage, multi-family
449

 
558

 
58

Mortgage, commercial
2,779

 
4,048

 
52

Loans to individuals
100

 
120

 
100

 
$
16,261

 
$
20,195

 
$
883



Page 26

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

Impaired loans increased $17.59 million from December 31, 2015 to June 30, 2016.  Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans.  Impaired loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement.  Impaired loans were 1.56% of loans held for investment as of June 30, 2016 and 0.76% as of December 31, 2015.  The increase in impaired loans is due mainly to an increase in nonaccrual loans of $2.91 million, a $16.39 million agricultural and farmland real estate relationship with a specific allowance for losses, and a decrease in TDR loans of $1.42 million from December 31, 2015 to June 30, 2016.

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

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

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


Page 27

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

Note 6.
Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments as of June 30, 2016 are as follows:
 
June 30, 2016
 
Carrying
Amount
 
Estimated Fair
Value
 
Readily
Available
Market
Prices(1)
 
Observable
Market
Prices(2)
 
Company
Determined
Market
Prices(3)
 
(Amounts In Thousands)
Financial instrument assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
36,614

 
$
36,614

 
$
36,614

 
$

 
$

Investment securities
260,621

 
260,621

 

 
260,621

 

Loans held for sale
7,239

 
7,239

 

 
7,239

 

Loans
 

 
 

 
 

 
 

 
 

Agricultural
86,132

 
86,173

 

 

 
86,173

Commercial and financial
166,335

 
166,286

 

 

 
166,286

Real estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
56,738

 
56,707

 

 

 
56,707

Construction, land development and commercial
115,822

 
115,847

 

 

 
115,847

Mortgage, farmland
187,267

 
187,578

 

 

 
187,578

Mortgage, 1 to 4 family first liens
737,242

 
741,638

 

 

 
741,638

Mortgage, 1 to 4 family junior liens
118,063

 
122,980

 

 

 
122,980

Mortgage, multi-family
283,830

 
283,577

 

 

 
283,577

Mortgage, commercial
317,382

 
316,736

 

 

 
316,736

Loans to individuals
23,839

 
23,820

 

 

 
23,820

Obligations of state and political subdivisions
50,815

 
50,353

 

 

 
50,353

Accrued interest receivable
9,601

 
9,601

 

 
9,601

 

Total financial instrument assets
$
2,457,540

 
$
2,465,770

 
$
36,614

 
$
277,461

 
$
2,151,695

Financial instrument liabilities
 

 
 

 
 

 
 

 
 

Deposits
 

 
 

 
 

 
 

 
 

Noninterest-bearing deposits
$
304,155

 
$
304,155

 
$

 
$
304,155

 
$

Interest-bearing deposits
1,591,853

 
1,593,284

 

 
1,593,284

 

Other borrowings
45,132

 
45,132

 

 
45,132

 

Federal Home Loan Bank borrowings
240,000

 
239,859

 

 
239,859

 

Interest rate swaps
6,611

 
6,611

 

 
6,611

 

Accrued interest payable
844

 
844

 

 
844

 

Total financial instrument liabilities
$
2,188,595

 
$
2,189,885

 
$

 
$
2,189,885

 
$

 
 
 
 
 
 
 
 
 
 
 
Face Amount
 
 

 
 

 
 

 
 

Financial instrument with off-balance sheet risk:
 

 
 

 
 

 
 

 
 

Loan commitments
$
420,305

 
$

 
$

 
$

 
$

Letters of credit
9,935

 

 

 

 

Total financial instrument liabilities with off-balance-sheet risk
$
430,240

 
$

 
$

 
$

 
$

(1)
Considered Level 1 under Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”).
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

Page 28

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

The carrying value and estimated fair values of the Company's financial instruments as of December 31, 2015 are as follows:

 
December 31, 2015
 
Carrying
Amount
 
Estimated Fair
Value
 
Readily
Available
Market
Prices(1)
 
Observable
Market
Prices(2)
 
Company
Determined
Market
Prices(3)
 
(Amounts In Thousands)
Financial instrument assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
35,427

 
$
35,427

 
$
35,427

 
$

 
$

Investment securities
276,069

 
276,069

 

 
276,069

 

Loans held for sale
5,554

 
5,554

 

 
5,554

 

Loans
 

 
 

 
 

 
 

 
 

Agricultural
98,506

 
98,530

 

 

 
98,530

Commercial and financial
179,682

 
179,649

 

 

 
179,649

Real estate:
 

 
 

 
 

 
 

 
 

Construction, 1 to 4 family residential
50,480

 
50,487

 

 

 
50,487

Construction, land development and commercial
81,707

 
81,705

 

 

 
81,705

Mortgage, farmland
184,514

 
184,640

 

 

 
184,640

Mortgage, 1 to 4 family first liens
720,229

 
718,566

 

 

 
718,566

Mortgage, 1 to 4 family junior liens
116,632

 
122,173

 

 

 
122,173

Mortgage, multi-family
270,261

 
272,446

 

 

 
272,446

Mortgage, commercial
320,899

 
319,090

 

 

 
319,090

Loans to individuals
23,518

 
23,509

 

 

 
23,509

Obligations of state and political subdivisions
51,978

 
51,073

 

 

 
51,073

Accrued interest receivable
8,672

 
8,672

 

 
8,672

 

Total financial instrument assets
$
2,424,128

 
$
2,427,590

 
$
35,427

 
$
290,295

 
$
2,101,868

Financial instrument liabilities:
 

 
 

 
 

 
 

 
 

Deposits
 

 
 

 
 

 
 

 
 

Noninterest-bearing deposits
$
314,968

 
$
314,968

 
$

 
$
314,968

 
$

Interest-bearing deposits
1,575,734

 
1,577,684

 

 
1,577,684

 

Other borrowings
44,051

 
44,051

 

 
44,051

 

Federal Home Loan Bank borrowings
225,000

 
226,157

 

 
226,157

 

Interest rate swaps
4,180

 
4,180

 
 
 
4,180

 
 
Accrued interest payable
846

 
846

 

 
846

 

Total financial instrument liabilities
$
2,164,779

 
$
2,167,886

 
$

 
$
2,167,886

 
$

 
 
 
 
 
 
 
 
 
 
 
Face Amount
 
 

 
 

 
 

 
 

