HBIA 10-Q Quarterly Report Sept. 30, 2012 | Alphaminr
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HBIA 10-Q Quarter ended Sept. 30, 2012

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Income Statement
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10-Q 1 form10q.htm HILLS BANCORPORATION 10-Q 9-30-2012 form10q.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 September 30, 2012

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
At October 31, 2012
Common Stock, no par value
4,742,954
HILLS BANCORPORATION
Part I
FINANCIAL INFORMATION
Page
Number
Item 1.
Financial Statements
3
4
5
6
7
9
Item 2.
34
Item 3.
51
Item 4.
51
Part II
OTHER INFORMATION
Item 1.
52
Item 1A.
52
Item 2.
52
Item 3.
52
Item 4.
52
Item 5.
52
Item 6.
53
54
55

Page 2


ASSETS
September 30, 2012
(Unaudited)
December 31, 2011
Cash and cash equivalents
$ 79,851 $ 29,291
Investment securities available for sale at fair value (amortized cost September 30, 2012 $212,601; December 31, 2011 $203,312)
219,774 211,367
Stock of Federal Home Loan Bank
8,960 10,728
Loans held for sale
16,003 24,615
Loans, net of allowance for loan losses (September 30, 2012 $26,170; December 31, 2011 $30,150)
1,663,195 1,661,916
Property and equipment, net
30,928 30,321
Tax credit real estate
19,193 20,130
Accrued interest receivable
9,114 8,689
Deferred income taxes, net
7,339 8,531
Other real estate
1,121 1,327
Goodwill
2,500 2,500
Prepaid FDIC insurance
3,185 3,879
Other assets
5,868 5,003
$ 2,067,031 $ 2,018,297
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Noninterest-bearing deposits
$ 234,785 $ 223,378
Interest-bearing deposits
1,372,366 1,302,099
Total deposits
$ 1,607,151 $ 1,525,477
Short-term borrowings
45,076 52,785
Federal Home Loan Bank borrowings
145,000 185,000
Accrued interest payable
1,437 1,625
Other liabilities
17,424 17,155
$ 1,816,088 $ 1,782,042
Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)
$ 29,598 $ 27,826
STOCKHOLDERS' EQUITY
Capital stock, no par value; authorized 10,000,000 shares; issued September 30, 2012 5,059,980 shares; December 31, 2011 5,051,901 shares
$ - $ -
Paid in capital
41,965 41,467
Retained earnings
224,264 207,790
Accumulated other comprehensive income
4,429 4,974
Unearned ESOP shares
(2,017 ) (2,017 )
Treasury stock at cost (September 30, 2012 318,073 shares; December 31, 2011 292,083 shares)
(17,698 ) (15,959 )
$ 250,943 $ 236,255
Less maximum cash obligation related to ESOP shares
29,598 27,826
$ 221,345 $ 208,429
$ 2,067,031 $ 2,018,297

See Notes to Consolidated Financial Statements.
Page 3

Three Months Ended September 30,
Nine Months Ended September 30,
2012
2011
2012
2011
Interest income:
Loans, including fees
$ 20,907 $ 21,977 $ 63,291 $ 65,084
Investment securities:
Taxable
460 692 1,535 2,182
Nontaxable
857 863 2,544 2,588
Federal funds sold
32 1 90 66
Total interest income
$ 22,256 $ 23,533 $ 67,460 $ 69,920
Interest expense:
Deposits
$ 3,396 $ 3,838 $ 10,493 $ 12,292
Short-term borrowings
61 109 156 305
FHLB borrowings
1,983 2,012 5,963 5,983
Total interest expense
$ 5,440 $ 5,959 $ 16,612 $ 18,580
Net interest income
$ 16,816 $ 17,574 $ 50,848 $ 51,340
Provision for loan losses
(608 ) 1,561 (2,900 ) 2,760
Net interest income after provision for loan losses
$ 17,424 $ 16,013 $ 53,748 $ 48,580
Other income:
Net gain on sale of loans
$ 1,023 $ 546 $ 2,589 $ 1,199
Trust fees
1,160 1,114 3,450 3,309
Service charges and fees
1,970 1,937 5,802 5,669
Rental revenue on tax credit real estate
397 397 1,189 1,075
Net gain on sale of other real estate owned and other repossessed assets
163 119 604 504
Other noninterest income
608 580 1,880 1,985
$ 5,321 $ 4,693 $ 15,514 $ 13,741
Other expenses:
Salaries and employee benefits
$ 5,782 $ 5,532 $ 17,725 $ 16,616
Occupancy
773 809 2,469 2,464
Furniture and equipment
1,183 957 3,477 2,739
Office supplies and postage
427 308 1,145 962
Advertising and business development
608 402 1,705 1,178
Outside services
1,689 1,829 5,026 5,052
Rental expenses on tax credit real estate
560 648 1,774 1,530
FDIC insurance assessment
259 267 784 1,053
Loss on extinguishment of debt - Federal Home Loan Bank borrowings
3,544 - 3,544 -
Other noninterest expense
447 392 1,382 1,130
$ 15,272 $ 11,144 $ 39,031 $ 32,724
Income before income taxes
$ 7,473 $ 9,562 $ 30,231 $ 29,597
Income taxes
1,971 2,753 8,759 8,657
Net income
$ 5,502 $ 6,809 $ 21,472 $ 20,940
Earnings per share:
Basic
$ 1.16 $ 1.55 $ 4.52 $ 4.77
Diluted
$ 1.16 $ 1.55 $ 4.51 $ 4.76

See Notes to Consolidated Financial Statements.
Page 4

Three Months Ended September 30,
Nine Months Ended September 30,
2012
2011
2012
2011
Net income
$ 5,502 $ 6,809 $ 21,472 $ 20,940
Other comprehensive income (loss), before tax:
Unrealized holding gains (losses) arising during the period
152 1,589 (876 ) 3,612
Less:  reclassification adjustments for gains included in net income
- (29 ) (6 ) (29 )
Other comprehensive income (loss), before tax:
$ 152 $ 1,560 $ (882 ) $ 3,583
Tax (expense) benefit related to other comprehensive income
(58 ) (597 ) 337 (1,371 )
Other comprehensive income (loss), net of tax
$ 94 $ 963 $ (545 ) $ 2,212
Comprehensive income
$ 5,596 $ 7,772 $ 20,927 $ 23,152

See Notes to Consolidated Financial Statements.
Page 5
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, 2010
$ 14,875 $ 185,412 $ 2,781 $ - $ (11,854 ) $ (24,945 ) $ 166,269
Issuance of 176,639 shares of common stock
11,012 - - - - - 11,012
Forfeiture of 905 shares of common stock
(48 ) - - - - - (48 )
Share-based compensation
12 - - - - - 12
Income tax benefit related to share-based compensation
49 - - - - - 49
Change related to ESOP shares
- - - - - (1,802 ) (1,802 )
Net income
- 20,940 - - - - 20,940
Cash dividends ($1.00 per share)
- (4,399 ) - - - - (4,399 )
Purchase of 61,182 shares of common stock
- - - - (3,805 ) - (3,805 )
Other comprehensive income
- - 2,212 - - - 2,212
Balance, September 30, 2011
$ 25,900 $ 201,953 $ 4,993 $ - $ (15,659 ) $ (26,747 ) $ 190,440
Balance, December 31, 2011
$ 41,467 $ 207,790 $ 4,974 $ (2,017 ) $ (15,959 ) $ (27,826 ) $ 208,429
Issuance of 8,797 shares of common stock
488 - - - - - 488
Forfeiture of 718 shares of common stock
(41 ) - - - - - (41 )
Share-based compensation
13 - - - - - 13
Income tax benefit related to share-based compensation
38 - - - - - 38
Change related to ESOP shares
- - - - - (1,772 ) (1,772 )
Net income
- 21,472 - - - - 21,472
Cash dividends ($1.05 per share)
- (4,998 ) - - - - (4,998 )
Purchase of 25,990 shares of common stock
- - - - (1,739 ) - (1,739 )
Other comprehensive loss
- - (545 ) - - - (545 )
Balance, September 30, 2012
$ 41,965 $ 224,264 $ 4,429 $ (2,017 ) $ (17,698 ) $ (29,598 ) $ 221,345

See Notes to Consolidated Financial Statements.
Page 6

Nine Months Ended September 30,
2012
2011
Cash Flows from Operating Activities
Net income
$ 21,472 $ 20,940
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation
2,149 1,862
Provision for loan losses
(2,900 ) 2,760
Net gain on sale of investment securities
(6 ) (29 )
Share-based compensation
13 12
Forfeiture of common stock
(41 ) (48 )
Compensation expensed through issuance of common stock
400 364
Excess tax benefits from share-based compensation
(38 ) (49 )
Provision for deferred income taxes
1,529 (338 )
Net gain on sale of other real estate owned and other repossessed assets
(604 ) (504 )
Increase in accrued interest receivable
(425 ) (700 )
Amortization of discount on investment securities, net
747 723
Decrease in prepaid FDIC insurance
694 957
Increase in other assets
(827 ) (1,206 )
Increase in accrued interest payable and other liabilities
81 6,193
Loans originated for sale
(235,155 ) (109,364 )
Proceeds on sales of loans
246,356 98,458
Net gain on sales of loans
(2,589 ) (1,199 )
Net cash and cash equivalents provided by operating activities
$ 30,856 $ 18,832
Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale
$ 43,126 $ 36,124
Proceeds from sales of investment securities available for sale
246 529
Purchases of investment securities available for sale
(51,634 ) (45,505 )
Loans made to customers, net of collections
(45 ) (80,975 )
Proceeds on sale of other real estate owned and other repossessed assets
2,476 2,731
Purchases of property and equipment
(2,756 ) (3,288 )
Investment in tax credit real estate, net
937 966
Net cash and cash equivalents used in investing activities
$ (7,650 ) $ (89,418 )
Cash Flows from Financing Activities
Net increase in deposits
$ 81,674 $ 44,549
Net decrease in short-term borrowings
(7,709 ) (1,618 )
Issuance of common stock
- 10,569
Stock options exercised
88 79
Excess tax benefits related to share-based compensation
38 49
Payments on FHLB borrowings
(40,000 ) (10,000 )
Purchase of treasury stock
(1,739 ) (3,805 )
Dividends paid
(4,998 ) (4,399 )
Net cash and cash equivalents provided by financing activities
$ 27,354 $ 35,424
(Continued)

Page 7

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)
Nine Months Ended September 30,
2012
2011
Increase (decrease) in cash and cash equivalents
$ 50,560 $ (35,162 )
Cash and cash equivalents:
Beginning of year
29,291 62,978
End of period
$ 79,851 $ 27,816
Supplemental Disclosures
Cash payments for:
Interest paid to depositors
$ 10,681 $ 12,671
Interest paid on other obligations
6,119 6,288
Income taxes paid
8,208 8,234
Noncash activities:
Increase in maximum cash obligation related to ESOP shares
$ 1,772 $ 1,802
Transfers to other real estate owned
1,666 1,972

See Notes to Consolidated Financial Statements.
Page 8
HILLS BANCORPORATION
(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 may be reclassified to conform to the current year presentation.  The Company considers that it operates as one business segment, a commercial bank.

