HBIA 10-Q Quarterly Report June 30, 2014 | Alphaminr
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HBIA 10-Q Quarter ended June 30, 2014

Balance Sheet
Cash Flow
Income Statement
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10-Q 1 hbia201463010q.htm 10-Q HBIA 2014.6.30 10Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
FORM 10-Q

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

For the quarterly period ended June 30, 2014

Commission file number: 0-12668
Hills Bancorporation

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

131 MAIN STREET, HILLS, IOWA 52235

Telephone number: (319) 679-2291

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

þ Yes o No

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

þ Yes o No

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

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

o Yes þ No

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date.
SHARES OUTSTANDING
CLASS
July 31, 2014
Common Stock, no par value
4,705,312


HILLS BANCORPORATION
Index to Form 10-Q

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

Page 2



HILLS BANCORPORATION CONSOLIDATED BALANCE SHEETS (Amounts In Thousands, Except Share Amounts)
June 30, 2014
December 31, 2013
ASSETS
(Unaudited)
Cash and cash equivalents
$
30,136

$
43,702

Investment securities available for sale at fair value (amortized cost June 30, 2014 $237,172; December 31, 2013 $236,702)
239,805

238,510

Stock of Federal Home Loan Bank
7,653

7,579

Loans held for sale
7,959

4,927

Loans, net of allowance for loan losses (June 30, 2014 $25,350; December 31, 2013 $25,550)
1,862,332

1,801,247

Property and equipment, net
28,827

29,836

Tax credit real estate
17,735

18,180

Accrued interest receivable
8,251

7,676

Deferred income taxes, net
9,230

8,605

Other real estate
1,533

541

Goodwill
2,500

2,500

Other assets
3,856

4,492

Total Assets
$
2,219,817

$
2,167,795

LIABILITIES AND STOCKHOLDERS' EQUITY


Liabilities


Noninterest-bearing deposits
$
261,565

$
256,788

Interest-bearing deposits
1,464,759

1,453,089

Total deposits
$
1,726,324

$
1,709,877

Short-term borrowings
68,572

42,016

Federal Home Loan Bank borrowings
125,000

125,000

Accrued interest payable
930

1,102

Other liabilities
19,142

16,437

Total Liabilities
$
1,939,968

$
1,894,432

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)
$
31,405

$
29,574

STOCKHOLDERS' EQUITY


Common stock, no par value; authorized 10,000,000 shares; issued June 30, 2014 5,079,719 shares; December 31, 2013 5,074,894 shares
$
—

$
—

Paid in capital
42,550

42,194

Retained earnings
258,875

250,370

Accumulated other comprehensive income
755

1,591

Unearned ESOP shares
(1,008
)
(1,008
)
Treasury stock at cost (June 30, 2014 367,498 shares; December 31, 2013 347,269 shares)
(21,323
)
(19,784
)
Total Stockholders' Equity
$
279,849

$
273,363

Less maximum cash obligation related to ESOP shares
31,405

29,574

Total Stockholders' Equity Less Maximum Cash Obligations Related to ESOP Shares
$
248,444

$
243,789

Total Liabilities & Stockholders' Equity
$
2,219,817

$
2,167,795


See Notes to Consolidated Financial Statements.

Page 3

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(Amounts In Thousands, Except Per Share Amounts)
Three Months Ended
June 30,
Six Months Ended
June 30,
2014
2013
2014
2013
Interest income:
Loans, including fees
$
20,350

$
19,747

$
40,099

$
39,467

Investment securities:


Taxable
270

304

540

654

Nontaxable
837

831

1,673

1,674

Federal funds sold
16

25

26

46

Total interest income
$
21,473

$
20,907

$
42,338

$
41,841

Interest expense:


Deposits
$
2,322

$
2,839

$
4,791

$
5,804

Short-term borrowings
44

44

47

61

FHLB borrowings
1,394

1,394

2,772

2,772

Total interest expense
$
3,760

$
4,277

$
7,610

$
8,637

Net interest income
$
17,713

$
16,630

$
34,728

$
33,204

Provision for loan losses
(246
)
(250
)
(201
)
(421
)
Net interest income after provision for loan losses
$
17,959

$
16,880

$
34,929

$
33,625

Noninterest income:


Net gain on sale of loans
$
189

$
521

$
300

$
1,262

Trust fees
1,439

1,295

2,899

2,555

Service charges and fees
2,012

2,262

3,849

4,376

Rental revenue on tax credit real estate
378

397

735

716

Net gain on sale of other real estate owned and other repossessed assets
168

110

240

150

Other noninterest income
761

734

1,345

1,348

$
4,947

$
5,319

$
9,368

$
10,407

Noninterest expenses:


Salaries and employee benefits
$
6,385

$
6,191

$
12,642

$
12,154

Occupancy
944

931

1,953

1,873

Furniture and equipment
1,242

1,186

2,473

2,467

Office supplies and postage
385

386

767

766

Advertising and business development
813

651

1,441

1,271

Outside services
1,673

1,768

3,208

3,570

Rental expenses on tax credit real estate
553

613

1,083

957

FDIC insurance assessment
271

270

541

531

Other noninterest expense
271

426

687

866

$
12,537

$
12,422

$
24,795

$
24,455

Income before income taxes
$
10,369

$
9,777

$
19,502

$
19,577

Income taxes
3,188

2,863

5,577

5,853

Net income
$
7,181

$
6,914

$
13,925

$
13,724

Earnings per share:


Basic
$
1.53

$
1.47

$
2.96

$
2.91

Diluted
$
1.53

$
1.47

$
2.96

$
2.91

See Notes to Consolidated Financial Statements.

Page 4

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

Three Months Ended
June 30,
Six Months Ended
June 30,
2014
2013
2014
2013
Net income
$
7,181

$
6,914

$
13,925

$
13,724

Other comprehensive loss


Securities:


Net change in unrealized gain (loss) on securities available for sale
$
741

$
(4,537
)
$
825

$
(5,320
)
Reclassification adjustment for net gains realized in net income
—

—

—

(17
)
Income taxes
(283
)
1,735

(315
)
2,041

Other comprehensive income (loss) on securities available for sale
$
458

$
(2,802
)
$
510

$
(3,296
)
Derivatives used in cash flow hedging relationships:


Unrealized loss on derivatives
$
(1,100
)
$
—

$
(2,179
)
$
—

Income taxes
420

—

833

—

Other comprehensive loss on cash flow hedges
$
(680
)
$
—

$
(1,346
)
$
—

Other comprehensive loss, net of tax
$
(222
)
$
(2,802
)
$
(836
)
$
(3,296
)
Comprehensive income
$
6,959

$
4,112

$
13,089

$
10,428

See Notes to Consolidated Financial Statements.

Page 5

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited) (Amounts In Thousands, Except Share Amounts)
Paid In Capital
Retained Earnings
Accumulated Other
Comprehensive
Income (Loss)
Unearned ESOP
Shares
Treasury Stock
Maximum Cash
Obligation Related
To ESOP Shares
Total
Balance, December 31, 2012
$
42,241

$
229,625

$
3,955

$
(1,513
)
$
(18,397
)
$
(30,715
)
$
225,196

Issuance of 5,310 shares of common stock
203

—

—

—

—

—

203

Issuance of 1,040 shares of common stock under the employee stock purchase plan
72

—

—

—

—

—

72

Unearned restricted stock compensation
(702
)
—

—

—

—

—

(702
)
Forfeiture of 375 shares of common stock
(25
)
—

—

—

—

—

(25
)
Share-based compensation
14

—

—

—

—

—

14

Income tax benefit related to share-based compensation
73

—

—

—

—

—

73

Change related to ESOP shares
—

—

—

—

—

2,993

2,993

Net income
—

13,724

—

—

—

—

13,724

Cash dividends ($1.10 per share)
—

(5,186
)
—

—

—

—

(5,186
)
Purchase of 9,393 shares of common stock
—

—

—

—

(670
)
—

(670
)
Other comprehensive loss
—

—

(3,296
)
—

—

—

(3,296
)
Balance, June 30, 2013
$
41,876

$
238,163

$
659

$
(1,513
)
$
(19,067
)
$
(27,722
)
$
232,396

Balance, December 31, 2013
$
42,194

$
250,370

$
1,591

$
(1,008
)
$
(19,784
)
$
(29,574
)
$
243,789

Issuance of 4,233 shares of common stock
200

—

—

—

—

—

200

Issuance of 1,026 shares of common stock under the employee stock purchase plan
76

—

—

—

—

—

76

Unearned restricted stock compensation
46

—

—

—

—

—

46

Forfeiture of 434 shares of common stock
(31
)
—

—

—

—

—

(31
)
Share-based compensation
14

—

—

—

—

—

14

Income tax benefit related to share-based compensation
51

—

—

—

—

—

51

Change related to ESOP shares
—

—

—

—

—

(1,831
)
(1,831
)
Net income
—

13,925

—

—

—

—

13,925

Cash dividends ($1.15 per share)
—

(5,420
)
—

—

—

—

(5,420
)
Purchase of 20,229 shares of common stock
—

—

—

—

(1,539
)
—

(1,539
)
Other comprehensive loss
—

—

(836
)
—

—

—

(836
)
Balance, June 30, 2014
$
42,550

$
258,875

$
755

$
(1,008
)
$
(21,323
)
$
(31,405
)
$
248,444

See Notes to Consolidated Financial Statements.