Financial instrument with off-balance sheet risk:
 

 
 

 
 

 
 

 
 

Loan commitments
$
344,602

 
$

 
$

 
$

 
$

Letters of credit
11,718

 

 

 

 

Total financial instrument liabilities with off-balance-sheet risk
$
356,320

 
$

 
$

 
$

 
$

 
(1)
Considered Level 1 under ASC 820.
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

Page 29

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

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

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

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

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

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

ASSETS

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

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

The pricing for investment securities is obtained from an independent source.  There are no level 1 or level 3 investment securities owned by the Company.  The Company obtains an understanding of the independent source’s valuation methodologies used to determine fair value by level of security. The Company validates assigned fair values on a sample basis using an additional third-party provider pricing service to determine if the fair value measurement is reasonable.  Due to the nature of our investment portfolio, we do not expect significant and unusual fluctuations as fair value changes primarily relate to interest rate changes.   No unusual fluctuations were identified during the six months ended June 30, 2016.   If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.

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


Page 30

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

Loans:  The Company does not record loans at fair value on a recurring basis.  For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values (Level 3).  The fair values for other loans are determined using estimated future cash flows, discounted at the interest rates currently being offered for loans with similar terms to borrowers with similar credit quality utilizing an entrance price concept (Level 3).  The Company does record nonrecurring fair value adjustments to loans to reflect (1) partial write-downs that are based on the observable market price or appraised value of the collateral or (2) the full charge-off of the loan carrying value (Level 3).  These loans are considered Level 3 as the instruments used to determine fair market value require significant management judgment and estimation.

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

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

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

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

LIABILITIES

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

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

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

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

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


Page 31

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

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

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

 
June 30, 2016
 
Readily
Available
Market
Prices(1)
 
Observable
Market Prices(2)
 
Company
Determined
Market
Prices(3)
 
Total at Fair
Value
Securities available for sale
(Amounts In Thousands)
U.S. Treasury
$

 
$
25,342

 
$

 
$
25,342

State and political subdivisions

 
63,315

 

 
63,315

Other securities (FHLB, FHLMC and FNMA)

 
159,341

 

 
159,341

Derivative Financial Instruments
 
 
 
 
 
 
 
Interest rate swaps
$

 
(6,611
)
 
$

 
(6,611
)
Total
$

 
$
241,387

 
$

 
$
241,387


 
December 31, 2015
 
Readily
Available
Market
Prices(1)
 
Observable
Market Prices(2)
 
Company
Determined
Market
Prices(3)
 
Total at Fair
Value
Securities available for sale
(Amounts In Thousands)
U.S. Treasury
$

 
$
24,978

 
$

 
$
24,978

State and political subdivisions

 
173,929

 

 
173,929

Other securities (FHLB, FHLMC and FNMA)

 
65,328

 

 
65,328

Derivative Financial Instruments
 
 
 
 
 
 
 
Interest rate swaps

 
(4,180
)
 

 
(4,180
)
Total
$

 
$
260,055

 
$

 
$
260,055

 
(1)
Considered Level 1 under ASC 820.
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.

There were no transfers between Levels 1, 2 or 3 during the six months ended June 30, 2016 and the year ended December 31, 2015.



Page 32

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

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

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

 
June 30, 2016
 
Three Months Ended June 30, 2016
 
Six Months Ended June 30, 2016
 
Readily
Available
Market
Prices(1)
 
Observable
Market
Prices(2)
 
Company
Determined
Market
Prices(3)
 
Total at
Fair
Value
 
Total Losses
 
Total Losses
 
(Amounts in Thousands)
 
 
 
 
Loans (4)
 
 
 
 
 
 
 
 
 
 
 
Agricultural
$

 
$

 
$
1,345

 
$
1,345

 
$

 
$

Commercial and financial

 

 
1,480

 
1,480

 
72

 
92

Real Estate:
 
 
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential

 

 
436

 
436

 

 

Construction, land development and commercial

 

 
129

 
129

 

 

Mortgage, farmland

 

 
1,972

 
1,972

 

 

Mortgage, 1 to 4 family first liens

 

 
4,609

 
4,609

 
79

 
354

Mortgage, 1 to 4 family junior liens

 

 
201

 
201

 

 

Mortgage, multi-family

 

 
317

 
317

 

 

Mortgage, commercial

 

 
1,764

 
1,764

 


 
65

Loans to individuals

 

 

 

 

 

Foreclosed assets (5)

 

 

 

 

 

Total
$

 
$

 
$
12,253

 
$
12,253

 
$
151

 
$
511

 
(1)
Considered Level 1 under ASC 820.
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.
(4)
Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully-charged off is zero.
(5)
Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.


Page 33

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

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

 
December 31, 2015
 
Year Ended December 31, 2015
 
Readily
Available
Market
Prices(1)
 
Observable
Market
Prices(2)
 
Company
Determined
Market
Prices(3)
 
Total at Fair
Value
 
Total Losses
 
(Amounts in Thousands)
 
 
Loans (4)
 
 
 
 
 
 
 
 
 
Agricultural
$

 
$

 
$
1,470

 
$
1,470

 
$
116

Commercial and financial

 

 
1,178

 
1,178

 
56

Real Estate:
 
 
 
 
 
 
 
 
 
Construction, 1 to 4 family residential

 

 
482

 
482

 
161

Construction, land development and commercial

 

 
132

 
132

 
35

Mortgage, farmland

 

 
2,233

 
2,233

 

Mortgage, 1 to 4 family first liens

 

 
4,487

 
4,487

 
529

Mortgage, 1 to 4 family junior liens

 

 
286

 
286

 
166

Mortgage, multi-family

 

 
391

 
391

 
38

Mortgage, commercial

 

 
1,152

 
1,152

 
140

Loans to individuals

 

 

 

 

Foreclosed assets (5)

 

 
100

 
100

 
69

Total
$

 
$

 
$
11,911

 
$
11,911

 
$
1,310


(1)
Considered Level 1 under ASC 820.
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.
(4)
Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully-charged off is zero.
(5)
Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.

Note 7.
Stock Repurchase Program

On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 1,500,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”).  The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2017.  The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis.  All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis.  The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.  The Company has purchased 926,268 shares of its common stock in privately negotiated transactions from August 1, 2005 through June 30, 2016.  Of these 926,268 shares, 13,427 shares were purchased during the quarter ended June 30, 2016, at an average price per share of $45.42.