Operating results for the nine month period ended September 30, 2012 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2012.  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, 2011 filed with the Securities Exchange Commission on March 9, 2012.

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

Recently Adopted Accounting Standards:

In April 2011, the FASB issued new standards that revised the determination of when the restructuring of a receivable should be considered a troubled debt restructuring (“TDR”).  The standard provides additional guidance for determining whether the debtor is experiencing financial difficulty.  The new standard became effective for the Company beginning July 1, 2011.  The adoption did not have a material impact on the Company’s financial position.

Also in April 2011, the FASB issued a new standard that changes the assessment of effective control of a transferor when determining whether repurchase agreements are accounted for as a secured borrowing or sale.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.

In May 2011, the FASB issued a new standard that provides guidance about how fair value should be determined where it already is required or permitted under international financial reporting standards (“IFRS”) or accounting principles generally accepted in the United States (“GAAP”).  For GAAP, most of the changes were clarifications of existing guidance or wording changes to align with IFRS.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.  The Company added additional disclosure requirements to Note 6: Fair Value Measurements.

In September 2011, the FASB issued a new standard that permits the Company to make a qualitative assessment of whether it is more likely than not that the fair value of the portion of the Company to which goodwill relates is less than its carrying amount before applying the two-step goodwill impairment test.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.

In June 2011 and December 2011, the FASB issued standards regarding the presentation of comprehensive income in the consolidated financial statements.  The new standard became effective for the Company beginning January 1, 2012.  The adoption did not have a material impact on the Company’s financial position.  The Company now presents comprehensive income in a separate statement of comprehensive income.

Page 9

HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1.
Summary of Significant Accounting Policies (continued)

Recently Issued Accounting Standards:

In July 2012, the FASB issued a new standard which permits an entity to make a qualitative assessment to determine whether it is more likely than not that an indefinite-lived intangible asset, other than goodwill, is impaired.  This accounting standard was subsequently codified into ASC Topic 350.  Under the new standard, if an entity concludes, based on an evaluation of all relevant qualitative factors, that it is not more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount, it will not be required to perform the quantitative impairment test for that asset.  The standard is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted.  The adoption of this standard is not expected to have a material impact on the consolidated financial statements.

Note 2.
Earnings Per Share

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

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

Three months Ended September 30,
Nine Months Ended September 30,
2012
2011
2012
2011
Common shares outstanding at the beginning of the period
4,746,393 4,358,392 4,759,818 4,398,337
Weighted average number of net shares (redeemed) issued
(4,818 ) 23,248 (9,203 ) (11,985 )
Weighted average shares outstanding (basic)
4,741,575 4,381,640 4,750,615 4,386,352
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method
6,777 10,705 6,954 10,773
Weighted average number of shares (diluted)
4,748,352 4,392,345 4,757,569 4,397,125
Net income (In thousands)
$ 5,502 $ 6,809 $ 21,472 $ 20,940
Earnings per share:
Basic
$ 1.16 $ 1.55 $ 4.52 $ 4.77
Diluted
$ 1.16 $ 1.55 $ 4.51 $ 4.76
Page 10
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 3.
Other Comprehensive Income

The following table summarizes the changes in the balances of each component of accumulated other comprehensive income (loss) for the three months and nine months ended September 30, 2012 and 2011 (in thousands):

Three Months Ended September 30, 2012
Nine Months Ended September 30, 2012
Unrealized Gains
on Securities
Accumulated Other
Comprehensive
Income
Unrealized Gains on
Securities
Accumulated Other
Comprehensive
Income
Balance at the beginning of the period
$ 4,335 $ 4,335 $ 4,974 $ 4,974
Current period, other comprehensive income (loss)
94 94 (545 ) (545 )
Balance September 30, 2012
$ 4,429 $ 4,429 $ 4,429 $ 4,429

Three Months Ended September 30, 2011
Nine Months Ended September 30, 2011
Unrealized Gains
on Securities
Accumulated Other
Comprehensive
Income
Unrealized Gains on
S ecurities
Accumulated Other
Comprehensive
Income
Balance at the beginning of the period
$ 4,030 $ 4,030 $ 2,781 $ 2,781
Current period, other comprehensive income
963 963 2,212 2,212
Balance September 30, 2011
$ 4,993 $ 4,993 $ 4,993 $ 4,993
The following tables show the tax effects allocated to each component of other comprehensive income (loss) for the three and nine months ended September 30, 2012 and 2011 (in thousands) :

Three Months Ended September 30, 2012
Nine Months Ended September 30, 2012
Before Tax
Amount
Tax
(Expense)
Benefit
Net of Tax
Amount
Before Tax
Amount
Tax
(Expense)
Benefit
Net of Tax
Amount
Unrealized gains on securities:
Unrealized holding gains (losses) arising during period
$ 152 $ (58 ) $ 94 $ (876 ) $ 335 $ (541 )
Less: reclassification adjustment for gains realized in net income
- - - 6 (2 ) 4
Other comprehensive income (loss)
$ 152 $ (58 ) $ 94 $ (882 ) $ 337 $ (545 )

Three Months Ended September 30, 2011
Nine Months Ended September 30, 2011
Before Tax
Amount
Tax
(Expense)
Benefit
Net of Tax
Amount
Before Tax
Amount
Tax
(Expense)
Benefit
Net of Tax
Amount
Unrealized gains on securities:
Unrealized holding gains (losses) arising during period
$ 1,589 $ (608 ) $ 981 $ 3,612 $ (1,382 ) $ 2,230
Less: reclassification adjustment for gains realized in net income
29 (11 ) 18 29 (11 ) 18
Other comprehensive income (loss)
$ 1,560 $ (597 ) $ 963 $ 3,583 $ (1,371 ) $ 2,212

Page 11

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

Note 4.
Securities

The carrying values of investment securities at September 30, 2012 and December 31, 2011 are summarized in the following table (dollars in thousands):

September 30, 2012
December 31, 2011
Amount
Percent
Amount
Percent
Securities available for sale
Obligations of state and political subdivisions
$ 127,610 58.06 % $ 119,431 56.50 %
Other securities (FHLB, FHLMC and FNMA)
92,164 41.94 91,936 43.50
Total securities available for sale
$ 219,774 100.00 % $ 211,367 100.00 %
Investment securities have been classified in the consolidated balance sheets according to management’s intent.  Available-for-sale securities consist of debt securities not classified as trading or held to maturity.  Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity.  There were no trading or held to maturity securities as of September 30, 2012 or December 31, 2011. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of September 30, 2012 and December 31, 2011 (in thousands):

Amortized Cost
Gross
Unrealized
Gains
Gross
Unrealized
(Losses)
Estimated Fair
Value
September 30, 2012:
State and political subdivisions
$ 121,580 $ 6,099 $ (69 ) $ 127,610
Other securities (FHLB, FHLMC and FNMA)
91,021 1,157 (14 ) 92,164
Total
$ 212,601 $ 7,256 $ (83 ) $ 219,774
December 31, 2011:
State and political subdivisions
$ 112,959 $ 6,524 $ (52 ) $ 119,431
Other securities (FHLB, FHLMC and FNMA)
90,353 1,583 - 91,936
Total
$ 203,312 $ 8,107 $ (52 ) $ 211,367
Page 12
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 4.
Securities (continued)

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at September 30, 2012, were as follows (in thousands):

Amortized
Cost
Fair Value
Due in one year or less
$ 23,138 $ 23,403
Due after one year through five years
122,732 126,502
Due after five years through ten years
66,291 69,433
Due over ten years
440 436
Total
$ 212,601 $ 219,774
The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2012 and December 31, 2011 (in thousands):

Less than 12 months
12 months or more
Total
September 30, 2012
Unrealized
Unrealized
Unrealized
Description of Securities
#
Fair Value
Loss
%
#
Fair Value
Loss
%
#
Fair Value
Loss
%
State and political subdivisions
29 $ 5,744 $ (50 ) 0.87 % 2 $ 481 $ (19 ) 3.95 % 31 $ 6,225 $ (69 ) 1.11 %
Other securities (FHLB, FHLMC and FNMA)
5 14,369 (14 ) 0.10 % - - - - 5 14,369 (14 ) 0.10 %
Total temporarily impaired securities
34 $ 20,113 $ (64 ) 0.32 % 2 $ 481 $ (19 ) 3.95 % 36 $ 20,594 $ (83 ) 0.40 %
Less than 12 months
12 months or more
Total
December 31, 2011
Unrealized
Unrealized
Unrealized
Description of Securities
#
Fair Value
Loss
%
#
Fair Value
Loss
%
#
Fair Value
Loss
%
State and political subdivisions
2 $ 409 $ (3 ) 0.73 % 2 $ 453 $ (49 ) 10.82 % 4 $ 862 $ (52 ) 6.03 %
Other securities (FHLB, FHLMC and FNMA)
- - - 0.00 % - - - - - - - 0.00 %
Total temporarily impaired securities
2 $ 409 $ (3 ) 0.73 % 2 $ 453 $ (49 ) 10.82 % 4 $ 862 $ (52 ) 6.03 %
The Company considered the following information in reaching the conclusion that the impairments disclosed in the table above are temporary and not other-than-temporary impairments.  The state and political subdivision securities with gross unrealized losses greater than twelve months as of September 30, 2012 included two issues.  The two securities are municipal bonds which are rated Ba2.  Bonds with a Ba2 rating are less than investment grade.   The aggregate fair value of these Ba2 rated bonds is $0.48 million while their amortized cost is $0.50 million, representing an unrealized loss of $0.02 million.  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 13
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)
Note 5.
Loans

Classes of loans are as follows:

September 30, 2012
December 31, 2011
(Amounts In Thousands)
Agricultural
$ 68,769 $ 68,556
Commercial and financial
142,888 143,174
Real estate:
Construction, 1 to 4 family residential
27,368 22,308
Construction, land development and commercial
79,370 84,508
Mortgage, farmland
102,457 99,799
Mortgage, 1 to 4 family first liens
585,577 577,881
Mortgage, 1 to 4 family junior liens
104,258 104,915
Mortgage, multi-family
217,737 222,851
Mortgage, commercial
308,690 316,329
Loans to individuals
19,117 20,598
Obligations of state and political subdivisions
33,134 31,147
$ 1,689,365 $ 1,692,066
Less allowance for loan losses
26,170 30,150
$ 1,663,195 $ 1,661,916
Page 14