Page 6

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

Six Months Ended
June 30,
2014
2013
Cash Flows from Operating Activities
Net income
$
13,925

$
13,724

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


Depreciation
1,361

1,451

Provision for loan losses
(201
)
(421
)
Net gain on sale of investment securities
—

(17
)
Share-based compensation
14

14

Forfeiture of common stock
(31
)
(25
)
Compensation expensed through issuance of common stock
175

126

Excess tax benefits from share-based compensation
(51
)
(73
)
Provision for deferred income taxes
(107
)
198

Net gain on sale of other real estate owned and other repossessed assets
(240
)
(150
)
Increase in accrued interest receivable
(575
)
(361
)
Amortization of discount on investment securities, net
433

565

Decrease in prepaid FDIC insurance
—

2,957

(Increase) decrease in other assets
(82
)
3,153

Increase (decrease) in accrued interest payable and other liabilities
1,170

(84
)
Loans originated for sale
(49,191
)
(136,340
)
Proceeds on sales of loans
46,459

139,810

Net gain on sales of loans
(300
)
(1,262
)
Net cash and cash equivalents provided by operating activities
$
12,759

$
23,265

Cash Flows from Investing Activities


Proceeds from maturities of investment securities available for sale
$
37,774

$
14,920

Proceeds from sales of investment securities available for sale
—

566

Purchases of investment securities available for sale
(38,752
)
(19,822
)
Loans made to customers, net of collections
(62,599
)
(20,943
)
Proceeds on sale of other real estate owned and other repossessed assets
963

896

Purchases of property and equipment
(352
)
(862
)
Income from tax credit real estate, net
445

192

Net cash and cash equivalents used in investing activities
$
(62,521
)
$
(25,053
)
Cash Flows from Financing Activities


Net increase (decrease) in deposits
$
16,447

$
(24,397
)
Net increase (decrease) in short-term borrowings
26,556

(7,856
)
Stock options exercised
101

149

Excess tax benefits related to share-based compensation
51

73

Purchase of treasury stock
(1,539
)
(670
)
Dividends paid
(5,420
)
(5,186
)
Net cash and cash equivalents provided by (used in) financing activities
$
36,196

$
(37,887
)
(Continued)


Page 7

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)
Six Months Ended
June 30,
2014
2013
Decrease in cash and cash equivalents
$
(13,566
)
$
(39,675
)
Cash and cash equivalents:


Beginning of year
43,702

63,582

End of period
$
30,136

$
23,907

Supplemental Disclosures


Cash payments for:


Interest paid to depositors
$
4,963

$
5,987

Interest paid on other obligations
2,819

2,833

Income taxes paid
5,268

3,974

Noncash activities:


Increase (decrease) in maximum cash obligation related to ESOP shares
$
1,831

$
(2,993
)
Transfers to other real estate owned
1,715

467

See Notes to Consolidated Financial Statements.


Page 8

HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1.
Summary of Significant Accounting Policies

Basis of Presentation:

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

Operating results for the six month period ended June 30, 2014 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2014.  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, 2013 filed with the Securities Exchange Commission on March 11, 2014.  The consolidated balance sheet as of December 31, 2013, has been derived from the audited consolidated financial statements for that period.

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

Effect of New Financial Accounting Standards:

In January 2014, the FASB issued ASU No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects", to amend FASB ASC Topic 323, Investments – Equity Method and Joint Ventures .  The objective of this standard is to provide guidance on accounting for investments by a reporting entity in flow-through limited liability entities that manage or invest in affordable housing projects that qualify for the low-income housing tax credit.  The amendments in the standard permit reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met.  Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit).  The standard will be effective for the Company beginning January 1, 2015; however, early adoption is permitted.  The Company does have significant investments in such qualified affordable housing projects and is currently reviewing the provisions of this standard to determine what, if any, impacts it may have on the Company’s financial position or results of operations.

In January 2014, the FASB issued ASU No. 2014-04, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. ASU 2014-4 clarifies that an in substance foreclosure repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either the creditor obtaining legal title to the residential real estate property upon foreclosure or the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement.  Additional disclosures are required.  ASU 2014-4 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2014.  The adoption of ASU 2014-4 by the Company is not expected to have a material impact.

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

Page 9
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)


Note 2.
Earnings Per Share

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

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

Three Months Ended June 30,
Six Months Ended
June 30,
2014
2013
2014
2013
Common shares outstanding at the beginning of the period
4,708,576

4,714,694

4,711,995

4,712,328

Weighted average number of net shares (redeemed) issued
(6,471
)
(1,842
)
(5,696
)
1,523

Weighted average shares outstanding (basic)
4,702,105

4,712,852

4,706,299

4,713,851

Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method
2,060

3,327

2,425

3,981

Weighted average number of shares (diluted)
4,704,165

4,716,179

4,708,724

4,717,832

Net income (In thousands)
$
7,181

$
6,914

$
13,925

$
13,724

Earnings per share:




Basic
$
1.53

$
1.47

$
2.96

$
2.91

Diluted
$
1.53

$
1.47

$
2.96

$
2.91



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 (AOCI), included in stockholders’ equity, at June 30, 2014 and December 31, 2013:

June 30, 2014

December 31, 2013
(amounts in thousands)
Net unrealized gain on available-for-sale securities
$
2,633

$
1,808

Net unrealized (loss) gain on derivatives used for cash flow hedges
(1,410
)
769

Tax effect
(468
)
(986
)
Net-of-tax amount
$
755

$
1,591

Amounts reclassified from AOCI and the affected line items in the statement of income during the three and six months ended June 30, 2014 and 2013, were as follows:

Amounts reclassifed from AOCI
Three Months Ended June 30,
2014
2013
Affected Line Item in the Statements of Income
(amounts in thousands)
Unrealized gains on available-for-sale securities
$
—

$
—

Other noninterest income
Tax effect
—

—

Tax (expense) benefit
Total reclassification out of AOCI
$
—

$
—

Six Months Ended
June 30,
2014
2013
Affected Line Item in the Statements of Income
(amounts in thousands)
Unrealized gains on available-for-sale securities
$
—

$
17

Other noninterest income
Tax effect
—

(7
)
Tax (expense) benefit
Total reclassification out of AOCI
$
—

$
10




Page 11
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 4.
Securities

The carrying values of investment securities at June 30, 2014 and December 31, 2013 are summarized in the following table (dollars in thousands):

June 30, 2014
December 31, 2013
Amount
Percent
Amount
Percent
Securities available for sale
U.S. Treasury
$
12,358

5.15
%
$
—

—
%
State and political subdivisions
151,954

63.37

151,366

63.46

Other securities (FHLB, FHLMC and FNMA)
75,493

31.48

87,144

36.54

Total securities available for sale
$
239,805

100.00
%
$
238,510

100.00
%

Investment securities have been classified in the consolidated balance sheets according to management’s intent.  Available-for-sale securities consist of debt securities not classified as trading or held to maturity.  Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity.  There were no trading or held to maturity securities as of June 30, 2014 or December 31, 2013. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of June 30, 2014 and December 31, 2013 (in thousands):

Amortized Cost
Gross
Unrealized
Gains
Gross
Unrealized
(Losses)
Estimated Fair
Value
June 30, 2014:
U.S. Treasury
$
12,363

$
14

$
(19
)
$
12,358

State and political subdivisions
149,511

3,078

(635
)
151,954

Other securities (FHLB, FHLMC and FNMA)
75,298

264

(69
)
75,493

Total
$
237,172

$
3,356

$
(723
)
$
239,805

December 31, 2013:




U.S. Treasury
$
—

$
—

$
—

$
—

State and political subdivisions
149,704

3,182

(1,520
)
151,366

Other securities (FHLB, FHLMC and FNMA)
86,998

316

(170
)
87,144

Total
$
236,702

$
3,498

$
(1,690
)
$
238,510


The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at June 30, 2014 , were as follows (in thousands):
Amortized
Cost
Fair Value
Due in one year or less
$
35,796

$
36,056

Due after one year through five years
135,486

137,795

Due after five years through ten years
65,890

65,954

Due over ten years
—

—

Total
$
237,172

$
239,805


As of June 30, 2014 investment securities with a carrying value of $68.57 million were pledged to collateralize short-term borrowings.