Page 34

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

Note 8.
Commitments and Contingencies

Concentrations of credit risk:  The Bank’s loans, commitments to extend credit, unused lines of credit and outstanding letters of credit have been granted to customers within the Bank's market area.  Investments in securities issued by state and political subdivisions within the state of Iowa totaled approximately $76.48 million.  The concentrations of credit by type of loan are set forth in Note 5 to the Consolidated Financial Statements.  Outstanding letters of credit were granted primarily to commercial borrowers.  Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the economic conditions in Johnson, Linn and Washington Counties, Iowa.

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

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

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments.  The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.  A summary of the Bank’s commitments at June 30, 2016 and December 31, 2015 is as follows:
 
 
June 30, 2016
 
December 31, 2015
 
(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
 
 
 
Home equity loans
$
47,329

 
$
44,376

Credit cards
43,999

 
41,518

Commercial, real estate and home construction
130,282

 
98,613

Commercial lines and real estate purchase loans
198,695

 
160,095

Outstanding letters of credit
9,935

 
11,718

 
Note 9.
Income Taxes

Federal income tax expense for the six months ended June 30, 2016 and 2015 was computed using the consolidated effective federal tax rate.  The Company also recognized income tax expense pertaining to state franchise taxes payable individually by the subsidiary bank.  The Company files a consolidated tax return for federal purposes and separate tax returns for State of Iowa purposes.  The tax years ended December 31, 2015, 2014, and 2013 remain subject to examination by the Internal Revenue Service.  For state tax purposes, the tax years ended December 31, 2015, 2014, and 2013 remain open for examination.  There were no material unrecognized tax benefits at June 30, 2016  and December 31, 2015 and therefore no interest or penalties on unrecognized tax benefits has been recorded.  As of June 30, 2016, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending March 31, 2016.

Income taxes as a percentage of income before taxes were 30.80% for the six months ended June 30, 2016 and 30.23% for the same period in 2015.  The slight increase in the effective tax rate is due to a decrease in the amount of low-income housing tax credits earned by the Company in 2016.


Page 35

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


Note 10.
Derivative Financial Instruments

In the normal course of business, the Bank may use derivative financial instruments to manage its interest rate risk.  These instruments carry varying degrees of credit, interest rate and market or liquidity risks.  Derivative instruments are recognized as either assets or liabilities in the accompanying financial statement and are measured at fair value.  The Bank’s objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates.  The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amount to be exchanged between the counterparties.  The Bank is exposed to credit risk in the event of nonperformance by counterparties to financial instruments.  The Bank minimizes this risk by entering into derivative contracts with large, stable financial institutions.  The Bank has not experienced any losses from nonperformance by counterparties.  The Bank monitors counterparty risk in accordance with the provisions of ASC 815.  In addition, the Bank’s interest rate-related derivative instruments contain language outlining collateral pledging requirements for each counterparty.  Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty.  The Bank was required to pledge $6.61 million of collateral as of June 30, 2016.

Cash Flow Hedges:

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

The table below identifies the balance sheet category and fair values of the Bank’s derivative instruments designated as cash flow hedges as of June 30, 2016 and December 31, 2015:

 
Notional
Amount
 
Fair
Value
 
Balance
Sheet
Category
 
Maturity
 
(Amounts in Thousands)
 
 
June 30, 2016
 
 
 
 
 
 
    
Interest rate swap
$
25,000

 
$
(2,194
)
 
Other Liabilities
 
11/9/2020
Interest rate swap
25,000

 
(4,417
)
 
Other Liabilities
 
11/7/2023
 
 
 
 
 
 
 
 
December 31, 2015
 

 
 

 
 
 
    
Interest rate swap
$
25,000

 
$
(1,501
)
 
Other Liabilities
 
11/9/2020
Interest rate swap
25,000

 
(2,679
)
 
Other Liabilities
 
11/7/2023



Page 36

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

The table below identifies the gains and losses recognized on the Bank’s derivative instruments designated as cash flow hedges as of June 30, 2016 and December 31, 2015:

 
Effective Portion
 
Ineffective Portion
 
Recognized
in OCI
 
Reclassifed from AOCI into
Income
 
Recognized in Income on
Derivatives
 
Amount of
Gain (Loss)
 
Category
 
Amount
of Gain
(Loss)
 
Category
 
Amount
of Gain
(Loss)
 
(Amounts in Thousands)
June 30, 2016
 
 
 
 
 
 
 
 
 
Interest rate swap
$
(428
)
 
Interest Expense
 
$

 
Other Income
 
$

Interest rate swap
(1,073
)
 
Interest Expense
 

 
Other Income
 

 
 
 
 
 
 
 
 
 
 
December 31, 2015
 

 
 
 
 

 
 
 
 

Interest rate swap
$
(394
)
 
Interest Expense
 
$

 
Other Income
 
$

Interest rate swap
(461
)
 
Interest Expense
 

 
Other Income
 


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

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

Special Note Regarding Forward Looking Statements

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

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

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

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

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


Page 37


HILLS BANCORPORATION

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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HILLS BANCORPORATION

Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these financial statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses. The Company's allowance for loan losses methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company's markets, including
economic conditions throughout the Midwest and the state of certain industries.  Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management.  Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position.  Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations.  Although management believes the levels of the allowance as of June 30, 2016 and December 31, 2015 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

Overview

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

The Company is a holding company engaged in the business of commercial banking.  The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned.  The Bank was formed in Hills, Iowa in 1904.  The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids, Marion, and Washington, Iowa.  At June 30, 2016, the Bank has eighteen full-service locations.

Net income for the six month period ended June 30, 2016 was $15.67 million compared to $14.85 million for the same six months of 2015, an increase of 5.50%.  The $0.82 million increase in net income was caused by a number of factors.  The principal factors in the increase in net income for the first six months of 2016 are an increase in net interest income of $1.69 million and a decrease in provision for loan losses of $0.63 million.  These changes were offset by an increase in income tax expense of $0.54 million, a decrease in noninterest income of $0.75 million, and an increase in noninterest expenses of $0.21 million.