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

Note 5.
Loans (continued)

Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the three and nine months ended September 30, 2012 were as follows:

Three Months Ended September 30, 2012
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
$ 1,607 $ 5,203 $ 4,104 $ 1,687 $ 8,271 $ 5,171 $ 627 $ 26,670
Charge-offs
- (162 ) (88 ) - (378 ) (3 ) (46 ) (677 )
Recoveries
10 461 8 - 155 99 52 785
Provision
287 (818 ) 8 (36 ) 89 (186 ) 48 (608 )
Ending balance
$ 1,904 $ 4,684 $ 4,032 $ 1,651 $ 8,137 $ 5,081 $ 681 $ 26,170

Nine Months Ended September 30, 2012
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
$ 1,354 $ 6,429 $ 4,994 $ 1,411 $ 9,051 $ 6,150 $ 761 $ 30,150
Charge-offs
- (991 ) (689 ) - (1,113 ) (214 ) (136 ) (3,143 )
Recoveries
43 1,156 15 - 409 225 215 2,063
Provision
507 (1,910 ) (288 ) 240 (210 ) (1,080 ) (159 ) (2,900 )
Ending balance
$ 1,904 $ 4,684 $ 4,032 $ 1,651 $ 8,137 $ 5,081 $ 681 $ 26,170
Ending balance, individually evaluated for impairment
$ 3 $ 24 $ 41 $ - $ 66 $ 82 $ - $ 216
Ending balance, collectively evaluated for impairment
$ 1,901 $ 4,660 $ 3,991 $ 1,651 $ 8,071 $ 4,999 $ 681 $ 25,954
Loans:
Ending balance
$ 68,769 $ 142,888 $ 106,738 $ 102,457 $ 689,835 $ 526,427 $ 52,251 $ 1,689,365
Ending balance, individually evaluated for impairment
$ 14 $ 3,012 $ 2,136 $ 810 $ 3,122 $ 19,921 $ - $ 29,015
Ending balance, collectively evaluated for impairment
$ 68,755 $ 139,876 $ 104,602 $ 101,647 $ 686,713 $ 506,506 $ 52,251 $ 1,660,350

Page 15
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

Changes in the allowance for loan losses for the three and nine months ended September 30, 2011 were as follows:
Three Months Ended September 30, 2011
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
c ommercial
Other
Total
(Amounts In Thousands)
Allowance for loan losses:
Beginning balance
$ 1,403 $ 6,634 $ 4,211 $ 1,429 $ 8,882 $ 5,877 $ 824 $ 29,260
Charge-offs
(81 ) (561 ) (205 ) - (518 ) (157 ) (44 ) (1,566 )
Recoveries
11 179 1 - 129 32 42 394
Provision
216 620 278 (8 ) 362 145 (51 ) 1,562
-
Ending balance
$ 1,549 $ 6,872 $ 4,285 $ 1,421 $ 8,855 $ 5,897 $ 771 $ 29,650

Nine Months Ended September 30, 2011
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
$ 2,170 $ 6,742 $ 4,394 $ 1,482 $ 7,952 $ 5,657 $ 833 $ 29,230
Charge-offs
(81 ) (1,668 ) (238 ) - (1,766 ) (216 ) (193 ) (4,162 )
Recoveries
34 642 8 - 726 252 160 1,822
Provision
(574 ) 1,156 121 (61 ) 1,943 204 (29 ) 2,760
Ending balance
$ 1,549 $ 6,872 $ 4,285 $ 1,421 $ 8,855 $ 5,897 $ 771 $ 29,650
Ending balance, individually evaluated for impairment
$ - $ 99 $ - $ 20 $ 64 $ 88 $ 1 $ 272
Ending balance, collectively evaluated for impairment
$ 1,549 $ 6,773 $ 4,285 $ 1,401 $ 8,791 $ 5,809 $ 770 $ 29,378
Loans:
Ending balance
$ 65,886 $ 148,686 $ 109,203 $ 94,840 $ 672,687 $ 523,823 $ 52,198 $ 1,667,323
Ending balance, individually evaluated for impairment
$ - $ 1,497 $ 1,452 $ 1,110 $ 4,387 $ 17,585 $ 3 $ 26,034
Ending balance, collectively evaluated for impairment
$ 65,886 $ 147,189 $ 107,751 $ 93,730 $ 668,300 $ 506,238 $ 52,195 $ 1,641,289

Page 16

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

Note 5.
Loans (continued)

The following table presents the credit quality indicators by type of loans in each category as of September 30, 2012 and December 31, 2011, respectively (amounts in thousands):

Agricultural
Commercial and
Financial
Real Estate:
Construction, 1 to 4
family residential
Real Estate:
Construction, land
development and
commercial
September 30, 2012
Grade:
Pass
$ 60,289 $ 117,617 $ 21,691 $ 61,935
Potential Watch
972 8,249 2,530 3,535
Watch
3,431 8,923 1,749 5,363
Substandard
4,077 8,099 1,398 8,537
Total
$ 68,769 $ 142,888 $ 27,368 $ 79,370

Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family first liens
Real Estate: Mortgage,
1 to 4 family junior
liens
Real Estate:
Mortgage, multi-
family
September 30, 2012
Grade:
Pass
$ 93,617 $ 520,636 $ 94,500 $ 177,871
Potential Watch
2,439 24,503 3,688 11,493
Watch
1,816 19,835 3,580 20,123
Substandard
4,585 20,603 2,490 8,250
Total
$ 102,457 $ 585,577 $ 104,258 $ 217,737

Real Estate:
Mortgage,
commercial
Loans to
individuals
Obligations of state and
political subdivisions
Total
September 30, 2012
Grade:
Pass
$ 259,856 $ 18,465 $ 32,044 $ 1,458,521
Potential Watch
12,388 181 - 69,978
Watch
27,392 324 1,090 93,626
Substandard
9,054 147 - 67,240
Total
$ 308,690 $ 19,117 $ 33,134 $ 1,689,365
Page 17
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

Agricultural
Commercial and
Financial
Real Estate:
Construction, 1 to 4
family residential
Real Estate:
Construction, land
development and
commercial
December 31, 2011
Grade:
Pass
$ 60,745 $ 116,234 $ 18,726 $ 60,279
Potential Watch
1,129 5,858 878 5,171
Watch
4,074 11,104 2,374 5,182
Substandard
2,608 9,978 330 13,876
Total
$ 68,556 $ 143,174 $ 22,308 $ 84,508
Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family first l iens
Real Estate: Mortgage,
1 to 4 family junior
liens
Real Estate:
Mortgage, multi-
family
December 31, 2011
Grade:
Pass
$ 93,447 $ 511,212 $ 93,761 $ 181,386
Potential Watch
1,393 20,532 3,021 12,561
Watch
2,490 20,706 4,667 19,317
Substandard
2,469 25,431 3,466 9,587
Total
$ 99,799 $ 577,881 $ 104,915 $ 222,851
Real Estate:
Mortgage,
commercial
Loans to
individuals
Obligations of state and
political subdivisions
Total
December 31, 2011
Grade:
Pass
$ 259,516 $ 19,914 $ 31,085 $ 1,446,305
Potential Watch
14,401 180 - 65,124
Watch
31,928 290 62 102,194
Substandard
10,484 214 - 78,443
Total
$ 316,329 $ 20,598 $ 31,147 $ 1,692,066

The below are descriptions of the credit quality indicators:

Pass – Pass rated loans are supported by sound payment capacity, are adequately collateralized and have no apparent weaknesses that would affect the full repayment of the loan under the established terms and conditions.

Potential Watch – Potential watch rated loans are supported by adequate payment capacity, are adequately collateralized and are performing according to the established terms and conditions.  However, the loan requires more than average monitoring due to a potential weakness.  The potential watch indicator assists the Company in identifying and monitoring loans for which credit quality could deteriorate.
Page 18

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

Note 5.
Loans (continued)

Watch – Watch rated loans are supported by a marginal payment capacity and may be marginally collateralized.  There are identified weaknesses that if not monitored and corrected may adversely affect the Company’s credit position.  A watch 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.

Past due loans as of September 30, 2012 and December 31, 2011 were as follows:

90 Days
Total
Accruing Loans
30 - 59 Days
60 - 89 Days
or More
Total Past
Loans
Past Due 90
Past Due
Past Due
Past Due
Due
Current
Receivable
Days or More
(Amounts In Thousands)
September 30, 2012
Agricultural
$ 215 $ - $ 13 $ 228 $ 68,541 $ 68,769 $ 13
Commercial and financial
211 555 213 979 141,909 142,888 28
Real estate:
Construction, 1 to 4 family residential
358 - - 358 27,010 27,368 -
Construction, land development and commercial
- - 419 419 78,951 79,370 332
Mortgage, farmland
- - 512 512 101,945 102,457 -
Mortgage, 1 to 4 family first liens
1,049 748 1,571 3,368 582,209 585,577 1,408
Mortgage, 1 to 4 family junior liens
537 - 53 590 103,668 104,258 53
Mortgage, multi-family
616 33 256 905 216,832 217,737 -
Mortgage, commercial
473 - 1,542 2,015 306,675 308,690 361
Loans to individuals
61 3 - 64 19,053 19,117 -
Obligations of state and political subdivisions
- - - - 33,134 33,134 -
$ 3,520 $ 1,339 $ 4,579 $ 9,438 $ 1,679,927 $ 1,689,365 $ 2,195
December 31, 2011:
Agricultural
$ 509 $ - $ 13 $ 522 $ 68,034 $ 68,556 $ 13
Commercial and financial
558 187 849 1,594 141,580 143,174 222
Real estate:
Construction, 1 to 4 family residential
367 - - 367 21,941 22,308 -
Construction, land development and commercial
164 719 327 1,210 83,298 84,508 14
Mortgage, farmland
752 - - 752 99,047 99,799 -
Mortgage, 1 to 4 family first liens
4,042 1,012 3,414 8,468 569,413 577,881 2,673
Mortgage, 1 to 4 family junior liens
454 353 396 1,203 103,712 104,915 105
Mortgage, multi-family
- - 267 267 222,584 222,851 -
Mortgage, commercial
838 755 718 2,311 314,018 316,329 185
Loans to individuals
38 21 - 59 20,539 20,598 -
Obligations of state and political subdivisions
2,834 - - 2,834 28,313 31,147 -
$ 10,556 $ 3,047 $ 5,984 $ 19,587 $ 1,672,479 $ 1,692,066 $ 3,212
The Company does not have a significant 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.
Page 19
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

The following table summarizes the Company’s impaired loans and non-performing assets at September 30, 2012 and December 31, 2011:
September 30, 2012
December 31, 2011
(Amounts In Thousands)
Non-accrual loans
$ 7,600 $ 7,378
Accruing loans past due 90 days or more (1)
2,195 3,212
TDR loans (2)
19,220 17,889
Total impaired loans
29,015 28,479
Other real estate
1,121 1,327
Non-performing assets (includes impaired loans and other real estate)
30,136 29,806
Loans held for investment
1,689,365 1,692,066
Ratio of allowance for loan losses to loans held for investment
1.55 % 1.78 %
Ratio of allowance for loan losses to impaired loans
90.19 105.87
Ratio of impaired loans to total loans held for investment
1.72 1.68
Ratio of non-performing assets to total assets
1.46 1.48

(1)
There were no TDR loans included within accruing loans past due 90 days or more as of September 30, 2012.  There were $0.26 million of TDR loans included within accruing loans past due 90 days or more as of December 31, 2011.
(2)
Total TDR loans were $21.91 million and $21.40 million as of September 30, 2012 and December 31, 2011, respectively.  Included in the total nonaccrual loans were $2.69 million and $3.25 million of TDR loans as of September 30, 2012 and December 31, 2011.