Page 12
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

The following table shows the fair value, gross unrealized losses and the percentage of fair value represented by gross unrealized losses of applicable investment securities owned by the Company, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2014 and December 31, 2013 (in thousands):

Less than 12 months
12 months or more
Total
June 30, 2014
Description of Securities
#
Fair Value
Unrealized
Loss
%
#
Fair Value
Unrealized
Loss
%
#
Fair Value
Unrealized
Loss
%
U.S. Treasury
3

$
7,414

$
(19
)
0.26
%
—

$
—

$
—

—
%
3

$
7,414

$
(19
)
0.26
%
State and political subdivisions
66

16,971

(116
)
0.68
%
111

24,089

(519
)
2.15
%
177

41,060

(635
)
1.55
%
Other securities (FHLB, FHLMC and FNMA)
5

10,525

(30
)
0.29
%
3

8,351

(39
)
0.47
%
8

18,876

(69
)
0.37
%
Total temporarily impaired securities
74

$
34,910

$
(165
)
0.47
%
114

$
32,440

$
(558
)
1.72
%
188

$
67,350

$
(723
)
1.07
%

Less than 12 months
12 months or more
Total
December 31, 2013
Description of Securities
#
Fair Value
Unrealized
Loss
%
#
Fair Value
Unrealized
Loss
%
#
Fair Value
Unrealized
Loss
%
U.S. Treasury
—

$
—

$
—

—
%
—

$
—

$
—

—
%
—

$
—

$
—

—
%
State and political subdivisions
164

36,212

(1,259
)
3.48
%
25

5,565

(261
)
4.69
%
189

41,777

(1,520
)
3.64
%
Other securities (FHLB, FHLMC and FNMA)
10

21,810

(149
)
0.68
%
1

2,557

(21
)
0.82
%
11

24,367

(170
)
0.70
%
Total temporarily impaired securities
174

$
58,022

$
(1,408
)
2.43
%
26

$
8,122

$
(282
)
3.47
%
200

$
66,144

$
(1,690
)
2.56
%

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


Page 13
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 5.
Loans

Classes of loans are as follows:

June 30,
2014
December 31,
2013
(Amounts In Thousands)
Agricultural
$
85,204

$
82,138

Commercial and financial
178,227

166,102

Real estate:
Construction, 1 to 4 family residential
33,942

30,309

Construction, land development and commercial
76,735

69,182

Mortgage, farmland
144,050

142,685

Mortgage, 1 to 4 family first liens
628,914

605,687

Mortgage, 1 to 4 family junior liens
107,949

105,785

Mortgage, multi-family
237,919

244,090

Mortgage, commercial
318,142

315,187

Loans to individuals
20,874

19,824

Obligations of state and political subdivisions
55,069

45,167

$
1,887,025

$
1,826,156

Net unamortized fees and costs
657

641

$
1,887,682

$
1,826,797

Less allowance for loan losses
25,350

25,550

$
1,862,332

$
1,801,247



Page 14
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the three and six months ended June 30, 2014 were as follows:

Three Months Ended June 30, 2014
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
$
4,062

$
4,519

$
2,961

$
2,782

$
6,621

$
4,264

$
651

$
25,860

Charge-offs
(25
)
(370
)
(245
)
—

(185
)
(48
)
(173
)
(1,046
)
Recoveries
2

259

88

—

273

119

41

782

Provision
(1,003
)
424

627

(33
)
122

(596
)
213

(246
)
Ending balance
$
3,036

$
4,832

$
3,431

$
2,749

$
6,831

$
3,739

$
732

$
25,350



Six Months Ended June 30, 2014
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
$
2,852

$
4,733

$
2,918

$
2,557

$
7,064

$
4,787

$
639

$
25,550

Charge-offs
(125
)
(455
)
(247
)
—

(492
)
(48
)
(205
)
(1,572
)
Recoveries
5

609

274

—

452

160

73

1,573

Provision
304

(55
)
486

192

(193
)
(1,160
)
225

(201
)
















Ending balance
$
3,036

$
4,832

$
3,431

$
2,749

$
6,831

$
3,739

$
732

$
25,350

















Ending balance, individually evaluated for impairment
$
3

$
11

$
28

$
15

$
23

$
14

$
—

$
94

















Ending balance, collectively evaluated for impairment
$
3,033

$
4,821

$
3,403

$
2,734

$
6,808

$
3,725

$
732

$
25,256

















Loans:
Ending balance
$
85,204

$
178,227

$
110,677

$
144,050

$
736,863

$
556,061

$
75,943

$
1,887,025

















Ending balance, individually evaluated for impairment
$
292

$
2,585

$
846

$
387

$
4,087

$
18,021

$
—

$
26,218

















Ending balance, collectively evaluated for impairment
$
84,912

$
175,642

$
109,831

$
143,663

$
732,776

$
538,040

$
75,943

$
1,860,807


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

Changes in the allowance for loan losses for the three and six months ended June 30, 2013 were as follows:
Three Months Ended June 30, 2013
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
$
2,158

$
4,468

$
3,247

$
2,065

$
7,276

$
4,711

$
695

$
24,620

Charge-offs
—

(380
)
(12
)
—

(298
)
(54
)
(82
)
(826
)
Recoveries
3

301

135

—

272

107

38

856

Provision
218

489

(382
)
85

(266
)
(394
)
—

(250
)
Ending balance
$
2,379

$
4,878

$
2,988

$
2,150

$
6,984

$
4,370

$
651

$
24,400


Six Months Ended June 30, 2013
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
$
1,653

$
4,573

$
3,175

$
1,746

$
8,088

$
5,104

$
821

$
25,160

Charge-offs
—

(495
)
(220
)
—

(548
)
(283
)
(124
)
$
(1,670
)
Recoveries
18

552

166

—

349

156

90

$
1,331

Provision
708

248

(133
)
404

(905
)
(607
)
(136
)
$
(421
)
Ending balance
$
2,379

$
4,878

$
2,988

$
2,150

$
6,984

$
4,370

$
651

$
24,400

Ending balance, individually evaluated for impairment
$
3

$
22

$
9

$
9

$
76

$
237

$
—

$
356

Ending balance, collectively evaluated for impairment
$
2,376

$
4,856

$
2,979

$
2,141

$
6,908

$
4,133

$
651

$
24,044

Loans:








Ending balance
$
76,419

$
170,985

$
105,458

$
126,767

$
678,185

$
522,379

$
61,498

$
1,741,691

Ending balance, individually evaluated for impairment
$
125

$
2,057

$
2,630

$
540

$
4,228

$
18,442

$
—

$
28,022

Ending balance, collectively evaluated for impairment
$
76,294

$
168,928

$
102,828

$
126,227

$
673,957

$
503,937

$
61,498

$
1,713,669




Page 16
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

The following table presents the credit quality indicators by type of loans in each category as of June 30, 2014 and December 31, 2013, respectively (amounts in thousands):

Agricultural
Commercial and
Financial
Real Estate:
Construction, 1 to 4
family residential
Real Estate:
Construction, land
development and
commercial
June 30, 2014
Grade:
Pass
$
60,842

$
139,704

$
28,002

$
59,506

Monitor
12,688

19,311

2,318

6,255

Special Mention
8,167

12,017

1,685

9,592

Substandard
3,507

7,195

1,937

1,382

Total
$
85,204

$
178,227

$
33,942

$
76,735


Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family first liens
Real Estate: Mortgage,
1 to 4 family junior
liens
Real Estate:
Mortgage, multi-
family
June 30, 2014
Grade:
Pass
$
126,967

$
550,560

$
100,399

$
191,591

Monitor
11,344

39,276

2,779

33,143

Special Mention
1,632

19,740

2,659

12,359

Substandard
4,107

19,338

2,112

826

Total
$
144,050

$
628,914

$
107,949

$
237,919


Real Estate:
Mortgage,
commercial
Loans to
individuals
Obligations of state and
political subdivisions
Total
June 30, 2014
Grade:
Pass
$
266,939

$
20,269

$
54,030

$
1,598,809

Monitor
32,446

191

1,039

160,790

Special Mention
11,944

274

—

80,069

Substandard
6,813

140

—

47,357

Total
$
318,142

$
20,874

$
55,069

$
1,887,025


Page 17
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Agricultural
Commercial and
Financial
Real Estate:
Construction, 1 to 4
family residential
Real Estate:
Construction, land
development and
commercial
December 31, 2013
Grade:
Pass
$
71,370

$
134,605

$
26,519

$
56,555

Monitor
3,579

12,469

758

3,963

Special Mention
1,076

12,971

2,242

6,854

Substandard
6,113

6,057

790

1,810

Total
$
82,138

$
166,102

$
30,309

$
69,182


Real Estate:
Mortgage,
farmland
Real Estate:
Mortgage, 1 to 4
family first liens
Real Estate: Mortgage,
1 to 4 family junior
liens
Real Estate:
Mortgage, multi-
family
December 31, 2013
Grade:
Pass
$
132,988

$
532,921

$
98,142

$
196,616

Monitor
5,413

30,454

2,273

28,438

Special Mention
1,795

22,097

3,187

18,161

Substandard
2,489

20,215

2,183

875

Total
$
142,685

$
605,687

$
105,785

$
244,090


Real Estate:
Mortgage,
commercial
Loans to
individuals
Obligations of state and
political subdivisions
Total
December 31, 2013
Grade:
Pass
$
262,252

$
19,263

$
43,047

$
1,574,278

Monitor
30,140

117

1,061

118,665

Special Mention
14,749

316

1,059

84,507

Substandard
8,046

128

—

48,706

Total
$
315,187

$
19,824

$
45,167

$
1,826,156



Page 18
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

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.

Monitor – Monitor 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 monitor indicator assists the Company in identifying and monitoring loans for which credit quality could deteriorate.  This grade was labeled potential watch in previous reports; the Company changed the label only and has not changed the overall description of the credit quality indicator.