The Company achieved a return on average assets of 1.19% and a return on average equity of 11.20% for the twelve months ended June 30, 2016, compared to the twelve months ended June 30, 2015, which were 1.22% and 11.09%, respectively.  Dividends of $0.65 per share were paid in January 2016 to 2,334 shareholders.  The 2015 dividend was $0.625 per share.

The Company’s net interest income is the largest component of revenue and it is primarily a function of the average earning assets and the net interest margin percentage.  The Company achieved a net interest margin on a tax-equivalent basis of 3.39% for the six months ended June 30, 2016 compared to 3.53% for the same six months of 2015.  Average earning assets were $2.429 billion year to date in 2016 and $2.245 billion in 2015.


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HILLS BANCORPORATION

Highlights noted on the balance sheet as of June 30, 2016 for the Company included the following:

Total assets were $2.521 billion, an increase of $27.81 million since December 31, 2015.
Cash and cash equivalents were $36.61 million, a decrease of $1.19 million since December 31, 2015.
Net loans were $2.151 billion, an increase of $45.98 million since December 31, 2015.  Loans held for sale increased $1.69 million since December 31, 2015.
Deposits increased $5.31 million since December 31, 2015
Federal Home Loan Bank borrowings increased $15.00 million since December 31, 2015.

Reference is made to Note 6 for a discussion of fair value measurements which relate to methods used by the Company in recording assets and liabilities on its financial statements.

Financial Condition

Loan demand has been increasing and is expected to increase throughout the year ending December 31, 2016 and into 2017.  As indicated in the table below, growth in the construction and multi-family real estate loans have been primarily responsible for the increase in total loans. 

The following table sets forth the composition of the loan portfolio as of June 30, 2016 and December 31, 2015:

 
June 30, 2016
 
December 31, 2015
 
Amount
 
Percent
 
Amount
 
Percent
 
(Amounts In Thousands)
 
(Amounts In Thousands)
Agricultural
$
89,129

 
4.11
%
 
$
101,588

 
4.78
%
Commercial and financial
170,346

 
7.85

 
184,199

 
8.67

Real estate:
 

 
 
 
 

 
 
Construction, 1 to 4 family residential
57,720

 
2.66

 
51,346

 
2.42

Construction, land development and commercial
117,738

 
5.43

 
83,121

 
3.91

Mortgage, farmland
191,194

 
8.81

 
187,856

 
8.84

Mortgage, 1 to 4 family first liens
743,450

 
34.25

 
727,160

 
34.22

Mortgage, 1 to 4 family junior liens
119,288

 
5.50

 
117,873

 
5.55

Mortgage, multi-family
285,588

 
13.16

 
271,974

 
12.80

Mortgage, commercial
319,825

 
14.74

 
323,409

 
15.22

Loans to individuals
24,485

 
1.13

 
24,019

 
1.13

Obligations of state and political subdivisions
51,199

 
2.36

 
52,371

 
2.46

 
$
2,169,962

 
100.00
%
 
$
2,124,916

 
100.00
%
Net unamortized fees and costs
793

 
 

 
768

 
 

 
$
2,170,755

 
 

 
$
2,125,684

 
 

Less allowance for loan losses
27,290

 
 

 
26,510

 
 

 
$
2,143,465

 
 

 
$
2,099,174

 
 



Page 40


HILLS BANCORPORATION


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

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

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

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


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HILLS BANCORPORATION

The following table presents the allowance for loan losses on loans by loan category, the percentage of the allowance for each category to the total allowance, and the percentage of all loans in each category to total loans as of June 30, 2016 and December 31, 2015:
 
 
June 30, 2016
 
December 31, 2015
 
Amount
 
% of Total
Allowance
 
% of Loans to
Total Loans
 
Amount
 
% of Total
Allowance
 
% of Loans to
Total Loans
 
(In Thousands)
 
 
 
 
 
(In Thousands)
 
 
 
 
Agricultural
$
2,997

 
10.98
%
 
4.11
%
 
$
3,082

 
11.63
%
 
4.78
%
Commercial and financial
4,011

 
14.70

 
7.85

 
4,517

 
17.04

 
8.67

Real estate:
 

 
 
 
 
 
 

 
 

 
 
Construction, 1 to 4 family residential
982

 
3.60

 
2.66

 
866

 
3.27

 
2.42

Construction, land development and commercial
1,916

 
7.02

 
5.43

 
1,414

 
5.33

 
3.91

Mortgage, farmland
3,927

 
14.39

 
8.81

 
3,342

 
12.61

 
8.84

Mortgage, 1 to 4 family first liens
7,001

 
25.65

 
34.25

 
6,931

 
26.14

 
34.22

Mortgage, 1 to 4 family junior liens
1,225

 
4.49

 
5.50

 
1,241

 
4.68

 
5.55

Mortgage, multi-family
1,758

 
6.44

 
13.16

 
1,713

 
6.46

 
12.80

Mortgage, commercial
2,443

 
8.95

 
14.74

 
2,510

 
9.47

 
15.22

Loans to individuals
646

 
2.37

 
1.13

 
501

 
1.89

 
1.13

Obligations of state and political subdivisions
384

 
1.41

 
2.36

 
393

 
1.48

 
2.46

 
$
27,290

 
100.00
%
 
100.00
%
 
$
26,510

 
100.00
%
 
100.00
%

The allowance for loan losses totaled $27.29 million at June 30, 2016 compared to $26.51 million at December 31, 2015.  The percentage of the allowance to outstanding loans was 1.26% and 1.25% at June 30, 2016 and December 31, 2015, respectively.  The allowance was based on management’s consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks and the overall amount of loans outstanding.  The increase in the allowance in 2016 is the result of an increase in net loans and a change in the composition and allocation of loans within credit quality ratings.

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

Management has determined that the allowance for loan losses was appropriate at June 30, 2016, and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for loan losses is based on a comprehensive, well documented, and consistently applied analysis of the Company’s loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for loan losses is reviewed and compared to industry data. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.

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

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HILLS BANCORPORATION


Investment securities available for sale held by the Company decreased by $16.24 million from December 31, 2015 to June 30, 2016.  The fair value of securities available for sale was $4.44 million more than the amortized cost of such securities as of June 30, 2016.  At December 31, 2015, the fair value of the securities available for sale was $2.24 million more than the amortized cost of such securities.