Certain impaired loan information by loan type at September 30, 2012 and December 31, 2011, was as follows:

September 30, 2012
December 31, 2011
Non-accrual
loans
Accruing loans
past due 90
days or more
TDR loans
Non-
accrual
loans
Accruing
loans past due
90 days or
more
TDR loans
(Amounts In Thousands)
(Amounts In Thousands)
Agricultural
$ - $ 14 $ - $ - $ 13 $ -
Commercial and financial
1,115 28 1,869 1,286 222 1,109
Real estate:
Construction, 1 to 4 family residential
- - - - - -
Construction, land development and commercial
1,804 332 - 648 14 -
Mortgage, farmland
512 - 298 556 - -
Mortgage, 1 to 4 family first liens
700 1,408 887 1,141 2,673 541
Mortgage, 1 to 4 family junior liens
19 52 56 291 105 50
Mortgage, multi-family
2,051 - 5,788 2,168 - 5,870
Mortgage, commercial
1,399 361 10,322 1,288 185 10,319
Loans to individuals
- - - - - -
$ 7,600 $ 2,195 $ 19,220 $ 7,378 $ 3,212 $ 17,889

Loans 90 days or more past due that are still accruing interest decreased $1.02 million from December 31, 2011 to September 30, 2012 due to an overall reduction in delinquency trends during the first nine months of 2012. The average 90 days or more past due loan balance was $88,000 as of September 30, 2012 and $80,000 as of December 31, 2011.  The loans 90 days or more past due and still accruing are believed to be adequately collateralized and the Company expects to collect all principal and interest as contractually due under these loans.
Page 20
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

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.

Below is a summary of information for TDR loans as of September 30, 2012 and December 31, 2011:

September 30, 2012
December 31, 2011
Number
Number
of
Recorded
Commitments
of
Recorded
Commitments
contracts
investment
outstanding
contracts
investment
outstanding
(Amounts In Thousands)
(Amounts In Thousands)
Agriculture
- $ - $ - - $ - $ -
Commercial and financial
11 1,895 89 9 1,802 108
Real estate:
Construction, 1 to 4 family residential
- - - - - -
Construction, land development and commercial
2 308 - 2 335 452
Mortgage, farmland
1 298 - - - -
Mortgage, 1 to 4 family first liens
8 1,146 - 7 801 -
Mortgage, 1 to 4 family junior liens
2 56 1 1 50 -
Mortgage, multi-family
5 7,427 - 4 7,597 -
Mortgage, commercial
7 10,775 - 6 10,814 -
Loans to individuals
- - - - - -
36 $ 21,905 $ 90 29 $ 21,399 $ 560
The following is a summary of TDR loans that were modified during the three and nine months ended September 30, 2012:

Three Months Ended September 30, 2012
Nine Months Ended September 30, 2012
Number
Pre-modification
Post-modification
Number
Pre-modification
Post-modification
of
recorded
recorded
of
recorded
recorded
contracts
investment
investment
contracts
investment
investment
(Amounts In Thousands)
(Amounts In Thousands)
Commercial and financial
- $ - $ - 4 $ 968 $ 968
Real estate:
Mortgage, farmland
- - - 1 297 297
Mortgage, 1 to 4 family first lien
1 271 271 1 271 271
Mortgage, 1 to 4 family junior liens
- - - 1 69 54
Mortgage, multi-family
- - - 1 12 12
Mortgage, commercial
- - - 3 885 735
1 $ 271 $ 271 11 $ 2,502 $ 2,337

The Company had commitments to lend $0.09 million in additional borrowings to restructured loan customers as of September 30, 2012.  The Company had commitments to lend $0.56 million in additional borrowings to restructured loan customers as of December 31, 2011.  These commitments were in the normal course of business and allowed the borrowers to build pre-sold homes and commercial property, which was expected to increase their overall cash flow.  The additional borrowings were not used to facilitate payments on these loans.
Page 21

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

Note 5.
Loans (continued)

There were $0.23 million and $0.26 million of TDR loans that were in payment default (defined as past due 90 days or more) as of September 30, 2012 and December 31, 2011, respectively.  As of September 30, 2012, TDR loans in payment default consisted of a $0.23 million commercial and financial loan.

Information regarding impaired loans as of and for the three and nine months ended September 30, 2012 is as follows:

September 30, 2012
Three Months Ended September 30, 2012
Nine Months Ended September 30, 2012
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
$ - $ - $ - $ - $ - $ - $ -
Commercial and financial
1,223 2,827 - 1,514 1 1,459 3
Real estate:
Construction, 1 to 4 family residential
- - - - - - -
Construction, land development and commercial
1,804 2,582 - 1,869 - 2,252 -
Mortgage, farmland
810 811 - 810 5 832 14
Mortgage, 1 to 4 family first liens
1,078 1,455 - 1,081 9 1,093 28
Mortgage, 1 to 4 family junior liens
70 363 - 72 1 72 3
Mortgage, multi-family
2,063 2,773 - 2,079 - 2,115 -
Mortgage, commercial
2,313 4,911 - 2,579 12 2,692 37
Loans to individuals
- 20 - - - - -
9,361 15,742 - 10,004 28 10,515 85
With an allowance recorded:
Agricultural
$ 14 $ 14 $ 3 $ 14 $ - $ 8 $ -
Commercial and financial
1,789 1,789 24 1,804 24 1,907 75
Real estate:
Construction, 1 to 4 family residential
- - - - - - -
Construction, land development and commercial
332 332 41 333 5 327 14
Mortgage, farmland
- - - - - - -
Mortgage, 1 to 4 family first liens
1,917 2,120 65 2,002 24 1,957 69
Mortgage, 1 to 4 family junior liens
57 57 1 62 1 80 3
Mortgage, multi-family
5,776 5,776 50 5,789 77 5,823 230
Mortgage, commercial
9,769 9,769 32 9,794 145 9,845 435
Loans to individuals
- - - - - - -
19,654 19,857 216 19,798 276 19,947 826
Total:
Agricultural
$ 14 $ 14 $ 3 $ 14 $ - $ 8 $ -
Commercial and financial
3,012 4,616 24 3,318 25 3,366 78
Real estate:
Construction, 1 to 4 family residential
- - - - - - -
Construction, land development and commercial
2,136 2,914 41 2,202 5 2,579 14
Mortgage, farmland
810 811 - 810 5 832 14
Mortgage, 1 to 4 family first liens
2,995 3,575 65 3,083 33 3,050 97
Mortgage, 1 to 4 family junior liens
127 420 1 134 2 152 6
Mortgage, multi-family
7,839 8,549 50 7,868 77 7,938 230
Mortgage, commercial
12,082 14,680 32 12,373 157 12,537 472
Loans to individuals
- 20 - - - - -
29,015 35,599 216 29,802 304 30,462 911
Page 22
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

Information regarding impaired loans as of December 31, 2011 is as follows:

Recorded
Investment
Unpaid Principal
Balance
Related
Allowance
With no related allowance recorded:
(Amounts In Thousands)
Agricultural
$ - $ - $ -
Commercial and financial
793 1,679 -
Real estate:
Construction, 1 to 4 family residential
- - -
Construction, land development and commercial
648 765 -
Mortgage, farmland
556 556 -
Mortgage, 1 to 4 family first liens
1,512 1,905 -
Mortgage, 1 to 4 family junior liens
291 568 -
Mortgage, multi-family
5,148 5,757 -
Mortgage, commercial
1,986 4,305 -
Loans to individuals
- 21 -
$ 10,934 $ 15,556 $ -
With an allowance recorded:
Agricultural
$ 13 $ 13 $ 1
Commercial and financial
1,824 2,954 97
Real estate:
Construction, 1 to 4 family residential
- - -
Construction, land development and commercial
14 27 3
Mortgage, farmland
- - -
Mortgage, 1 to 4 family first liens
2,843 3,187 88
Mortgage, 1 to 4 family junior liens
155 155 5
Mortgage, multi-family
2,890 2,890 29
Mortgage, commercial
9,806 9,806 36
Loans to individuals
- - -
$ 17,545 $ 19,032 $ 259
Total:
Agricultural
$ 13 $ 13 $ 1
Commercial and financial
2,617 4,633 97
Real estate:
Construction, 1 to 4 family residential
- - -
Construction, land development and commercial
662 792 3
Mortgage, farmland
556 556 -
Mortgage, 1 to 4 family first liens
4,355 5,092 88
Mortgage, 1 to 4 family junior liens
446 723 5
Mortgage, multi-family
8,038 8,647 29
Mortgage, commercial
11,792 14,111 36
Loans to individuals
- 21 -
$ 28,479 $ 34,588 $ 259
Page 23
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans (continued)

Impaired loans increased $0.54 million from December 31, 2011 to September 30, 2012.  Impaired loans include any loan that has been placed on nonaccrual status, loans past due 90 days or more and still accruing interest 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 1.72% of loans held for investment as of September 30, 2012 and 1.68% as of December 31, 2011.  The increase in impaired loans is due mainly to an increase in TDR loans of $0.51 million from December 31, 2011 to September 30, 2012 as a result of eleven additional restructured loans.