Special Mention – Special mention 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 special mention credit would typically have a weakness in one of the general categories (cash flow, collateral position or payment history) but not in all categories.  This grade was labeled watch in previous reports; the Company changed the label only and has not changed the overall description of the credit quality indicator

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

Page 19
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Past due loans as of June 30, 2014 and December 31, 2013 were as follows:

30 - 59 Days
Past Due
60 - 89 Days
Past Due
90 Days
or More
Past Due
Total Past
Due
Current
Total
Loans
Receivable
Accruing Loans
Past Due 90
Days or More
(Amounts In Thousands)
June 30, 2014:
Agricultural
$
8

$
—

$
—

$
8

$
85,196

$
85,204

$
—

Commercial and financial
350

74

952

1,376

176,851

178,227

—

Real estate:
Construction, 1 to 4 family residential
484

—

—

484

33,458

33,942

—

Construction, land development and commercial
1,244

—

144

1,388

75,347

76,735

—

Mortgage, farmland
147

310

105

562

143,488

144,050

105

Mortgage, 1 to 4 family first liens
476

1,814

1,179

3,469

625,445

628,914

367

Mortgage, 1 to 4 family junior liens
360

444

—

804

107,145

107,949

—

Mortgage, multi-family
26

—

—

26

237,893

237,919

—

Mortgage, commercial
121

178

1,089

1,388

316,754

318,142

—

Loans to individuals
12

—

—

12

20,862

20,874

—

Obligations of state and political subdivisions
—

—

—

—

55,069

55,069

—

$
3,228

$
2,820

$
3,469

$
9,517

$
1,877,508

$
1,887,025

$
472

December 31, 2013:







Agricultural
$
8

$
10

$
—

$
18

$
82,120

$
82,138

$
—

Commercial and financial
526

177

951

1,654

164,448

166,102

—

Real estate:







Construction, 1 to 4 family residential
—

—

—

—

30,309

30,309

—

Construction, land development and commercial
276

144

731

1,151

68,031

69,182

—

Mortgage, farmland
108

—

—

108

142,577

142,685

—

Mortgage, 1 to 4 family first liens
4,418

1,649

2,223

8,290

597,397

605,687

959

Mortgage, 1 to 4 family junior liens
835

43

29

907

104,878

105,785

—

Mortgage, multi-family
—

150

—

150

243,940

244,090

—

Mortgage, commercial
1,350

—

493

1,843

313,344

315,187

—

Loans to individuals
7

4

—

11

19,813

19,824

—

Obligations of state and political subdivisions
14

—

—

14

45,153

45,167

—

$
7,542

$
2,177

$
4,427

$
14,146

$
1,812,010

$
1,826,156

$
959


Page 20
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

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.

Certain impaired loan information by loan type at June 30, 2014 and December 31, 2013, was as follows:

June 30, 2014
December 31, 2013
Non-accrual
loans (1)
Accruing loans
past due 90 days
or more (2)
TDR loans
Non-
accrual
loans (1)
Accruing loans
past due 90 days
or more (2)
TDR loans
(Amounts In Thousands)
(Amounts In Thousands)
Agricultural
$
—

$
—

$
291

$
—

$
—

$
120

Commercial and financial
1,068

—

1,518

1,462

—

945

Real estate:






Construction, 1 to 4 family residential
144

—

170

—

—

—

Construction, land development and commercial
359

—

173

1,319

—

—

Mortgage, farmland
—

105

282

—

—

284

Mortgage, 1 to 4 family first liens
1,905

367

1,421

2,209

959

1,272

Mortgage, 1 to 4 family junior liens
394

—

—

178

—

—

Mortgage, multi-family
424

—

5,627

456

—

5,608

Mortgage, commercial
1,914

—

10,056

1,568

—

10,146

Loans to individuals
—

—

—

—

—

—

$
6,208

$
472

$
19,538

$
7,192

$
959

$
18,375


(1)
There were $2.42 million and $2.72 million of TDR loans included within nonaccrual loans as of June 30, 2014 and December 31, 2013, respectively.
(2)
There were no TDR loans within accruing loans past due 90 days or more as of June 30, 2014 and December 31, 2013, respectively.

Loans 90 days or more past due that are still accruing interest decreased $0.49 million from December 31, 2013 to June 30, 2014 due to a decrease in the number of loans past due greater than 90 days. The average accruing loans past due 90 days or more balance was $0.09 million as of June 30, 2014 and $0.08 million as of December 31, 2013.  The accruing loans past due 90 days or more balances are believed to be adequately collateralized and the Company expects to collect all principal and interest as contractually due under these loans.

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


Page 21
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Below is a summary of information for TDR loans as of June 30, 2014 and December 31, 2013:

June 30, 2014
December 31, 2013
Number
of
contracts
Recorded
investment
Commitments
outstanding
Number
of
contracts
Recorded
investment
Commitments
outstanding
(Amounts In Thousands)
(Amounts In Thousands)
Agricultural
4

$
291

$
252

1

$
120

$
4

Commercial and financial
15

2,361

149

12

2,214

101

Real estate:






Construction, 1 to 4 family residential
1

170

—

—

—

—

Construction, land development and commercial
1

173

—

1

13

—

Mortgage, farmland
1

282

—

1

284

—

Mortgage, 1 to 4 family first liens
14

225

—

12

1,697

—

Mortgage, 1 to 4 family junior liens
1

1,701

—

—

—

177

Mortgage, multi-family
4

5,992

—

3

6,000

—

Mortgage, commercial
10

10,758

—

9

10,766

10

Loans to individuals
—

—

—

—

—

—

51

$
21,953

$
401

39

$
21,094

$
292


The following is a summary of TDR loans that were modified during the three and six months ended June 30, 2014 :

Three Months Ended June 30, 2014
Six Months Ended June 30, 2014
Number
of
contracts
Pre-modification
recorded
investment
Post-modification
recorded
investment
Number
of
contracts
Pre-modification
recorded
investment
Post-modification
recorded
investment
(Amounts In Thousands)
Agricultural
1

$
40

$
40

3

$
243

$
196

Commercial and financial
1

63

63

7

775

775

Real estate:






Construction, 1 to 4 family residential
1

170

170

1

170

170

Construction, land development and commercial
1

184

173

1

184

173

Mortgage, 1 to 4 family first lien
1

100

100

3

181

181

Mortgage, 1 to 4 family junior liens
—

—

—

1

225

225

Mortgage, multi-family
—

—

—

1

89

89

Mortgage, commercial
—

—

—

2

269

269

5

$
557

$
546

19

$
2,136

$
2,078



Page 22
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

The Company had commitments to lend $0.40 million in additional borrowings to restructured loan customers as of June 30, 2014 .  The Company had commitments to lend $0.29 million in additional borrowings to restructured loan customers as of December 31, 2013.  These commitments were in the normal course of business.  The additional borrowings were not used to facilitate payments on these loans.

There were $1.23 million and $0.00 million of TDR loans that were in payment default (defined as past due 90 days or more) as of June 30, 2014 and December 31, 2013, respectively.  As of June 30, 2014 , TDR loans in payment default consisted of a $0.09 million 1to 4 family first lien mortgage loan, a $0.22 million 1 to 4 family junior lien loan, a $0.16 million commercial mortgage loan and a commercial and financial loan totaling $0.76 million .


Page 23
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Information regarding impaired loans as of and for the three and six months ended June 30, 2014 is as follows:
June 30, 2014
Three Months Ended June 30, 2014
Six Months Ended
June 30, 2014
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
$
176

$
276

$
—

$
199

$
3

$
238

$
6

Commercial and financial
1,890

3,393

—

1,876

10

1,923

21

Real estate:




Construction, 1 to 4 family residential
—

—

—

—

—

—

—

Construction, land development and commercial
503

1,778

—

529

—

618

—

Mortgage, farmland
—

—

—

—

—

—

—

Mortgage, 1 to 4 family first liens
3,226

4,352

—

3,248

15

3,288

32

Mortgage, 1 to 4 family junior liens
394

680

—

398

3

398

5

Mortgage, multi-family
6,051

6,683

—

6,078

63

6,102

126

Mortgage, commercial
2,935

5,604

—

3,000

15

3,060

31

Loans to individuals
—

20

—

—

—

—

—

$
15,175

$
22,786

$
—

$
15,328

$
109

$
15,627

$
221

With an allowance recorded:





Agricultural
$
116

$
116

$
3

$
117

$
1

$
118

$
2

Commercial and financial
695

695

11

710

9

725

19

Real estate:
Construction, 1 to 4 family residential
170

170

20

170

2

170

4

Construction, land development and commercial
173

184

8

178

2

178

5

Mortgage, farmland
387

387

15

388

5

388

9

Mortgage, 1 to 4 family first liens
467

519

23

472

5

475

11

Mortgage, 1 to 4 family junior liens
—

—

—

—

—

—

—

Mortgage, multi-family
—

—

—

—

—

—

—

Mortgage, commercial
9,035

9,048

14

9,063

129

9,092

260

Loans to individuals
—

—

—

—

—

—

—

$
11,043

$
11,119

$
94

$
11,098

$
153

$
11,146

$
310

Total:





Agricultural
$
292

$
392

$
3

$
316

$
4

$
356

$
8

Commercial and financial
2,585

4,088

11

2,586

19

2,648

40

Real estate:





Construction, 1 to 4 family residential
170

170

20

170

2

170

4

Construction, land development and commercial
676

1,962

8

707

2

796

5

Mortgage, farmland
387

387

15

388

5

388

9

Mortgage, 1 to 4 family first liens
3,693

4,871

23

3,720

20

3,763

43

Mortgage, 1 to 4 family junior liens
394

680

—

398

3

398

5

Mortgage, multi-family
6,051

6,683

—

6,078

63

6,102

126

Mortgage, commercial
11,970

14,652

14

12,063

144

12,152

291

Loans to individuals
—

20

—

—

—

—

—

$
26,218

$
33,905

$
94

$
26,426

$
262

$
26,773

$
531


Page 24
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Information regarding impaired loans as of December 31, 2013 is as follows:

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

$
—

$
—

Commercial and financial
1,602

3,140

—

Real estate:



Construction, 1 to 4 family residential
1,270

2,974

—

Construction, land development and commercial
140

140

—

Mortgage, farmland
—

—

—

Mortgage, 1 to 4 family first liens
2,597

3,542

—

Mortgage, 1 to 4 family junior liens
177

451

—

Mortgage, multi-family
456

1,068

—

Mortgage, commercial
2,494

5,303

—

Loans to individuals
—

20

—

$
8,736

$
16,638

$
—

With an allowance recorded:



Agricultural
$
120

$
120

$
3

Commercial and financial
805

838

16

Real estate:



Construction, 1 to 4 family residential
—

—

—

Construction, land development and commercial
—

—

—

Mortgage, farmland
284

284

14

Mortgage, 1 to 4 family first liens
1,768

1,897

66

Mortgage, 1 to 4 family junior liens
—

—

—

Mortgage, multi-family
5,608

5,608

188

Mortgage, commercial
9,205

9,205

17

Loans to individuals
—

—

—

$
17,790

$
17,952

$
304

Total:



Agricultural
$
120

$
120

$
3

Commercial and financial
2,407

3,978

16

Real estate:



Construction, 1 to 4 family residential
1,270

2,974

—

Construction, land development and commercial
140

140

—

Mortgage, farmland
284

284

14

Mortgage, 1 to 4 family first liens
4,365

5,439

66

Mortgage, 1 to 4 family junior liens
177

451

—

Mortgage, multi-family
6,064

6,676

188

Mortgage, commercial
11,699

14,508

17

Loans to individuals
—

20

—

$
26,526

$
34,590

$
304



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

Impaired loans decreased $0.31 million from December 31, 2013 to June 30, 2014 .  Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans.  Impaired loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement.  Impaired loans were 1.39% of loans held for investment as of June 30, 2014 and 1.45% as of December 31, 2013.  The decrease in impaired loans is due mainly to a decrease in nonaccrual loans of $0.98 million from December 31, 2013 to June 30, 2014 .

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

Note 6.
Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments as of June 30, 2014 are as follows:
June 30, 2014
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
$
30,136


$
30,136


$
30,136


$
—


$
—

Investment securities
247,458


247,458


—


247,458


—

Loans held for sale
7,959


7,959




7,959



Loans









Agricultural
82,168


89,378


—


—


89,378

Commercial and financial
173,395


190,186


—


—


190,186

Real estate:









Construction, 1 to 4 family residential
32,641


31,408


—


—


31,408

Construction, land development and commercial
74,605


72,631


—


—


72,631

Mortgage, farmland
141,301


138,847


—


—


138,847

Mortgage, 1 to 4 family first liens
623,000


618,387


—


—


618,387

Mortgage, 1 to 4 family junior liens
107,032


106,338


—


—


106,338

Mortgage, multi-family
236,512


235,599


—


—


235,599

Mortgage, commercial
315,810


314,137


—


—


314,137

Loans to individuals
20,510


20,654


—


—


20,654

Obligations of state and political subdivisions
54,701


54,929


—


—


54,929

Accrued interest receivable
8,251


8,251


—


8,251


—

Total financial instrument assets
$
2,155,479

$
2,166,298

$
30,136

$
263,668

$
1,872,494

Financial instrument liabilities





Deposits





Noninterest-bearing deposits
$
261,565


$
261,565


$
—


$
261,565


$
—

Interest-bearing deposits
1,464,759


1,468,410


—


1,468,410


—

Short-term borrowings
68,572


68,572


—


68,572


—

Federal Home Loan Bank borrowings
125,000


131,356


—


131,356


—

Accrued interest payable
930


930


—


930


—

Total financial instrument liabilities
$
1,920,826

$
1,930,833

$
—

$
1,930,833

$
—

Face Amount




Financial instrument with off-balance sheet risk:





Loan commitments
$
394,585

$
—

$
—

$
—

$
—

Letters of credit
14,417

—

—

—

—

Total financial instrument liabilities with off-balance-sheet risk
$
409,002

$
—

$
—

$
—

$
—

(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 27
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

The carrying value and estimated fair values of the Company's financial instruments as of December 31, 2013 are as follows:

December 31, 2013
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
$
43,702

$
43,702

$
43,702

$
—

$
—

Investment securities
246,089

246,089

—

246,089

—

Loans held for sale
4,927

4,927

—

4,927

—

Loans





Agricultural
79,286

86,137

—

—

86,137

Commercial and financial
161,369

176,385

—

—

176,385

Real estate:





Construction, 1 to 4 family residential
29,298

28,364

—

—

28,364

Construction, land development and commercial
67,275

65,544

—

—

65,544

Mortgage, farmland
140,128

137,938

—

—

137,938

Mortgage, 1 to 4 family first liens
599,586

595,054

—

—

595,054

Mortgage, 1 to 4 family junior liens
104,822

104,133

—

—

104,133

Mortgage, multi-family
242,026

240,595

—

—

240,595

Mortgage, commercial
312,464

310,558

—

—

310,558

Loans to individuals
19,554

19,710

—

—

19,710

Obligations of state and political subdivisions
44,798

45,184

—

—

45,184

Accrued interest receivable
7,676

7,676

—

7,676

—

Total financial instrument assets
$
2,103,000

$
2,111,996

$
43,702

$
258,692

$
1,809,602

Financial instrument liabilities:





Deposits





Noninterest-bearing deposits
$
256,788

$
256,788

$
—

$
256,788

$
—

Interest-bearing deposits
1,453,089

1,461,454

—

1,461,454

—

Short-term borrowings
42,016

42,016

—

42,016

—

Federal Home Loan Bank borrowings
125,000

132,469

—

132,469

—

Accrued interest payable
1,102

1,102

—

1,102

—

Total financial instrument liabilities
$
1,877,995

$
1,893,829

$
—

$
1,893,829

$
—

Face Amount




Financial instrument with off-balance sheet risk:





Loan commitments
$
360,945

$
—

$
—

$
—

$
—

Letters of credit
11,019

—

—

—

—

Total financial instrument liabilities with off-balance-sheet risk
$
371,964

$
—

$
—

$
—

$
—

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


Page 28
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)


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

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

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

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

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

ASSETS

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

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

The pricing for investment securities is obtained from an independent source.  There are no level 1 or level 3 investment securities owned by the Company.  The Company obtains an understanding of the independent source’s valuation methodologies used to determine fair value by level of security. The Company validates assigned fair values on a sample basis using an additional third-party provider pricing service to determine if the fair value measurement is reasonable.  Due to the nature of our investment portfolio, we do not expect significant and unusual fluctuations as fair value changes primarily relate to interest rate changes.   No unusual fluctuations were identified during the six months ended June 30, 2014 .   If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.

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


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

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

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

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

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

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

LIABILITIES

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

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.

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

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 30
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

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

June 30, 2014
Readily
Available
Market
Prices(1)
Observable
Market Prices(2)
Company
Determined
Market
Prices(3)
Total at Fair
Value
(Amounts In Thousands)
U.S. Treasury
$
—

$
12,358

$
—

$
12,358

State and political subdivisions
—

151,954

—

151,954

Other securities (FHLB, FHLMC and FNMA)
—

75,493

—

75,493

Total
$
—

$
239,805

$
—

$
239,805


December 31, 2013
Readily
Available
Market
Prices(1)
Observable
Market Prices(2)
Company
Determined
Market
Prices(3)
Total at Fair
Value
(Amounts In Thousands)
U.S. Treasury
$
—

$
—

$
—

$
—

State and political subdivisions
—

151,366

—

151,366

Other securities (FHLB, FHLMC and FNMA)
—

87,144

—

87,144

Total
$
—

$
238,510

$
—

$
238,510

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

There were no transfers between Levels 1, 2 or 3 during the six months ended June 30, 2014 .