Deposits increased $5.31 million in the first six months of 2016. Repurchase agreements increased $1.08 million and Federal Home Loan Bank borrowings increased $15.00 million since December 31, 2015.  In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Brokered deposits are included in total deposits and totaled $60.58 million as of June 30, 2016 with an average rate of 0.56%.  Brokered deposits were $62.74 million as of December 31, 2015 with an average interest rate of 0.42%. As of June 30, 2016 and December 31, 2015, brokered deposits were 3.20% and 3.32% of total deposits, respectively.

Dividends and Equity

In January 2016, Hills Bancorporation paid a dividend of $6.06 million or $0.65 per share.  The dividend was $0.625 per share in January 2015.  After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of June 30, 2016 totaled $278.95 million. On January 1, 2015, the final rules of the Federal Reserve Board went into effect implementing in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision. The final rule also adopted changes to the agencies’ regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Under the BASEL III rules, the minimum capital ratios are 4% for Tier 1 Leverage Capital Ratio, 4.5% for the Common Equity Tier 1 Capital Ratio, 6% for the Tier 1 Risk-Based Capital Ratio and 8% for the Total Risk-Based Capital Ratio. A new capital conservation buffer is being phased in beginning January 1, 2016, at 0.625% of risk-weighted assets and increased each subsequent year by an additional 0.625% until reaching 2.5% on January 1, 2019. As of June 30, 2016 and December 31, 2015, the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements. The actual amounts and capital ratios as of June 30, 2016 and December 31, 2015 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 June 30, 2016:
 
 
 
 
 
 
 
Company:
 
 
 
 
 
 
 
Total risk-based capital
$
335,003

 
15.99
%
 
8.000
%
 
10.000
%
Tier 1 risk-based capital
308,685

 
14.74

 
6.000

 
8.000

Tier 1 common equity
308,685

 
14.74

 
4.500

 
6.500

Leverage ratio
308,685

 
12.38

 
4.000

 
5.000

Bank:
 

 
 

 
 

 
 

Total risk-based capital
334,982

 
16.02

 
8.000

 
10.000

Tier 1 risk-based capital
308,686

 
14.77

 
6.000

 
8.000

Tier 1 common equity
308,686

 
14.77

 
4.500

 
6.500

Leverage ratio
308,686

 
12.41

 
4.000

 
5.000



Page 43


HILLS BANCORPORATION

 
Actual
 
For Capital Adequacy Purposes
 
To Be Well Capitalized Under Prompt Corrective Action Provisions
 
Amount
 
Ratio
 
Ratio
 
Ratio
As of December 31, 2015:
 
 
 
 
 
 
 
Company:
 
 
 
 
 
 
 
Total risk-based capital
$
334,899

 
15.82
%
 
8.00
%
 
10.00
%
Tier 1 risk-based capital
308,432

 
14.57

 
6.00

 
8.00

Tier 1 common equity
308,432

 
14.57

 
4.50

 
6.50

Leverage ratio
308,432

 
12.53

 
4.00

 
5.00

Bank:
 

 
 

 
 

 
 

Total risk-based capital
335,010

 
15.83

 
8.00

 
10.00

Tier 1 risk-based capital
308,562

 
14.58

 
6.00

 
8.00

Tier 1 common equity
308,562

 
14.58

 
4.50

 
6.50

Leverage ratio
308,562

 
12.54

 
4.00

 
5.00





Page 44


HILLS BANCORPORATION

Discussion of operations for the six months ended June 30, 2016 and 2015

Net Income Overview

Net income increased $0.82 million for the six months ended June 30, 2016 compared to the first six months of 2015.  Total net income was $15.67 million in 2016 and $14.85 million in the comparable period in 2015, an increase of 5.50%.  The changes in net income in 2016 from the first six months of 2015 were primarily the result of the following:

Net interest income increased by $1.69 million, before provision expense. Total interest income increased by $2.57 million as a result of growth in the volume of earning assets. Total interest expense increased by $0.88 million as a result of $1.33 million in additional FHLB borrowings interest expense.
The provision for loan losses decreased by $0.63 million.
Noninterest income decreased by $0.76 million.
Noninterest expenses increased by $0.21 million.
Income tax expense increased by $0.54 million.
 
For the six month period ended June 30, 2016 and June 30, 2015 basic earnings per share was $1.69 and $1.59, respectively. Diluted earnings per share was $1.68 for the six months ended June 30, 2016 compared to $1.59 for the same period in 2015.

The Company’s net income continues to be driven primarily by three important factors.  The first important factor is the interaction between changes in net interest margin and changes in average volumes of the Bank's earnings assets.  Net interest income of $39.64 million for the first six months of 2016 was derived from the Company’s $2.429 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.39%.  Average earning assets in the six months ended June 30, 2015 were $2.245 billion and the tax-equivalent net interest margin was 3.53%.  The importance of net interest margin is illustrated by the fact that an increase or decrease in the net interest margin of 10 basis points would have resulted approximately in a $1.21 million change in income before income taxes in the six month period ended June 30, 2016.  Net interest income for the Company increased primarily as a result of growth in the volume of earning assets.  The Company expects net interest compression to continue to impact earnings for the foreseeable future.  The Company believes growth in net interest income will be contingent on the growth of the Company’s earnings assets.

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $2.151 billion at June 30, 2016.  The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio.  The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more.  In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historically higher credit risk.  The provision for loan losses was a reduction of expense of $0.17 million in 2016 compared to an expense of $0.46 million in 2015.  The Company believes that the provision for loan losses will steadily increase for the foreseeable future resulting from projected increases in the size of the Company’s loan portfolio.

The third significant factor affecting the Company’s net income is income tax expense.  Federal and state income tax expenses were $6.97 million and $6.44 million for the six months ended June 30, 2016 and 2015, respectively.  Income taxes as a percentage of income before taxes were 30.80% in 2016 and 30.23% in 2015.