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 recognizes a charge off 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 24
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 September 30, 2012 are as follows:

September 30, 2012
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
$ 79,851 $ 79,851 $ 79,851 $ - $ -
Investment securities
228,734 228,734 - 228,734 -
Loans held for sale
16,003 16,003 16,003
Loans
Agricultural
66,865 67,922 - - 67,922
Commercial and financial
138,204 139,641 - - 139,641
Real estate:
Construction, 1 to 4 family residential
26,389 26,689 - - 26,689
Construction, land development and commercial
76,317 76,964 - - 76,964
Mortgage, farmland
100,806 104,042 - - 104,042
Mortgage, 1 to 4 family first liens
579,088 600,674 - - 600,674
Mortgage, 1 to 4 family junior liens
102,610 105,937 - - 105,937
Mortgage, multi-family
216,083 224,905 - - 224,905
Mortgage, commercial
305,263 316,636 - - 316,636
Loans to individuals
18,788 18,991 - - 18,991
Obligations of state and political subdivisions
32,782 32,824 - - 32,824
Accrued interest receivable
9,114 9,114 - 9,114 -
Total financial instrument assets
$ 1,996,897 $ 2,048,928 $ 79,851 $ 253,851 $ 1,715,226
Financial instrument liabilities:
Deposits
Noninterest-bearing deposits
$ 234,785 $ 234,783 $ - $ 234,783 $ -
Interest-bearing deposits
1,372,366 1,384,715 - 1,384,715 -
Short-term borrowings
45,076 45,076 - 45,076 -
Federal Home Loan Bank borrowings
145,000 164,546 - 164,546 -
Accrued interest payable
1,437 1,437 - 1,437 -
Total financial instrument liabilities
$ 1,798,664 $ 1,830,557 $ - $ 1,830,557 $ -
Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments
$ 342,943 $ - $ - $ - $ -
Letters of credit
10,097 - - - -
Total financial instrument liabilities with off-balance-sheet risk
$ 353,040 $ - $ - $ - $ -

(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 25
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

The carrying value and estimated fair values of the Company's financial instruments as of December 31, 2011 are as follows:

December 31, 2011
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
$ 29,291 $ 29,291 $ 29,291 $ - $ -
Investment securities
222,095 222,095 - 222,095 -
Loans held for sale
24,615 24,615 24,615
Loans
Agricultural
67,202 68,306 - - 68,306
Commercial and financial
136,745 135,317 - - 135,317
Real estate:
Construction, 1 to 4 family residential
21,744 22,233 - - 22,233
Construction, land development and commercial
80,078 79,527 - - 79,527
Mortgage, farmland
98,388 101,743 - - 101,743
Mortgage, 1 to 4 family first liens
570,844 591,460 - - 591,460
Mortgage, 1 to 4 family junior liens
102,901 105,872 - - 105,872
Mortgage, multi-family
220,963 229,779 - - 229,779
Mortgage, commercial
312,067 322,922 - - 322,922
Loans to individuals
20,227 20,542 - - 20,542
Obligations of state and political subdivisions
30,757 30,811 - - 30,811
Accrued interest receivable
8,689 8,689 - 8,689 -
Total financial instrument assets
$ 1,946,606 $ 1,993,202 $ 29,291 $ 255,399 $ 1,708,512
Financial instrument liabilities:
Deposits
Noninterest-bearing deposits
$ 223,378 $ 223,378 $ - $ 223,378 $ -
Interest-bearing deposits
1,302,099 1,309,545 - 1,309,545 -
Short-term borrowings
52,785 52,785 - 52,785 -
Federal Home Loan Bank borrowings
185,000 199,008 - 199,008 -
Accrued interest payable
1,625 1,625 - 1,625 -
Total financial instrument liabilities
$ 1,764,887 $ 1,786,341 $ - $ 1,786,341 $ -
Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments
$ 269,687 $ - $ - $ - $ -
Letters of credit
12,016 - - - -
Total financial instrument liabilities with off-balance-sheet risk
$ 281,703 $ - $ - $ - $ -
(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.

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.
Page 26
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

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 active markets, quoted prices for identical or 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.  Recent market conditions have led to diminished, and in some cases, non-existent trading in certain of the financial asset classes.  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.  Despite the Company’s best efforts to maximize the use of relevant observable inputs, the current market environment has diminished the observability of trades and assumptions that have historically been available.

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.  The Company’s investment securities are low risk and are measured at fair value as Level 2 assets.  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 the 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 the Company’s investment portfolio, there is no expectation of significant and unusual fluctuations as fair value changes primarily relate to interest rate changes.  No unusual fluctuations were identified during the nine months ended September 30, 2012.  If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.
Page 27

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

Note 6.
Fair Value Measurements (continued)

ASSETS (continued)

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).

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.

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). These loans are Level 3 as there are unobservable inputs supported by little market activity.  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 :  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 upon transfer of the loans to foreclosed assets.   Fair value is generally based upon independent market prices or appraised values of the collateral.  The value of foreclosed assets is evaluated periodically by management and may be adjusted based on management’s judgment of appraisals and/or current real estate market conditions (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).
Page 28
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

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.

Short-term borrowings :  Short-term 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).  Short-term borrowings are classified as Level 2 due to available prices for similar liabilities in the market.

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

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 29
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

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

September 30, 2012
Readily
Available
Market
Prices(1)
Observable
Market
Prices(2)
Company
Determined
Market
Prices(3)
Total at Fair
Value
(Amounts In Thousands)
Investment securities available for sale
$ - $ 219,774 $ - $ 219,774
Total
$ - $ 219,774 $ - $ 219,774

December 31, 2011
Readily
Available
Market
Prices(1)
Observable
Market
Prices(2)
Company
Determined
Market
Prices(3)
Total at Fair
Value
(Amounts in Thousands)
Investment securities available for sale
$ - $ 211,367 $ - $ 211,367
Total
$ - $ 211,367 $ - $ 211,367

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

There were no transfers between Levels 1, 2 or 3 during the nine months ended September 30, 2012.
Page 30
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

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.

Three Months Ended
Nine Months Ended
September 30, 2012
September 30, 2012
September 30, 2012
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
$ - $ - $ 11 $ 11
Commercial and financial
- - 2,988 2,988 $ 50 $ 249
Real Estate:
Construction, land development and commercial
- - 2,095 2,095 - 563
Mortgage, farmland
- - 810 810 - -
Mortgage, 1 to 4 family first liens
- - 2,930 2,930 145 544
Mortgage, 1 to 4 family junior liens
- - 126 126 70 82
Mortgage, multi-family
- - 7,789 7,789 - -
Mortgage, commercial
- - 12,050 12,050 - 210
Loans to individuals
- - - - - 12
Foreclosed assets (5)
- - 301 301 20 140
Total
$ - $ - $ 29,100 $ 29,100 $ 285 $ 1,800

(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 31
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 6.
Fair Value Measurements (continued)

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

Year Ended
December 31, 2011
December 31, 2011
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)
Commercial and financial
$ - $ - $ 2,163 $ 2,163 $ 548
Real Estate:
Construction, land development and commercial
- - 472 472 30
Mortgage, farmland
- - 331 331 -
Mortgage, 1 to 4 family first liens
- - 7,174 7,174 1,205
Mortgage, 1 to 4 family junior liens
- - 222 222 207
Mortgage, multi-family
- - 613 613 50
Mortgage, commercial
- - 2,297 2,297 525
Loans to individuals
- - - - 5
Foreclosed assets (5)
- - 286 286 198
Total
$ - $ - $ 13,558 $ 13,558 $ 2,768
(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.

As of September 30, 2012 the Company revised the classification of impaired loans and foreclosed assets from previous filings.  In previous filings, the Company classified impaired loans and foreclosed assets as Level 2 under ASC 820.  The Company revised the classification to Level 3 as of September 30, 2012 as the determination of fair value requires significant management judgment or estimation due to the inherent subjectivity of the inputs used to determine value.  The resulting change in presentation does not have a material impact on the Company’s financial position.

As of September 30, 2012, the $28.80 million of loans recorded at fair value on a nonrecurring basis consisted of the following loan types:  $3.06 million of 1-to-4 family residential loans, $2.99 million of commercial and financial loans, and $7.79 million of multi-family mortgage loans and $12.05 million of commercial mortgage loans.  The remaining $2.91 million includes loans in the following categories:  construction and land development, agricultural, real estate construction, mortgage – farmland, and loans to individuals.  Of the total $28.80 million, $7.60 million was included in the nonaccrual loan total.  The remaining $21.20 million is accruing interest based on the fact that loan payments have been made as contractually agreed.
Page 32
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 7.
Stock Repurchase Program

In July of 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”).  This authorization is set to expire on December 31, 2014.  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.  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 and legal factors.  The Company has purchased 318,073 shares of its common stock in privately negotiated transactions from August 1, 2005 through September 30, 2012.  Of these 318,073 shares, 8,803 shares were purchased during the quarter ended September 30, 2012, at an average price per share of $67.94.

Note 8.
Commitments and Contingencies

The Company’s subsidiary, Hills Bank and Trust Company (the “Bank”) is a party to financial instruments with off-balance–sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit, credit card participations and standby letters of credit.  These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments.  The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.  A summary of the Bank’s commitments at September 30, 2012 and December 31, 2011 is as follows:

September 30, 2012
December 31, 2011
(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans
$ 35,528 $ 35,345
Credit cards
44,543 42,493
Commercial, real estate and home construction
115,466 62,388
Commercial lines and real estate purchase loans
147,406 129,461
Outstanding letters of credit
10,097 12,016

Note 9.
Income Taxes

Federal income tax expense for the nine months ended September 30, 2012 and 2011 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, 2011, 2010 and 2009 remain subject to examination by the Internal Revenue Service.  For state tax purposes, the tax years ended December 31, 2011, 2010 and 2009 remain open for examination.  There were no material unrecognized tax benefits at December 31, 2011 and September 30, 2012 and therefore no interest or penalties on unrecognized tax benefits has been recorded.  As of September 30, 2012, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending September 30, 2013.

Income taxes as a percentage of income before taxes were 28.97% for the nine months ended September 30, 2012 and 29.25% for the same period in 2011.  The decrease in the effective tax rate is due to tax-exempt interest income and income tax credits and the relationship to total income before income taxes.
Page 33
HILLS BANCORPORATION


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 the current global economic recession, and monetary and other governmental actions designed to address such disruptions and recession.

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

·
The credit quality and credit agency ratings of the securities in the Company’s investment securities portfolio, a deterioration or downgrade of which could lead to 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.
Page 34
HILLS BANCORPORATION

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

·
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.