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

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

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

June 30, 2014
Three Months Ended June 30, 2014
Six Months Ended June 30, 2014
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
$
—

$
—

$
289

$
289

$
25

$
25

Commercial and financial
—

—

2,574

2,574

60

60

Real Estate:
Construction, 1 to 4 family residential
—

—

150

150

—

—

Construction, land development and commercial
—

—

668

668

—

—

Mortgage, farmland
—

—

372

372

—

—

Mortgage, 1 to 4 family first liens
—

—

3,670

3,670

83

98

Mortgage, 1 to 4 family junior liens
—

—

394

394

—

24

Mortgage, multi-family
—

—

6,051

6,051

—

—

Mortgage, commercial
—

—

11,956

11,956

40

140

Loans to individuals
—

—

—

—

—

—

Foreclosed assets (5)
—

—

20

20

—

23

Total
$
—

$
—

$
26,144

$
26,144

$
208

$
370

(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 32
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

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

December 31, 2013
Year Ended
December 31, 2013
Readily
Available
Market
Prices(1)
Observable
Market
Prices(2)
Company
Determined
Market
Prices(3)
Total at Fair
Value
Total Losses
(Amounts in Thousands)
Loans (4)
Agricultural
$
—

$
—

$
117

$
117

$
—

Commercial and financial
—

—

2,391

2,391

53

Real Estate:





Construction, 1 to 4 family residential
—

—

1,270

1,270

—

Construction, land development and commercial
—

—

140

140

—

Mortgage, farmland
—

—

270

270

—

Mortgage, 1 to 4 family first liens
—

—

4,299

4,299

424

Mortgage, 1 to 4 family junior liens
—

—

177

177

59

Mortgage, multi-family
—

—

5,876

5,876

69

Mortgage, commercial
—

—

11,682

11,682

229

Loans to individuals
—

—

—

—

—

Foreclosed assets (5)
—

—

427

427

68

Total
$
—

$
—

$
26,649

$
26,649

$
902


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

Note 7.
Stock Repurchase Program

On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”).  The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2015.  The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis.  All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis.  The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.  The Company has purchased 367,498 shares of its common stock in privately negotiated transactions from August 1, 2005 through June 30, 2014 .  Of these 367,498 shares, 13,374 shares were purchased during the quarter ended June 30, 2014 , at an average price per share of $76.53 .


Page 33
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note 8.
Commitments and Contingencies

Concentrations of credit risk :  The Bank’s loans, commitments to extend credit, unused lines of credit and outstanding letters of credit have been granted to customers within the Bank's market area.  Investments in securities issued by state and political subdivisions within the state of Iowa totaled approximately $68.46 million .  The concentrations of credit by type of loan are set forth in Note 5 to the Consolidated Financial Statements.  Outstanding letters of credit were granted primarily to commercial borrowers.  Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the economic conditions in Johnson, Linn and Washington Counties, Iowa.

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

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

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments.  The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.  A summary of the Bank’s commitments at June 30, 2014 and December 31, 2013 is as follows:
June 30, 2014
December 31, 2013
(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans
$
40,413

$
38,243

Credit cards
42,887

44,326

Commercial, real estate and home construction
112,898

106,241

Commercial lines and real estate purchase loans
198,387

172,135

Outstanding letters of credit
14,417

11,019

Note 9.
Income Taxes

Federal income tax expense for the six months ended June 30, 2014 and 2013 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, 2013, 2012, and 2011 remain subject to examination by the Internal Revenue Service.  For state tax purposes, the tax years ended December 31, 2013, 2012, and 2011 remain open for examination.  There were no material unrecognized tax benefits at June 30, 2014 and December 31, 2013 and therefore no interest or penalties on unrecognized tax benefits has been recorded.  As of June 30, 2014 , the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending June 30, 2015.

Income taxes as a percentage of income before taxes were 28.60% for the six months ended June 30, 2014 and 29.90% for the same period in 2013.  The decrease in the effective tax rate is due to tax-exempt interest income and the relationship to total income before income taxes.


Page 34
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)


Note 10.
Derivative Financial Instruments

In the normal course of business, the Bank may use derivative financial instruments to manage its interest rate risk.  These instruments carry varying degrees of credit, interest rate and market or liquidity risks.  Derivative instruments are recognized as either assets or liabilities in the accompanying financial statement and are measured at fair value.  The Bank’s objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates.  The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amount to be exchanged between the counterparties.  The Bank is exposed to credit risk in the event of nonperformance by counterparties to financial instruments.  The Bank minimizes this risk by entering into derivative contracts with large, stable financial institutions.  The Bank has not experienced any losses from nonperformance by counterparties.  The Bank monitors counterparty risk in accordance with the provisions of ASC 815.  In addition, the Bank’s interest rate-related derivative instruments contain language outlining collateral pledging requirements for each counterparty.  Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty.  The Bank was not required to pledge any collateral as of June 30, 2014 .

Cash Flow Hedges:

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

The table below identifies the balance sheet category and fair values of the Bank’s derivative instruments designated as cash flow hedges as of June 30, 2014 and December 31, 2013:

Notional
Amount
Fair
Value
Balance
Sheet
Category
Maturity
(Amounts in Thousands)
June 30, 2014
Interest rate swap
$
25,000

$
(456
)
Other Liabilities
11/9/2020
Interest rate swap
25,000

(954
)
Other Liabilities
11/7/2023
December 31, 2013


Interest rate swap
$
25,000

$
357

Other Assets
11/9/2020
Interest rate swap
25,000

412

Other Assets
11/7/2023



Page 35
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

The table below identifies the gains and losses recognized on the Bank’s derivative instruments designated as cash flow hedges as of June 30, 2014 and December 31, 2013:

Effective Portion
Ineffective Portion
Recognized
in OCI
Reclassifed from AOCI into
Income
Recognized in Income on
Derivatives
Amount of
Gain (Loss)
Category
Amount
of Gain
(Loss)
Category
Amount
of Gain
(Loss)
(Amounts in Thousands)
June 30, 2014
Interest rate swap
$
(502
)
Interest Expense
$
—

Other Income
$
—

Interest rate swap
(844
)
Interest Expense
—

Other Income
—

December 31, 2013



Interest rate swap
$
220

Interest Expense
$
—

Other Income
$
—

Interest rate swap
255

Interest Expense
—

Other Income
—



Page 36

HILLS BANCORPORATION

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

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

Special Note Regarding Forward Looking Statements

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

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

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

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

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

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

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

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

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

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

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

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

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


Page 37

HILLS BANCORPORATION

•
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.  Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position.  Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations.  Although management believes the levels of the allowance as of June 30, 2014 and December 31, 2013 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

Overview

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

The Company is a holding company engaged in the business of commercial banking.  The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned.  The Bank was formed in Hills, Iowa in 1904.  The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa.  At June 30, 2014 , the Bank has seventeen full-service locations.


Page 38

HILLS BANCORPORATION

Net income for the six month period ended June 30, 2014 was $13.93 million compared to $13.72 million for the same six months of 2013, an increase of 1.46% .  The $0.21. million increase in net income was caused by a number of factors.  The principal factors in the increase in net income for the first six months of 2014 are an increase in net interest income of $1.52 million and a decrease in income tax expense of $0.28 million .  These changes were offset by an increase in the provision for loan losses of $0.22 million , a decrease in noninterest income of $1.04 million and an increase in noninterest expenses of $0.34 million .

The Company achieved a return on average assets of 1.22% and a return on average equity of 11.22% for the twelve months ended June 30, 2014 , compared to the twelve months ended June 30, 2013, which were 1.18% and 11.06%, respectively.  Dividends of $1.15 per share were paid in January 2014 to 2,204 shareholders.  The 2013 dividend was $1.10 per share.

The Company’s net interest income is the largest component of revenue and it is primarily a function of the average earning assets and the net interest margin percentage.  The Company achieved a net interest margin on a tax-equivalent basis of 3.48% for the six months ended June 30, 2014 compared to 3.52% for the same six months of 2013.  Average earning assets were $2.090 billion in 2014 and $1.980 billion in 2013.

Highlights noted on the balance sheet as of June 30, 2014 for the Company included the following:

•
Total assets were $2.220 billion , an increase of $52.02 million since December 31, 2013.
•
Cash and cash equivalents were $30.14 million , a decrease of $13.57 million since December 31, 2013.
•
Net loans were $1.870 billion , an increase of $64.12 million since December 31, 2013.  Loans held for sale increased $3.03 million since December 31, 2013.
•
Deposit growth of $16.45 million since December 31, 2013.

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

Financial Condition

The following table sets forth the composition of the loan portfolio as of June 30, 2014 and December 31, 2013:

June 30, 2014
December 31, 2013
Amount
Percent
Amount
Percent
(Amounts In Thousands)
(Amounts In Thousands)
Agricultural
$
85,204

4.52
%
$
82,138

4.50
%
Commercial and financial
178,227

9.44

166,102

9.10

Real estate:




Construction, 1 to 4 family residential
33,942

1.80

30,309

1.66

Construction, land development and commercial
76,735

4.07

69,182

3.79

Mortgage, farmland
144,050

7.63

142,685

7.81

Mortgage, 1 to 4 family first liens
628,914

33.32

605,687

33.16

Mortgage, 1 to 4 family junior liens
107,949

5.72

105,785

5.79

Mortgage, multi-family
237,919

12.61

244,090

13.37

Mortgage, commercial
318,142

16.86

315,187

17.26

Loans to individuals
20,874

1.11

19,824

1.09

Obligations of state and political subdivisions
55,069

2.92

45,167

2.47

$
1,887,025

100.00
%
$
1,826,156

100.00
%
Net unamortized fees and costs
657


641


$
1,887,682


$
1,826,797


Less allowance for loan losses
25,350


25,550


$
1,862,332


$
1,801,247




Page 39

HILLS BANCORPORATION

Loan demand has been steady and is expected to remain steady or increase throughout the year ended December 31, 2014.  As indicated above growth in the agricultural, 1 to 4 family real estate loans, obligation of state and political subdivisions loan portfolios as well as real estate loans secured by farmland have been primarily responsible for the increase in total loans.  Management expects overall portfolio loan growth to increase as a result of general improvement in market conditions.