Page 45


HILLS BANCORPORATION

Discussion of operations for the six months ended June 30, 2016 and 2015

Net Interest Income

Net interest income increased for the six months ended June 30, 2016 compared to the comparable period in 2015.  The increase was as a result of growth in the average volume of earning assets.  Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities.  The factors that have the greatest impact on net interest income are the average volume of earning assets for the period and the net interest margin.  The net interest margin for the first six months of 2016 was 3.39% compared to 3.53% in 2015 for the same period.  The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable.  The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the six months ended in 2016 compared to the comparable period in 2015 are shown in the following table:

 
 
 
 
 
Increase (Decrease) in Net Interest Income
 
Change in
Average Balance
 
Change in
Average Rate
 
Volume Changes
 
Rate Changes
 
Net Change
 
(Amounts in Thousands)
Interest income:
 
 
 
 
 
 
 
 
 
Loans, net
$
140,616

 
(0.13
)%
 
$
3,320

 
$
(982
)
 
$
2,338

Taxable securities
3,303

 
0.22

 
54

 
78

 
132

Nontaxable securities
4,866

 
(0.16
)
 
77

 
(127
)
 
(50
)
Federal funds sold
34,988

 
0.25

 
45

 
58

 
103

 
$
183,773

 
 

 
$
3,496

 
$
(973
)
 
$
2,523

 
 
 
 
 
 
 
 
 
 
Interest expense:
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
$
46,611

 
 %
 
$
(37
)
 
$
(4
)
 
$
(41
)
Savings deposits
72,488

 
0.04

 
(71
)
 
(117
)
 
(188
)
Time deposits
(59,162
)
 
(0.13
)
 
383

 
295

 
678

Other borrowings
(914
)
 
0.79

 
(4
)
 
(6
)
 
(10
)
FHLB borrowings
97,093

 
(0.64
)
 
(2,086
)
 
758

 
(1,328
)
Interest-bearing other liabilities
(4,517
)
 
(0.03
)
 
13

 
(1
)
 
12

 
$
151,599

 
 

 
$
(1,802
)
 
$
925

 
$
(877
)
Change in net interest income
 

 
 

 
$
1,694

 
$
(48
)
 
$
1,646


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

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

(Tax Equivalent Basis)
 
2016
 
2015
Yield on average interest-earning assets
 
4.06
%
 
4.19
%
Rate on average interest-bearing liabilities
 
0.86

 
0.84

Net interest spread
 
3.20
%
 
3.35
%
Effect of noninterest-bearing funds
 
0.19

 
0.18

Net interest margin (tax equivalent interest income divided by average interest-earning assets)
 
3.39
%
 
3.53
%

Page 46


HILLS BANCORPORATION

Discussion of operations for the six months ended June 30, 2016 and 2015

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates.  The Federal Open Market Committee met four times during the first six months of 2016.  The target rate remains unchanged since December, 2015 at 0.50%.  Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate.  As of June 30, 2016, the rate indexes for the one, three and five year indexes were 0.45%, 0.71% and 1.01%, respectively.  The one year index increased 155.17% from 0.29% at June 30, 2015, the three year index decreased 33.65% and the five year index decreased 40.94%.  The three year index was 1.07% and the five year index was 1.71% at June 30, 2015.  The targeted federal funds rate was 0.50% and 0.25% at June 30, 2016 and 2015, respectively.  The Company anticipates possible increases in short term and long term rates in the indexes for 2016.

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $0.17 million for the six months ended June 30, 2016 compared to an expense of $0.46 million in 2015, an expense decrease of $0.63 million.  The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio.  The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio.  The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more.  In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks.  The decrease in expense in 2016 is the net result of an increase in net loans, the effects of loan recoveries in 2016, a change in the composition and allocation of loans within credit quality ratings, and a specific allowance recorded for a $16.22 agricultural and farmland real estate loan relationship.

The allowance for loan losses increased $0.78 million during the first six months of 2016.  In the first six months of 2016, there was an increase of $0.21 million due to the volume and composition of loans outstanding and a $0.57 million increase in the amount allocated to the allowance due to credit quality.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented.  For the six months ended June 30, 2016 and 2015, recoveries were $1.99 million and $3.04 million, respectively; and charge-offs were $1.04 million in 2016 and $1.72 million in 2015.  The allowance for loan losses totaled $27.29 million at June 30, 2016 compared to $26.51 million at December 31, 2015.  The allowance represented 1.26% and 1.25% of loans held for investment at June 30, 2016 and December 31, 2015.

Page 47


HILLS BANCORPORATION



Discussion of operations for the six months ended June 30, 2016 and 2015

Noninterest Income

The following table sets forth the various categories of noninterest income for the six months ended June 30, 2016 and 2015.

 
Six Months Ended June 30,
 
 
 
 
 
2016
 
2015
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Net gain on sale of loans
$
835

 
$
748

 
$
87

 
11.63
 %
Trust fees
3,454

 
3,248

 
206

 
6.34

Service charges and fees
4,273

 
4,027

 
246

 
6.11

Rental revenue on tax credit real estate

 
904

 
(904
)
 
(100.00
)
Net gain on sale of other real estate owned and other repossessed assets
34

 
117

 
(83
)
 
(70.94
)
Other noninterest income
1,145

 
1,452

 
(307
)
 
(21.14
)
 
$
9,741

 
$
10,496

 
$
(755
)
 
(7.19
)

Loans originated for sale in the first six months of 2016 totaled $89.29 million compared to $90.67 million in the same period in 2015, a decrease of 1.52%.  In the six months ended June 30, 2016 and 2015, the net gain on sale of loans was $0.84 million and $0.75 million, respectively.  The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly.  The volume of activity in these types of loans is directly related to the level of interest rates.  The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income.  The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

The Company adopted ASU 2015-02 for the period ending March 31, 2016 and have changed the accounting for its tax credit limited partnership investments to the equity method. As a result the Company no longer records rental revenue on tax credit real estate as of June 30, 2016. The Company recorded net income from its investments in tax credit partnerships of $(0.02) million as of June 30, 2016.

The net gain on sale of other real estate owned and other repossessed assets decreased $0.08 million to a net gain of $0.03 million for the six months ended June 30, 2016.  The total net gain on sale of other real estate owned for the six months ended consisted of a $0.03 million net gain on the sale of five properties. During the same period in 2015, the gain consisted of a $0.16 million net gain on sale of eight properties offset by a $0.04 million fair market value adjustment on three properties.

Trust fees increased $0.21 million in the six months ended June 30, 2016 compared to June 30, 2015 due to new trust relationships.


Page 48


HILLS BANCORPORATION

Discussion of operations for the six months ended June 30, 2016 and 2015

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the six months ended June 30, 2016 and 2015.