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.  The future impact of the global recession has introduced additional uncertainty into such determinations.  Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position.  Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations.  Although management believes the levels of the allowance as of September 30, 2012 and December 31, 2011 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

Page 35

HILLS BANCORPORATION

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

Non-GAAP Financial Measures

The accounting and reporting policies of the Company conform to GAAP.  However, management uses certain non-GAAP measures and ratios to evaluate and measure the Company’s performance.  These measures and ratios include return on average shareholders’ equity and average shareholders’ equity to average total assets.  For each of these measures and ratios, the Company adds to shareholders’ equity the amount in “maximum cash obligation related to ESOP shares”.  Under the ESOP, the Company has certain contingent repurchase obligations to buy back common stock distributed to participants.  This contingent repurchase obligation is reflected in the Company’s financial statements as “maximum cash obligation related to ESOP shares” and, in accordance with GAAP, reduces shareholders’ equity.  The Company believes that it is unlikely that the Company would be required to satisfy its contingent repurchase obligation and therefore believes that adjusting shareholders’ equity by adding “maximum cash obligation related to ESOP shares” to that amount provides a more meaningful view of the applicable measures and ratios.  In addition, management believes that the return on average shareholders’ equity, a financial measure frequently considered to evaluate the performance of bank holding companies, would be significantly overstated.

The following table presents a reconciliation of certain non-GAAP performance measures and ratios used by the Company to the most directly comparable GAAP financial measures for the nine months ended September 30, 2012 and the year ended December 31, 2011 (dollars in thousands, except per share data):

September 30, 2012
December 31, 2011
Shareholders' equity (GAAP)
$ 221,345 $ 208,429
Shareholders' equity plus common stock in ESOP subject to contingent repurchase obligation (non-GAAP)
250,943 236,255
Net income (1)
27,309 26,777
Average shareholders' equity (GAAP) (2)
213,822 178,984
Average shareholders' equity plus common stock in ESOP subject to contingent repurchase obligation (non-GAAP) (2)
238,869 205,370
Return on average shareholders' equity (GAAP) (3)
12.77 % 14.96 %
Return on average shareholders' equity plus common stock in ESOP subject to contingent repurchase obligation (non-GAAP) (4)
11.43 % 13.04 %

(1)
Calculation based on trailing 12 month figures.
(2)
Calculation based on trailing 12 month average.
(3)
Return on average shareholders’ equity (GAAP) equals net income divided by average shareholders’ equity.  Average shareholders’ equity is calculated using a trailing 12 month average.
(4)
Return on average shareholders’ equity plus common stock in ESOP subject to contingent repurchase obligation (non-GAAP) equals net income divided by average shareholders’ equity plus common stock in ESOP subject to contingent repurchase obligation.  Average shareholders’ equity is calculated using a trailing 12 month average.
Page 36
HILLS BANCORPORATION

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

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 and Marion, Iowa.  At September 30, 2012, the Bank has seventeen full-service locations. The Company added three additional offices during the nine months ended September 30, 2012.  The new office locations are located at the University of Iowa Memorial Union, the University of Iowa Hospitals and Clinics and North Liberty, Iowa.

Net income for the nine month period ended September 30, 2012 was $21.47 million compared to $20.94 million for the same nine months of 2011, an increase of 2.53%.  The $0.53 million increase in net income was caused by a number of factors.  The principal factors in the increase in net income for the first nine months of 2012 are a decrease in the provision for loan losses of $5.66 million and an increase in other income of $1.77 million.  These changes were offset by increases in certain expense items including $3.54 million in early repayment fees related to Federal Home Loan Bank borrowings.

The Company achieved a return on average assets of 1.34% and a return on average equity of 12.77% for the twelve months ended September 30, 2012, compared to the twelve months ended September 30, 2011, which were 1.34% and 13.27%, respectively. Dividends of $1.05 per share were paid in January 2012 to 2,186 shareholders.  The 2011 dividend was $1.00 per share.

The Bank’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 Bank achieved a net interest margin on a tax-equivalent basis of 3.63% for the nine months ended September 30, 2012 compared to 3.85% for the same nine months of 2011.  Average earning assets were $1.937 billion in 2012 and $1.849 billion in 2011.

Highlights noted on the balance sheet as of September 30, 2012 for the Company included the following:

·
Total assets were $2.067 billion, an increase of $48.73 million since December 31, 2011.
·
Cash and cash equivalents were $79.85 million, an increase of $50.56 million since December 31, 2011.  The growth in cash and cash equivalents included $46.57 million of temporary public funds.
·
Net loans were $1.679 billion, a decrease of $7.33 million since December 31, 2011.
·
Deposit growth of $81.67 million since December 31, 2011.  Deposit growth included $46.57 million of temporary public funds.
·
Federal Home Loan Bank borrowing decreased by $40.00 million since December 31, 2011.

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.
Page 37

HILLS BANCORPORATION

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

Financial Condition

The following table sets forth the composition of the loan portfolio as of September 30, 2012 and December 31, 2011:

September 30, 2012
December 31, 2011
Amount
Percent
Amount
Percent
(Amounts In Thousands)
(Amounts In Thousands)
Agricultural
$ 68,769 4.07 % $ 68,556 4.05 %
Commercial and financial
142,888 8.46 143,174 8.46
Real estate:
Construction, 1 to 4 family residential
27,368 1.62 22,308 1.32
Construction, land development and commercial
79,370 4.70 84,508 4.99
Mortgage, farmland
102,457 6.07 99,799 5.90
Mortgage, 1 to 4 family first liens
585,577 34.66 577,881 34.16
Mortgage, 1 to 4 family junior liens
104,258 6.17 104,915 6.20
Mortgage, multi-family
217,737 12.89 222,851 13.17
Mortgage, commercial
308,690 18.27 316,329 18.69
Loans to individuals
19,117 1.13 20,598 1.22
Obligations of state and political subdivisions
33,134 1.96 31,147 1.84
$ 1,689,365 100.00 % $ 1,692,066 100.00 %
Less allowance for loan losses
26,170 30,150
$ 1,663,195 $ 1,661,916

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.
Page 38

HILLS BANCORPORATION

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

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 is immediately downgraded and the uncollectible amount is charged-off.  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.

The following table presents the allowance for loan losses on loans by type of loans and the percentage in each category to total loans as of September 30, 2012 and December 31, 2011:

September 30, 2012
December 31, 2011
Amount
% of Total
Allowance
% of Loans to
Total Loans
Amount
% of
Total
Allowance
% of Loans
to Total
Loans
(In Thousands)
(In Thousands)
Agricultural
$ 1,904 7.28 % 4.07 % $ 1,354 4.49 % 4.05 %
Commercial and financial
4,684 17.90 8.46 6,429 21.32 8.46
Real estate:
Construction, 1 to 4 family residential
979 3.74 1.62 564 1.87 1.32
Construction, land development and commercial
3,053 11.66 4.70 4,430 14.69 4.99
Mortgage, farmland
1,651 6.31 6.07 1,411 4.68 5.90
Mortgage, 1 to 4 family first liens
6,489 24.79 34.66 7,037 23.34 34.16
Mortgage, 1 to 4 family junior liens
1,648 6.30 6.17 2,014 6.68 6.20
Mortgage, multi-family
1,654 6.32 12.89 1,888 6.26 13.17
Mortgage, commercial
3,427 13.09 18.27 4,262 14.14 18.69
Loans to individuals
329 1.26 1.13 371 1.24 1.22
Obligations of state and political subdivisions
352 1.35 1.96 390 1.29 1.84
$ 26,170 100.00 % 100.00 % $ 30,150 100.00 % 100.00 %

The allowance for loan losses totaled $26.17 million at September 30, 2012 compared to $30.15 million at December 31, 2011.  The percentage of the allowance to outstanding loans was 1.55% and 1.78% at September 30, 2012 and December 31, 2011, 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 reduction in the allowance in 2012 is the result of a decrease in the historical loss rates used in the allowance for loan losses calculation as well as improvements in asset quality.

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.
Page 39

HILLS BANCORPORATION

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

Management has determined that the allowance for loan losses was appropriate at September 30, 2012, 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.  During the nine months ended September 30, 2012, drought conditions have occurred in the Midwest including the Company’s primary market area.  These conditions could lead to an increased risk of negative operating results for agricultural customers of the Company and could have a negative impact on the loan portfolio in the future.

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

Investment securities available for sale held by the Company increased by $8.41 million from December 31, 2011 to September 30, 2012.  The fair value of securities available for sale was $7.17 million more than the amortized cost of such securities as of September 30, 2012.  At December 31, 2011, the fair value of the securities available for sale was $8.06 million more than the amortized cost of such securities.

Deposit growth was $81.67 million in the first nine months of 2012.  Deposit growth included $46.57 million of temporary public funds.  Repurchase agreements decreased $7.71 million in the same period.  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 $47.02 million as of September 30, 2012 with an average rate of 0.67%.  Brokered deposits were $32.12 million as of December 31, 2011 with an average rate of 0.71%.  As of September 30, 2012 and December 31, 2011, brokered deposits were 2.93% and 2.11% of total deposits, respectively.

Dividends and Equity

In January 2012, Hills Bancorporation paid a dividend of $5.00 million or $1.05 per share.  The dividend was $1.00 per share in January 2011.  After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of September 30, 2012 totaled $221.35 million.  Under risk-based capital rules, the total amount of Tier 1 risk-based capital was 15.81% and 14.69% as of September 30, 2012 and December 31, 2011, respectively.  The Tier 1 risk-based capital was in excess of the required minimum of 8.00%.  Risk-based capital was 17.07% and 15.95% as of September 30, 2012 and December 31, 2011, respectively. As of September 30, 2012, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  There are no conditions or events since that notification that management believes have changed the Company’s category.
Page 40
HILLS BANCORPORATION

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

Discussion of operations for the nine months ended September 30, 2012 and 2011

Net Income Overview

Net income increased $0.53 million for the nine months ended September 30, 2012 compared to the first nine months of 2011.  Total net income was $21.47 million in 2012 and $20.94 million in the comparable period in 2011, an increase of 2.53%.  The changes in net income in 2012 from the first nine months of 2011 were primarily the result of the following:

·
Net interest income decreased by $0.49 million.
·
The provision for loan losses decreased by $5.66 million.
·
Other income increased by $1.77 million.
·
Other expenses increased by $6.31 million.

For the nine-month periods ended September 30, 2012 and 2011, basic earnings per share were $4.52 and $4.77, respectively. Diluted earnings per share were $4.51 for the nine months ended September 30, 2012 compared to $4.76 for the same period in 2011.