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

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

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

Through the credit risk rating process, loans are reviewed to determine if they are performing in accordance with the original contractual terms. If the borrower has failed to comply with the original contractual terms, further action may be required by the Company, including a downgrade in the credit risk rating, movement to non-accrual status, a charge-off or the establishment of a specific impairment reserve. In the event a collateral shortfall is identified during the credit review process, the Company will work with the borrower for a principal reduction and/or a pledge of additional collateral and/or additional guarantees. In the event that these options are not available, the loan may be subject to a downgrade of the credit risk rating. If the Company determines a loan amount or portion thereof is uncollectible, the loan’s credit risk rating 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.


Page 40

HILLS BANCORPORATION

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 June 30, 2014 and December 31, 2013:
June 30, 2014
December 31, 2013
Amount
% of Total
Allowance
% of Loans to
Total Loans
Amount
% of Total
Allowance
% of Loans to
Total Loans
(In Thousands)
(In Thousands)
Agricultural
$
3,036

11.98
%
4.52
%
$
2,852

11.17
%
4.50
%
Commercial and financial
4,832

19.06

9.44

4,733

18.52

9.10

Real estate:





Construction, 1 to 4 family residential
1,301

5.13

1.80

1,011

3.96

1.66

Construction, land development and commercial
2,130

8.40

4.07

1,907

7.46

3.79

Mortgage, farmland
2,749

10.84

7.63

2,557

10.01

7.81

Mortgage, 1 to 4 family first liens
5,914

23.33

33.32

6,101

23.87

33.16

Mortgage, 1 to 4 family junior liens
917

3.62

5.72

963

3.77

5.79

Mortgage, multi-family
1,407

5.55

12.61

2,064

8.08

13.37

Mortgage, commercial
2,332

9.20

16.86

2,723

10.66

17.26

Loans to individuals
364

1.44

1.11

369

1.44

1.09

Obligations of state and political subdivisions
368

1.45

2.92

270

1.06

2.47

$
25,350

100.00
%
100.00
%
$
25,550

100.00
%
100.00
%

The allowance for loan losses totaled $25.35 million at June 30, 2014 compared to $25.55 million at December 31, 2013.  The percentage of the allowance to outstanding loans was 1.34% and 1.40% at June 30, 2014 and December 31, 2013, 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 decrease in the allowance in 2014 is the result of a change in the composition and allocation of loans within credit quality ratings.

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

Management has determined that the allowance for loan losses was appropriate at June 30, 2014 , and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for loan losses is based on a comprehensive, well documented, and consistently applied analysis of the Company’s loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for loan losses is reviewed and compared to industry data. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.

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


Page 41

HILLS BANCORPORATION

Investment securities available for sale held by the Company increased by $1.30 million from December 31, 2013 to June 30, 2014 .  The fair value of securities available for sale was $2.63 million more than the amortized cost of such securities as of June 30, 2014 .  At December 31, 2013, the fair value of the securities available for sale was $1.81 million more than the amortized cost of such securities.

Deposit growth was $16.45 million in the first six months of 2014. Federal funds borrowed increased $31.63 million and repurchase agreements decreased $5.07 million in the same period resulting in a net increase of $26.56 in short term borrowings.  In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Brokered deposits are included in total deposits and totaled $60.65 million as of June 30, 2014 with an average rate of 0.41%.  Brokered deposits were $57.77 million as of December 31, 2013 with an average interest rate of 0.44%.  As of June 30, 2014 and December 31, 2013, brokered deposits were 3.51% and 3.38% of total deposits, respectively.

Dividends and Equity

In January 2014, Hills Bancorporation paid a dividend of $5.42 million or $1.15 per share.  The dividend was $1.10 per share in January 2013.  After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of June 30, 2014 totaled $248.44 million .  Under risk-based capital rules, the total amount of Tier 1 risk-based capital was 16.25% and 16.19% as of June 30, 2014 and December 31, 2013, respectively.  The Tier 1 risk-based capital was in excess of the required minimum of 8.00%.  Risk-based capital was 17.50% and 17.44% as of June 30, 2014 and December 31, 2013, respectively. As of June 30, 2014 , 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.

In July 2013, the Officer of the Comptroller of the Currency and Board of Governors of the Federal Reserve System adopted a final rule implementing agreements reached by the Basel Committee on Banking Supervision in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems”(BASEL III).   The final rule also adopts changes to the agencies’ regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The rule implements a revised definition of regulatory capital, a new 4.50% common equity tier 1 minimum capital requirement, a 6.00% tier 1 capital requirement, and a tier 1 risk-based capital ratio of 8.00%.   The Bank expects to remain categorized as well capitalized under the final rule when it becomes effective on January 1, 2015.

Discussion of operations for the six months ended June 30, 2014 and 2013

Net Income Overview

Net income increased $0.21 million for the six months ended June 30, 2014 compared to the first six months of 2013.  Total net income was $13.93 million in 2014 and $13.72 million in the comparable period in 2013, an increase of 1.46% .  The changes in net income in 2014 from the first six months of 2013 were primarily the result of the following:

•
Net interest income increased by $1.52 million , before provision expense, primarily as a result of total interest expense reductions significantly outpacing reductions in total interest income.
•
The provision for loan losses increased by $0.22 million .
•
Noninterest income decreased by $1.04 million .
•
Noninterest expenses increased by $0.34 million .
•
Income tax expense decreased by $0.28 million .

For the six -month period ended June 30, 2014 basic and diluted earnings per share were $ 2.96 . For the six months ended June 30, 2013 basic and diluted earnings per share were both $ 2.91 .


Page 42

HILLS BANCORPORATION

Discussion of operations for the six months ended June 30, 2014 and 2013

The Company’s net income continues to be driven primarily by three important factors.  The first important factor is the interaction between changes in net interest margin and changes in average volumes of the Bank's earnings assets.  Net interest income of $34.73 million for the first six months of 2014 was derived from the Company’s $2.090 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.48%.  Average earning assets in the six months ended June 30, 2013 were $1.980 billion and the tax-equivalent net interest margin was 3.52%.  The importance of net interest margin is illustrated by the fact that an increase or decrease in the net interest margin of 10 basis points would have resulted approximately in a $1.04 million change in income before income taxes in the six month period ended June 30, 2014 .  Net interest income for the Company increased as a result of a decrease in net interest expense due to the mix of interest bearing liabilities of the Company as well as a reduction in dollar amount and rate on time deposits.  The Company expects continued net interest compression to impact earnings for the foreseeable future.  The Company believes growth in net interest income will be contingent on the growth of the Company’s earnings assets.

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $1.870 billion at June 30, 2014 .  The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio.  The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more.  In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historically higher credit risk.  The provision for loan losses was a reduction of expense of $0.20 million in 2014 compared to a reduction of expense of $0.42 million in 2013.  The Company believes that the provision for loan losses will increase for the foreseeable future resulting from projected increases in the size of the Company’s loan portfolio as well as stabilization of credit quality.

The third significant factor affecting the Company’s net income is income tax expense.  Federal and state income tax expenses were $5.58 million and $5.85 million for the six months ended June 30, 2014 and 2013, respectively.  Income taxes as a percentage of income before taxes were 28.60% in 2014 and 29.90% in 2013.


Page 43

HILLS BANCORPORATION

Discussion of operations for the six months ended June 30, 2014 and 2013

Net Interest Income

Net interest income increased for the six months ended June 30, 2014 compared to the comparable period in 2013.  The increase was primarily the result of a decrease in net interest expense due to the mix of interest bearing liabilities of the bank as well as a reduction in dollar amount and rate on time deposits.  Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities.  The factors that have the greatest impact on net interest income are the average volume of earning assets for the period and the net interest margin.  The net interest margin for the first six months of 2014 was 3.48% compared to 3.52% in 2013 for the same period.  The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable.  The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the six months ended in 2014 compared to the comparable period in 2013 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
$
112,244

(0.22
)%
$
2,561

$
(1,885
)
$
676

Taxable securities
(4,491
)
(0.18
)
(29
)
(85
)
(114
)
Nontaxable securities
18,249

(0.50
)
363

(364
)
(1
)
Federal funds sold
(16,148
)
—

(20
)
—

(20
)
$
109,854


$
2,875

$
(2,334
)
$
541

Interest expense:





Interest-bearing demand deposits
$
35,851

(0.05
)%
$
(38
)
$
113

$
75

Savings deposits
89,265

(0.02
)
(102
)
54

(48
)
Time deposits
(54,277
)
(0.21
)
462

524

986

Short-term borrowings
4,555

(0.02
)
(11
)
8

(3
)
FHLB borrowings
—

—

—

—

—

Interest-bearing other liabilities
(50
)
(1.30
)
—

17

17

$
75,344


$
311

$
716

$
1,027

Change in net interest income


$
3,186

$
(1,618
)
$
1,568


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)
2014
2013
Yield on average interest-earning assets
4.21
%
4.39
%
Rate on average interest-bearing liabilities
0.92

1.10

Net interest spread
3.29
%
3.29
%
Effect of noninterest-bearing funds
0.19

0.23

Net interest margin (tax equivalent interest income divided by average interest-earning assets)
3.48
%
3.52
%


Page 44

HILLS BANCORPORATION

Discussion of operations for the six months ended June 30, 2014 and 2013

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 five times during the first six months of 2014.  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 June 30, 2014 , the rate indexes for the one, three and five year indexes were 0.11%, 0.92% and 1.68%, respectively.  The one year index decreased 15.39% from 0.13% at June 30, 2013, the three year index increased 61.40% and the five year index increased 37.70%.  The three year index was 0.57% and the five year index was 1.22% at June 30, 2013.  The targeted federal funds rate was 0.25% at June 30, 2014 and 2013.  The Company anticipates no increases in short term rates and possible increases in long term rates in the indexes for 2014.