 
Six Months Ended June 30,
 
 
 
 
 
2016
 
2015
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Salaries and employee benefits
$
14,459

 
$
13,575

 
$
884

 
6.51
 %
Occupancy
1,984

 
1,968

 
16

 
0.81

Furniture and equipment
2,761

 
2,607

 
154

 
5.91

Office supplies and postage
846

 
854

 
(8
)
 
(0.94
)
Advertising and business development
1,626

 
1,693

 
(67
)
 
(3.96
)
Outside services
3,541

 
3,433

 
108

 
3.15

Rental expenses on tax credit real estate

 
1,161

 
(1,161
)
 
(100.00
)
FDIC insurance assessment
623

 
573

 
50

 
8.73

Other noninterest expense
1,075

 
839

 
236

 
28.13

 
$
26,915

 
$
26,703

 
$
212

 
0.79


In the six months ended June 30, 2016 and 2015, salaries and employee benefits expense increased $0.88 million. The increase is primarily the result of annual salary adjustments and additional employees. Other noninterest expense categories experienced marginal period-to-period fluctuations for the six months ended June 30, 2016.

The Company adopted ASU 2015-02 for the period ending March 31, 2016 and have changed the accounting for its tax credit limited partnership investments to the equity method. As a result the Company no longer records rental expenses on tax credit real estate as of June 30, 2016.

Discussion of operations for the three months ended June 30, 2016 and 2015

Net Income Overview

Net income increased $0.50 million for the three months ended June 30, 2016 compared to the same period in 2015.  Total net income was $7.97 million in 2016 and $7.47 million in the comparable period in 2015, an increase of 6.65%.  For the three month period ended June 30, 2016 and June 30, 2015 basic earning per share was $0.86 and $0.80, respectively. Diluted earnings per share was $0.85 for the three months ended June 30, 2016 compared to $0.80 for the same period in 2015.

Net Interest Income

Net interest income increased for the three months ended June 30, 2016 compared to the comparable period in 2015.  The increase was primarily the result of growth in the volume of earning assets.  Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities.  The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin.  The net interest margin for the three months ended June 30, 2016 was 3.38% compared to 3.57% in 2015 for the same period.  The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable.  The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2016 compared to the comparable period in 2015 are shown in the following table:




Page 49


HILLS BANCORPORATION

 
 
 
 
 
Increase (Decrease) in Net Interest Income
 
Change in
Average Balance
 
Change in
Average Rate
 
Volume Changes
 
Rate Changes
 
Net Change
 
(Amounts in Thousands)
Interest income:
 
 
 
 
 
 
 
 
 
Loans, net
$
145,988

 
(0.13
)%
 
$
1,573

 
$
(670
)
 
$
903

Taxable securities
1,094

 
0.24

 
20

 
42

 
62

Nontaxable securities
4,820

 
(0.17
)
 
39

 
(65
)
 
(26
)
Federal funds sold
43,835

 
0.25

 
28

 
36

 
64

 
$
195,737

 
 

 
$
1,660

 
$
(657
)
 
$
1,003

 
 
 
 
 
 
 
 
 
 
Interest expense:
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
$
48,997

 
 %
 
$
(18
)
 
$

 
$
(18
)
Savings deposits
83,151

 
0.04

 
(39
)
 
(62
)
 
(101
)
Time deposits
(60,457
)
 
(0.11
)
 
201

 
124

 
325

Short-term borrowings
(1,783
)
 
(0.04
)
 
5

 
2

 
7

FHLB borrowings
97,500

 
(0.63
)
 
(1,032
)
 
382

 
(650
)
Interest-bearing other liabilities
(4,687
)
 
(1.18
)
 
8

 

 
8

 
$
162,721

 
 
 
$
(875
)
 
$
446

 
$
(429
)
Change in net interest income
 

 
 

 
$
785

 
$
(211
)
 
$
574


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



Page 50


HILLS BANCORPORATION

Discussion of operations for the three months ended June 30, 2016 and 2015

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

(Tax Equivalent Basis)
 
2016
 
2015
Yield on average interest-earning assets
 
4.04
%
 
4.21
%
Rate on average interest-bearing liabilities
 
0.85

 
0.83

Net interest spread
 
3.19
%
 
3.38
%
Effect of noninterest-bearing funds
 
0.19

 
0.19

Net interest margin (tax equivalent interest income divided by average interest-earning assets)
 
3.38
%
 
3.57
%

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $0.72 million for the three months ended June 30, 2016 compared to an expense of $0.52 million million in 2015, an expense decrease of $1.24 million. The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio.  The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio.  The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more.  In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks. 
 
The allowance for loan losses increased $0.16 million during the three months ended June 30, 2016.  In the three months ended June 30, 2016, there was a $0.16 million increase in the amount allocated to the allowance due to credit quality.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented.  For the three months ended June 30, 2016 and 2015, recoveries were $1.28 million and $1.87 million, respectively; and charge-offs were $0.40 million in 2016 and $0.95 million in 2015.  The allowance for loan losses totaled $27.29 million at June 30, 2016 compared to $26.51 million at December 31, 2015.  The allowance represented 1.26% and 1.25% of loans held for investment at June 30, 2016 and December 31, 2015, respectively.





Page 51


HILLS BANCORPORATION

Discussion of operations for the three months ended June 30, 2016 and 2015

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended June 30, 2016 and 2015.

 
Three Months Ended June 30,
 
 
 
 
 
2016
 
2015
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Net gain on sale of loans
$
546

 
$
440

 
$
106

 
24.09
 %
Trust fees
1,726

 
1,679

 
47

 
2.80

Service charges and fees
2,218

 
2,081

 
137

 
6.58

Rental revenue on tax credit real estate

 
393

 
(393
)
 
(100.00
)
Net gain on sale of other real estate owned and other repossessed assets

 
110

 
(110
)
 
(100.00
)
Other noninterest income
378

 
803

 
(425
)
 
(52.93
)
 
$
4,868

 
$
5,506

 
$
(638
)
 
(11.59
)

In the three months ended June 30, 2016 and 2015, the net gain on sale of loans was $0.55 million and $0.44 million , respectively.  The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly.  The volume of activity in these types of loans is directly related to the level of interest rates.  The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income.  The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

Trust fees increased $0.05 million in the three months ended June 30, 2016 compared to June 30, 2015 due to new trust relationships.