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 earnings assets. Net interest income of $50.85 million for the first nine months of 2012 was derived from the Company’s $1.937 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.63%.  Average earning assets in the nine months ended September 30, 2011 were $1.849 billion and the tax-equivalent net interest margin was 3.85%. The importance of net interest margin is illustrated by the fact that a decrease in the net interest margin of 10 basis points to 3.53% would have resulted approximately in a $1.45 million decrease in income before income taxes in the nine month period ended September 30, 2012. Similarly, an increase in the net interest margin of 10 basis points to 3.73% would have resulted in approximately a $1.45 million increase in net interest income before taxes.  Net interest income for the Company decreased due to the decrease in the interest rates on average earning 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 $1.679 billion at September 30, 2012.  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 in expense of $2.90 million in 2012 compared to an expense of $2.76 million in 2011.  The reduction in expense in 2012 is the result of a decrease in the historical loss rates used in the allowance for loan losses calculation as well as improvements in asset quality.

The third significant factor affecting the Company’s net income is income tax expense.  Federal and state income tax expenses were $8.76 million and $8.66 million for the nine months ended September 30, 2012 and 2011, respectively.  Income taxes as a percentage of income before taxes were 28.97% in 2012 and 29.25% in 2011.

In addition, for the nine months ended September 30, 2012 the Company incurred a prepayment penalty of $3.54 million for prepaying $40.00 million of Federal Home Loan Bank borrowings.  The Company prepaid the borrowings in an effort to utilize the bank’s liquidity, improve net interest margin and decrease interest rate risk in the future.  The Company did not prepay Federal Home Loan Bank borrowing during the nine months ended September 30, 2011.
Page 41
HILLS BANCORPORATION

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

Discussion of operations for the nine months ended September 30, 2012 and 2011

Net Interest Income

Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities.  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 first nine months of 2012 was 3.63% compared to 3.85% in 2011 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 nine months ended in 2012 compared to the comparable period in 2011 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
$ 77,277 (0.41 )% $ 3,169 $ (4,938 ) $ (1,769 )
Taxable securities
(7,334 ) (0.66 ) (145 ) (502 ) (647 )
Nontaxable securities
5,571 (0.31 ) 201 (269 ) (68 )
Federal funds sold
12,454 - 24 - 24
$ 87,968 $ 3,249 $ (5,709 ) $ (2,460 )
Interest expense:
Interest-bearing demand deposits
$ 37,213 (0.06 )% $ (78 ) $ 139 $ 61
Savings deposits
17,411 (0.09 ) (31 ) 276 245
Time deposits
(17,760 ) (0.26 ) 263 1,229 1,493
Short-term borrowings
(7,500 ) (0.30 ) 22 127 149
FHLB borrowings
(37,611 ) 0.06 99 (79 ) 20
$ (8,247 ) $ 275 $ 1,692 $ 1,968
Change in net interest income
$ 3,524 $ (4,017 ) $ (492 )
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)
2012
2011
Yield on average interest-earning assets
4.77 % 5.19 %
Rate on average interest-bearing liabilities
1.40 1.60
Net interest spread
3.37 % 3.59 %
Effect of noninterest-bearing funds
0.26 0.26
Net interest margin (tax equivalent interest income divided by average interest-earning assets)
3.63 % 3.85 %
Page 42
HILLS BANCORPORATION

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

Discussion of operations for the nine months ended September 30, 2012 and 2011

Net Interest Income (continued)

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates.  The Federal Open Market Committee met six times during the first nine months of 2012.  The target rate remains unchanged since December 31, 2008 at 0.25%.  Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate.  As of September 30, 2012, the rate indexes for the one, three and five year indexes were 0.18%, 0.36% and 0.70%, respectively.  The one year index increased 80.00% from 0.10% at September 30, 2011, the three year index increased 9.09% and the five year index decreased 17.65%.  The three year index was 0.33% and the five year index was 0.85% at September 30, 2011.  The targeted federal funds rate was 0.25% at September 30, 2012 and 2011.

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $2.90 million in 2012 compared to an expense of $2.76 million in 2011, a decrease of $5.66 million.  The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management.  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 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 reduction in expense in 2012 is the result of a decrease in the historical loss rates used in the allowance for loan losses calculation as well as improvements in asset quality.

The allowance for loan losses decreased $3.98 million during the first nine months of 2012.  In the first nine months of 2012, there was a decrease of $1.84 million due to the volume and composition of loans outstanding and a $2.14 million decrease in the amount allocated to the allowance due to a combination of improvement in credit quality and charge-offs.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented.  For the nine months ended September 30, 2012 and 2011, recoveries were $2.06 million and $1.82 million, respectively; and charge-offs were $3.14 million in 2012 and $4.16 million in 2011.  The allowance for loan losses totaled $26.17 million at September 30, 2012 compared to $30.15 million at December 31, 2011.  The allowance represented 1.55% and 1.78% of loans held for investment at September 30, 2012 and December 31, 2011, respectively.
Page 43
HILLS BANCORPORATION

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

Discussion of operations for the nine months ended September 30, 2012 and 2011

Noninterest Income

The following table sets forth the various categories of noninterest income for the nine months ended September 30, 2012 and 2011.

Nine Months Ended September 30,
2012
2011
$ Change
% Change
(Amounts in thousands)
Net gain on sale of loans
$ 2,589 $ 1,199 $ 1,390 115.93 %
Trust fees
3,450 3,309 141 4.26
Service charges and fees
5,802 5,669 133 2.35
Rental revenue on tax credit real estate
1,189 1,075 114 10.60
Net gain on sale of other real estate owned and other reposessed assets
604 504 100 19.84
Other noninterest income
1,880 1,985 (105 ) (5.29 )
$ 15,514 $ 13,741 $ 1,773

Loans originated for sale in the first nine months of 2012 totaled $235.16 million compared to $109.36 million in the same period in 2011, an increase of 114.95%.  In the nine months ended September 30, 2012 and 2011, the net gain on sale of loans was $2.59 million and $1.20 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.

Trust fees increased $0.14 million in the first nine months of 2012 as a result of assets under management increasing from $0.95 billion as of September 30, 2011 to $1.08 billion as of September 30, 2012 due to market conditions and new trust relationships.

Service charges and fees increased $0.13 million in the first nine months of 2012 from their level for the comparable period in 2011.  Credit card merchant, debit card and point of sale (POS) pin interchange fees are included in service charges and fees, and that component increased during the same period by $0.20 million due to volume of activity.

The net gain on sale of other real estate owned and other repossessed assets increased $0.10 million to a net gain of $0.60 million for the nine months ended September 30, 2012.  The total net gain on sale of other real estate owned for the nine months ended September 30, 2012 consisted of a $0.14 million fair market value adjustment on 6 properties within other real estate owned and a $0.74 million net gain on sale of 19 properties.  During the same period in 2011, the gain consisted of a $0.14 million fair market value adjustment on 8 properties within other real estate owned, a $0.66 million gain on sale of 19 properties and a $0.02 million loss on sale of 5 properties, for a net gain of $0.50 million.

Page 44
HILLS BANCORPORATION

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

Discussion of operations for the nine months ended September 30, 2012 and 2011

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the nine months ended September 30, 2012 and 2011.

Nine Months Ended September 30,
2012
2011
$ Change
% Change
(Amounts in thousands)
Salaries and employee benefits
$ 17,725 $ 16,616 $ 1,109 6.67 %
Occupancy
2,469 2,464 5 0.20
Furniture and equipment
3,477 2,739 738 26.94
Office supplies and postage
1,145 962 183 19.02
Advertising and business development
1,705 1,178 527 44.74
Outside services
5,026 5,052 (26 ) (0.51 )
Rental expenses on tax credit real estate
1,774 1,530 244 15.95
FDIC insurance assessment
784 1,053 (269 ) (25.55 )
Loss on extinguishment of debt - Federal Home Loan Bank borrowings
3,544 - 3,544 100.00
Other noninterest expense
1,382 1,130 252 22.30
$ 39,031 $ 32,724 $ 6,307

Other expenses of $39.03 million increased $6.31 million for the nine months ended September 30, 2012 from the same period in 2011, an increase of 19.27%.  Salaries and employee benefits expense was $17.73 million for the nine months ended September 30, 2012 which was a $1.11 million increase from the same period in 2011.  The increase is primarily due to an increase in bonuses paid to real estate lenders related to loan sales production.  Furniture and equipment expense was $3.48 million for the nine months ended September 30, 2012 which represents a $0.74 million increase from the 2011 period.  The negative variance is partially due to an increase of $0.82 million in expense for non-capitalized furniture, fixtures and equipment and an increase of $0.54 million in software expense.

In an effort to utilize the Bank’s liquidity, improve net interest margin and decrease interest rate risk in the future the Bank prepaid $40.00 million of Federal Home Loan Bank borrowings during the nine months ended September 30, 2012.  The Bank incurred a prepayment penalty of $3.54 million. The $40.00 million borrowing was due in June 2015 at a 3.70% interest rate.  The Bank did not prepay Federal Home Loan Bank borrowings during the nine months ended September 30, 2011.

FDIC insurance assessment expense was $0.78 million for the nine months ended September 30, 2012.  This is a decrease of $0.27 million when compared to the same period in 2011.  As of September 30, 2012, the Company has prepaid FDIC insurance of $3.19 million, which represents the FDIC premiums paid by the Bank on December 30, 2009 for the years of 2010, 2011 and 2012.  The prepaid FDIC insurance is being amortized on a quarterly basis as premiums are assessed.  The balance remaining in prepaid FDIC insurance after collection of the amount due on June 30, 2013 will be refunded to the Company.

Income Taxes

Federal and state income tax expenses were $8.76 million and $8.66 million for the nine months ended September 30, 2012 and 2011, respectively.  Income taxes as a percentage of income before taxes were 28.97% in 2012 and 29.25% in 2011.
Page 45
HILLS BANCORPORATION

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

Discussion of operations for the three months ended September 30, 2012 and 2011

Net Income

Net income decreased to $5.50 million for the three months ended September 30, 2012 from $6.81 million for the same period in 2011, a decrease of 19.24%.  Earnings per share, both basic and diluted, decreased for the three months ended September 30, 2012 compared to the same period in 2011.  The decrease is due to the decrease in net income and an increase in the number of shares outstanding resulting from the fourth quarter 2011 stock issuance.  For the three month period ended September 30, 2012, basic earnings per share was $1.16 and diluted earnings per share was $1.16.  For the three months ended September 30, 2011, basic earnings per share was $1.55 and diluted earnings per share was $1.55.