The Company adopted ASU 2015-02 for the period ending March 31, 2016 and have changed the accounting for its tax credit limited partnership investments to the equity method. As a result the Company no longer records rental revenue on tax credit real estate as of June 30, 2016. The Company recorded net income from its investments in tax credit partnerships of $(0.02) million as of June 30, 2016.

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended June 30, 2016 and 2015.

 
Three Months Ended 
 June 30,
 
 
 
 
 
2016
 
2015
 
$ Change
 
% Change
 
(Amounts in thousands)
 
 
 
 
Salaries and employee benefits
$
7,475

 
$
6,924

 
$
551

 
7.96
 %
Occupancy
983

 
953

 
30

 
3.15

Furniture and equipment
1,357

 
1,309

 
48

 
3.67

Office supplies and postage
445

 
413

 
32

 
8

Advertising and business development
840

 
919

 
(79
)
 
(8.60
)
Outside services
1,765

 
1,619

 
146

 
9.02

Rental expenses on tax credit real estate

 
559

 
(559
)
 
(100.00
)
FDIC insurance assessment
320

 
284

 
36

 
12.68

Other noninterest expense
678

 
524

 
154

 
29.39

 
$
13,863

 
$
13,504

 
$
359

 
2.66



Page 52


HILLS BANCORPORATION

In the three months ended June 30, 2016 and 2015, salaries and employee benefits expense increased $0.55 million. The increase is primarily the result of annual salary adjustments and additional employees. Other noninterest expense categories experienced marginal period-to-period increases for the three months ended June 30, 2016.

The Company adopted ASU 2015-02 for the period ending March 31, 2016 and have changed the accounting for its tax credit limited partnership investments to the equity method. As a result the Company no longer records rental expenses on tax credit real estate as of June 30, 2016.

Income Taxes

Federal and state income tax expenses were $3.73 million and $3.38 million for the three months ended June 30, 2016 and 2015, respectively.  Income taxes as a percentage of income before taxes were 31.87% in 2016 and 31.17% in 2015.

Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs.  Federal funds sold and investment securities available for sale are readily marketable assets.  Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position.  Investment securities available for sale comprised 9.84% of the Company’s total assets at June 30, 2016 compared to 10.60% at December 31, 2015.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position.  As of June 30, 2016, the Company had borrowed $240.00 million from the Federal Home Loan Bank (“FHLB”) of Des Moines.  Advances are used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk.  The Company had additional borrowing capacity available from the FHLB of approximately $405.83 million at June 30, 2016.

As additional sources of liquidity, the Company has the ability to borrow up to $10.00 million from the Federal Reserve Bank of Chicago, and has lines of credit with three banks totaling $213.34 million.  The borrowings under these credit lines would be secured by the Bank’s investment securities.  The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at June 30, 2016.

As of June 30, 2016, investment securities with a carrying value of $70.16 million were pledged to collateralize public and trust deposits, repurchase agreements, derivative financial instruments, and other borrowings.  As of December 31, 2015, investment securities with a carrying value of $69.52 million were pledged.

Contractual Obligations

There have been no material changes with regard to contractual obligations disclosed in the Company’s Form 10-K for the year ended December 31, 2015.


Page 53


HILLS BANCORPORATION

Item 3.
Quantitative and Qualitative Disclosures about Market Risk

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

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

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

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

The Bank's interest rate risk, as monitored by management, has not changed materially from December 31, 2015.

Item 4.
Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission.  There have been no changes in the Company’s internal controls over financial reporting during the six months ended June 30, 2016 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.


Page 54


HILLS BANCORPORATION
PART II - OTHER INFORMATION

Item 1.
Legal Proceedings

None
Item 1A.
Risk Factors
 
There have been no material changes from the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2015.
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended June 30, 2016:

Period
Total number of shares
purchased
Average price paid per
share
Total number of
shares purchased
as part of publicly
announced plans
or programs
Maximum number
of shares that may
yet be purchased
under the plans
or programs (1)
April 1 to April 30
1,598

$
45.00

1,598

585,561

May 1 to May 31
6,490

45.46

6,490

579,071

June 1 to June 30
5,339

45.50

5,339

573,732

Total
13,427

$
44.79

13,427

573,732

 
(1)  On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 1,500,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”).  The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2017.  The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis.  All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis.  The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors. 

During the first six months of 2016, the Company issued 5,660 shares of restricted stock under the 2010 Stock Option and Incentive Plan.  The restricted shares were issued to officers of the company for no cash consideration and will vest over a five-year period from the date of grant.  The issuance of these shares was exempt from the registration requirements of the SEC pursuant to Section 4(a)(2) of the Securities Act of 1933.

Item 3.
Defaults upon Senior Securities
 
Hills Bancorporation has no senior securities.

Item 4.
Mine Safety Disclosure
 
Not applicable.

Page 55


Item 5.
Other Information

None

Item 6.
Exhibits

3.1
Restated Articles of Incorporation, incorporated by reference to Exhibit 3.1 to the Company's Form 10-Q Filed with the Commission on May 6, 2015.
3.2
Amended and Restated Bylaws, incorporated by reference to Exhibit 3.2 to the Company's Form 10-K Filed with the Commission on March 11, 2015.
31
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
32
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
101.INS
XBRL Instance Document (1)
101.SCH
XBRL Taxonomy Extension Schema Document (1)
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document (1)
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document (1)
101.LAB
XBRL Taxonomy Extension Label Linkbase Document (1)
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document (1)
(1)
Users of this data are advised that, pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934, and are otherwise not subject to liability under these sections.

Page 56


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

 
 
 
HILLS BANCORPORATION
 
 
 
 
Date:
August 4, 2016
 
By:  /s/ Dwight O. Seegmiller
 
 
 
Dwight O. Seegmiller, Director, President and Chief Executive Officer
 
 
 
 
Date:
August 4, 2016
 
By:  /s/ Shari DeMaris
 
 
 
Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer


Page 57


HILLS BANCORPORATION
QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED JUNE 30, 2016
Exhibit
Number
Description
Page Number In The Sequential
Numbering System
June 30, 2016 Form 10-Q
 
 
 
31
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
59-60

 
 
 
32
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
61



Page 58