Net Interest Income

Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities.  The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin.  The net interest margin for the three months ended September 30, 2012 was 3.55% compared to 3.91% in 2011 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 September 30, 2012 compared to the comparable period in 2011 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
$ 53,872 (0.43 )% $ 636 $ (1,705 ) $ (1,069 )
Taxable securities
(9,692 ) (0.23 ) (59 ) (173 ) (232 )
Nontaxable securities
7,825 (0.35 ) 93 (103 ) (10 )
Federal funds sold
48,461 0.01 29 2 31
$ 100,466 $ 699 $ (1,979 ) $ (1,280 )
Interest expense:
Interest-bearing demand deposits
$ 43,283 - % $ (23 ) $ 3 $ (20 )
Savings deposits
29,584 (0.01 ) (17 ) 41 24
Time deposits
(12,331 ) (0.24 ) 68 370 438
Short-term borrowings
(20,252 ) (0.04 ) 20 28 48
FHLB borrowings
(3,111 ) 0.01 33 (4 ) 29
$ 37,173 $ 81 $ 438 $ 519
Change in net interest income
$ 780 $ (1,541 ) $ (761 )
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 46

HILLS BANCORPORATION

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

Discussion of operations for the three months ended September 30, 2012 and 2011

Net Interest Income (continued)

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

(Tax Equivalent Basis)
2012
2011
Yield on average interest-earning assets
4.65 % 5.18 %
Rate on average interest-bearing liabilities
1.37 1.53
Net interest spread
3.28 % 3.65 %
Effect of noninterest-bearing funds
0.27 0.26
Net interest margin (tax equivalent interest income divided by average interest-earning assets)
3.55 % 3.91 %

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $0.61 million in 2012 compared to an expense of $1.56 million in 2011, a decrease of $2.17 million.  The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management.  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 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 reduction in expense in 2012 is the result of a decrease in the historical loss rates used in the allowance for loan losses calculation as well as improvements in asset quality.

The allowance for loan losses decreased $0.50 million during the three months ended September 30, 2012.  For the three months ended September 30, 2012, there was a decrease of $0.39 million due to the volume and composition of loans outstanding and a $0.11 million decrease in the amount allocated to the allowance due to a combination of improvement in credit quality and charge-offs.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented.  For the three months ended September 30, 2012 and 2011, recoveries were $0.79 million and $0.39 million, respectively; and charge-offs were $0.68 million in 2012 and $1.57 million in 2011.  The allowance for loan losses totaled $26.17 million at September 30, 2012 compared to $29.65 million at September 30, 2011.  The allowance represented 1.55% and 1.78% of loans held for investment at September 30, 2012 and September 30, 2011, respectively.
Page 47
HILLS BANCORPORATION

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

Discussion of operations for the three months ended September 30, 2012 and 2011

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended September 30, 2012 and 2011.
Three Months Ended September 30,
2012
2011
$ Change
% Change
(Amounts in thousands)
Net gain on sale of loans
$ 1,023 $ 546 $ 477 87.36
Trust fees
1,160 1,114 46 4.13
Service charges and fees
1,970 1,937 33 1.70
Rental revenue on tax credit real estate
397 397 - -
Net gain on sale of other real estate owned and other reposessed assets
163 119 44 36.97
Other noninterest income
608 580 28 4.83
$ 5,321 $ 4,693 $ 628

In the three months ended September 30, 2012 and 2011, the net gain on sale of loans was $1.02 million and $0.55 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 net gain on sale of other real estate owned and other repossessed assets increased $0.04 million to a net gain of $0.16 million for the three months ended September 30, 2012.  The total net gain on sale of other real estate owned for the three months ended September 30, 2012 consisted of a $0.02 million fair market value adjustment on 1 property within other real estate owned and a $0.18 million net gain on sale of 5 properties.  During the same period in 2011, the gain consisted of a $0.01 million fair market value adjustment on 2 properties within other real estate owned, a $0.14 million gain on sale of 5 properties and a $0.01 million loss on sale of 3 properties, for a net gain of $0.12 million.

Page 48
HILLS BANCORPORATION

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

Discussion of operations for the three months ended September 30, 2012 and 2011

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended September 30, 2012 and 2011.
Three Months Ended September 30,
2012
2011
$ Change
% Change
(Amounts in thousands)
Salaries and employee benefits
$ 5,782 $ 5,532 $ 250 4.52 %
Occupancy
773 809 (36 ) (4.45 )
Furniture and equipment
1,183 957 226 23.62
Office supplies and postage
427 308 119 38.64
Advertising and business development
608 402 206 51.24
Outside services
1,689 1,829 (140 ) (7.65 )
Rental expenses on tax credit real estate
560 648 (88 ) (13.58 )
FDIC insurance assessment
259 267 (8 ) (3.00 )
Loss on extinguishment of debt - Federal Home Loan Bank borrowings
3,544 - 3,544 100.00
Other noninterest expense
447 392 55 14.03
$ 15,272 $ 11,144 $ 4,128

Other expenses of $15.27 million increased $4.13 million for the three months ended September 30, 2012 from the same period in 2011, an increase of 37.04%.  Salaries and employee benefits expense was $5.78 million for the three months ended September 30, 2012, which was a $0.25 million increase from the same period in 2011. The increase is due to an increase in bonuses paid to real estate lenders related to loan sales production.  Furniture and equipment expense was $1.18 million for the three months ended September 30, 2012, which represents a $0.23 million increase from the 2011 period.  The negative variance is due to an increase in depreciation expense resulting from the addition of three offices and an increase in software maintenance contracts for the three months ended September 30, 2012.

In an effort to utilize the bank’s liquidity, improve net interest margin and decrease interest rate risk in the future the Bank prepaid $40.00 million of Federal Home Loan Bank borrowings during the three months ended September 30, 2012.  The Bank incurred a prepayment penalty of $3.54 million. The $40.00 million borrowing was due in June 2015 at a 3.70% interest rate.  The Bank did not prepay Federal Home Loan Bank borrowings during the three months ended September 30, 2011.

Advertising and business development expense was $0.61 million for the three months ended September 30, 2012, an increase of $0.21 million from the same period in 2011.  The increase is partially due to a new debit card reward program added in 2012.

Income Taxes

Federal and state income tax expenses were $1.97 million and $2.75 million for the three months ended September 30, 2012 and 2011, respectively.  Income taxes as a percentage of income before taxes were 26.37% in 2012 and 28.79 % in 2011.
Page 49
HILLS BANCORPORATION

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

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 10.63% of the Company’s total assets at September 30, 2012, compared to 10.47% at December 31, 2011.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position.  As of September 30, 2012, the Company had borrowed $145 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 $372 million at June 30, 2012.

As additional sources of liquidity, the Company has the ability to borrow up to $10 million from the Federal Reserve Bank of Chicago, and has lines of credit with two banks totaling $152 million. Those two lines of credit require the pledging of investment securities when drawn upon.  The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at September 30, 2012.

As of September 30, 2012, investment securities with a carrying value of $45.08 million were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as permitted by law.  As of December 31, 2011, investment securities with a carrying value of $52.79 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, 2011.
Page 50

HILLS BANCORPORATION


Market Risk Management

The Company's primary market risk exposure is to changes in interest rates.  The Company's asset/liability management, or its management of interest rate risk, is focused primarily on evaluating and managing net interest income given various risk criteria.  Factors beyond the Company's control, such as market interest rates and competition, may also have an impact on the Company's interest income and interest expense.  In the absence of other factors, the Company's overall yield on interest-earning assets will increase, as will its cost of funds on its interest-bearing liabilities when market interest rates increase over an extended period of time.  Conversely, 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.

Asset/Liability Management

The Bank maintains an asset/liability committee, which meets at least quarterly to review the Bank’s interest rate sensitivity position and to review various strategies as to interest rate risk management.  In addition, the Bank uses a simulation model to review various assumptions relating to interest rate movement.  The model attempts to limit rate risk even if it appears the Bank’s asset and liability maturities are perfectly matched and a favorable interest margin is present.

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

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

Management believes there has been no material change in the Company’s market risk from the information contained in the Company’s Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2011.


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 nine months of 2012 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.
Page 51
HILLS BANCORPORATION
PART II - OTHER INFORMATION
No material legal proceedings are pending.
Item 1A.
There have been no material changes from the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2011.
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended September 30, 2012:

Period
Total number of shares
purchased
Average price paid per
share
Total number of shares
purchased as part of publicly
announced plans or
programs
Maximum number of
shares that may yet be
purchased under the
plans or programs (1)
July 1 to July 31
5,208 $ 67.50 314,478 435,522
August 1 to August 31
2,170 68.31 316,648 433,352
September 1 to September 30
1,425 69.00 318,073 431,927
Total
8,803 $ 67.94 318,073 431,927

(1)  On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”).  This authorization was previously set to expire on December 31, 2013.  At its September 2012 meeting, the Company’s Board of Directors extended the expiration date of the 2005 Stock Repurchase Program to December 31, 2014. 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 nine months of 2012, the Company issued 5,797 shares of restricted stock under the 2010 Stock Option and Incentive Plan.  The restricted shares were issued 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(2) of the Securities Act of 1933.

Item 3.

Hills Bancorporation has no senior securities.


Not applicable.


None

Page 52

Item 6.

3.1
Articles of Incorporation of Hills Bancorporation, incorporated by reference to Exhibit 3.1 to the Company’s Form S-3 filed with the Commission on May 12, 2011.
3.2
By-laws of Hills Bancorporation, incorporated by reference to Exhibit 3.2 to the Company’s Form S-3 filed with the Commission on May 12, 2011.
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**
The following material from Hills Bancorporation Form 10-Q Report for the quarterly period ended September 30, 2012, formatted in XBRL: (1) Unaudited Condensed Consolidated Balance Sheets, (2) Unaudited Condensed Consolidated Statements of Income, (3) Unaudited Condensed Consolidated Statements of Comprehensive Income, (4) Unaudited Condensed Consolidated Statement of Changes in Stockholders’ Equity, (5) Unaudited Condensed Consolidated Statements of Cash Flows, and (6) the Notes to Unaudited Condensed Consolidated Financial Statements.

**
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 53
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

HILLS BANCORPORATION
Date:  November 7, 2012
By:  /s/ Dwight O. Seegmiller
Dwight O. Seegmiller, Director, President and Chief Executive Officer
Date:  November 7, 2012
By:  /s/ Shari DeMaris
Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer

Page 54
QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED SEPTEMBER 30, 2012
Exhibit
Number
Description
Page Number In The Sequential
Numbering System September 30, 2012 Form 10-Q
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
56-57
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
58
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