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $0.20 million in 2014 compared to a reduction of expense of $0.42 million in 2013, an increase of $0.22 million.  The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio.  The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio.  The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more.  In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks.  The increase in expense in 2014 is the result of an increase in loan volume as well as a change in the composition and allocation of balances within the credit quality ratings.

The allowance for loan losses decreased $0.20 million during the first six months of 2014.  In the first six months of 2014, there was an increase of $0.07 million due to the volume and composition of loans outstanding and a $0.27 million decrease in the amount allocated to the allowance due to a combination of credit quality improvements.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented.  For the six months ended June 30, 2014 and 2013, recoveries were $1.57 million and $1.33 million, respectively; and charge-offs were $1.57 million in 2014 and $1.67 million in 2013.  The allowance for loan losses totaled $25.35 million at June 30, 2014 compared to $25.55 million at December 31, 2013.  The allowance represented 1.34% and 1.40% of loans held for investment at June 30, 2014 and December 31, 2013, respectively.





Page 45

HILLS BANCORPORATION

Discussion of operations for the six months ended June 30, 2014 and 2013

Noninterest Income

The following table sets forth the various categories of noninterest income for the six months ended June 30, 2014 and 2013.

Six Months Ended June 30,
2014
2013
$ Change
% Change
(Amounts in thousands)
Net gain on sale of loans
$
300

$
1,262

$
(962
)
(76.23
)%
Trust fees
2,899

2,555

344

13.46

Service charges and fees
3,849

4,376

(527
)
(12.04
)
Rental revenue on tax credit real estate
735

716

19

2.65

Net gain on sale of other real estate owned and other reposessed assets
240

150

90

60.00

Other noninterest income
1,345

1,348

(3
)
(0.22
)
$
9,368

$
10,407

$
(1,039
)
(9.98
)

Loans originated for sale in the first six months of 2014 totaled $49.19 million compared to $136.34 million in the same period in 2013, a decrease of 63.92%.  In the six months ended June 30, 2014 and 2013, the net gain on sale of loans was $0.30 million and $1.26 million , respectively.  The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly.  The volume of activity in these types of loans is directly related to the level of interest rates.  The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income.  The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

Trust fees increased $0.34 million in the first six months of 2014 as a result of assets under management increasing to $1.249 billion as of June 30, 2014 from $1.086 billion as of June 30, 2013 due to market conditions and new trust relationships.

Service charges and fees decreased $0.53 million in the first six months of 2014 from their level for the comparable period in 2013.  Credit card merchant fees are included in service charges and fees, and that component decreased during the same period by $0.67 million due to a change to an agent program utilized by the Bank.  This decrease was offset by an increase of $0.15 million in credit card, debit card and POS Pin interchange income due to increased volume in transactions during the period.

The net gain on sale of other real estate owned and other repossessed assets increased $0.09 million to a net gain of $0.24 million for the six months ended June 30, 2014 .  The total net gain on sale of other real estate owned for the six months ended consisted of a $0.26 million net gain on the sale of 9 properties offset by a $0.02 million fair market value adjustment on one property.  During the same period in 2013, the gain consisted of a $0.16 million net gain on sale of 7 properties offset by a $0.01 million loss on sale of one property.


Page 46

HILLS BANCORPORATION

Discussion of operations for the six months ended June 30, 2014 and 2013

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the six months ended June 30, 2014 and 2013.

Six Months Ended June 30,
2014
2013
$ Change
% Change
(Amounts in thousands)
Salaries and employee benefits
$
12,642

$
12,154

$
488

4.02
%
Occupancy
1,953

1,873

80

4.27

Furniture and equipment
2,473

2,467

6

0.24

Office supplies and postage
767

766

1

—

Advertising and business development
1,441

1,271

170

13.38

Outside services
3,208

3,570

(362
)
(10.14
)
Rental expenses on tax credit real estate
1,083

957

126

13.17

FDIC insurance assessment
541

531

10

1.88

Other noninterest expense
687

866

(179
)
(20.67
)
$
24,795

$
24,455

$
340

1.39


Advertising and business development expense increased $0.17 million in the first six months of 2014 compared to 2013 as a result of $0.11 million increase in mail processing expense and $0.06 million in charitable contributions. Outside services expenses decreased $0.36 million in the first six months of 2014 from their level for the comparable period in 2013.  Merchant card processing charges are included in outside services expense, and that component decreased during the same period by $0.62 million due to a change to an agent program utilized by the Bank.  Most other noninterest expense categories experienced marginal period-to-period fluctuations for the six months ended June 30, 2014 .


Page 47

HILLS BANCORPORATION

Discussion of operations for the three months ended June 30, 2014 and 2013

Net Income Overview

Net income increased $0.27 million for the three months ended June 30, 2014 compared to the same period in 2012.  Total net income was $7.18 million in 2014 and $6.91 million in the comparable period in 2013, an increase of 3.86% .  For the three-month period ended June 30, 2014 and 2013, basic and diluted earnings per share were $1.53 and $1.47 , respectively.

Net Interest Income

Net interest income increased for the three months ended June 30, 2014 compared to the comparable period in 2013.  The increase was primarily the result of a decrease in net interest expense due to the mix of interest bearing liabilities of the Company as well as a reduction in dollar amount and rate on time deposits.  Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities.  The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin.  The net interest margin for the three months ended June 30, 2014 was 3.49% compared to 3.48% in 2013 for the same period.  The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable.  The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2014 compared to the comparable period in 2013 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
$
123,096

(0.17
)%
$
1,391

$
(753
)
$
638

Taxable securities
(4,206
)
(0.09
)
(9
)
(25
)
(34
)
Nontaxable securities
17,618

(0.44
)
172

(162
)
10

Federal funds sold
(15,731
)
—

(9
)
—

(9
)
$
120,777


$
1,545

$
(940
)
$
605

Interest expense:





Interest-bearing demand deposits
$
35,979

(0.06
)%
$
(19
)
$
70

$
51

Savings deposits
90,947

(0.03
)
(51
)
45

(6
)
Time deposits
(52,273
)
(0.20
)
219

253

472

Short-term borrowings
7,645

0.01

(9
)
3

(6
)
FHLB borrowings
—

—

—

—

—

Interest-bearing other liabilities
(45
)
(0.88
)
—

6

6

$
82,253

$
140

$
377

$
517

Change in net interest income


$
1,685

$
(563
)
$
1,122


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 48

HILLS BANCORPORATION

Discussion of operations for the three months ended June 30, 2014 and 2013

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

(Tax Equivalent Basis)
2014
2013
Yield on average interest-earning assets
4.20
%
4.34
%
Rate on average interest-bearing liabilities
0.90

1.08

Net interest spread
3.30
%
3.26
%
Effect of noninterest-bearing funds
0.19

0.22

Net interest margin (tax equivalent interest income divided by average interest-earning assets)
3.49
%
3.48
%

Provision for Loan Losses

The provision for loan losses was a reduction of expense of $0.25 million in 2014 as well as in 2013.  The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio.  The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio.  The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more.  In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks.
The allowance for loan losses decreased $0.51 million during the three months ended June 30, 2014 .  In the three months ended June 30, 2014 , there was an increase of $0.40 million due to the volume and composition of loans outstanding and a $0.91 million decrease in the amount allocated to the allowance due to an improvement in credit quality.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented.  For the three months ended June 30, 2014 and 2013, recoveries were $0.78 million and $0.86 million, respectively; and charge-offs were $1.05 million in 2014 and $0.83 million in 2013.  The allowance for loan losses totaled $25.35 million at June 30, 2014 compared to $25.55 million at December 31, 2013.  The allowance represented 1.34% and 1.40% of loans held for investment at June 30, 2014 and December 31, 2013, respectively.





Page 49

HILLS BANCORPORATION

Discussion of operations for the three months ended June 30, 2014 and 2013

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended June 30, 2014 and 2013.

Three Months Ended
June 30, 2014
2014
2013
$ Change
% Change
(Amounts in thousands)
Net gain on sale of loans
$
189

$
521

$
(332
)
(63.72
)%
Trust fees
1,439

1,295

144

11.12

Service charges and fees
2,012

2,262

(250
)
(11.05
)
Rental revenue on tax credit real estate
378

397

(19
)
(4.79
)
Net gain on sale of other real estate owned and other reposessed assets
168

110

58

52.73

Other noninterest income
761

734

27

3.68

$
4,947

$
5,319

$
(372
)
(6.99
)

In the three months ended June 30, 2014 and 2013, the net gain on sale of loans was $0.19 million and $0.52 million , respectively.  The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly.  The volume of activity in these types of loans is directly related to the level of interest rates.  The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income.  The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

Trust fees increased $0.14 million in the three months ended June 30, 2014 as a result of assets under management increasing to $1.085 billion as of June 30, 2014 from $1.054 billion as of June 30, 2013 due to market conditions and new trust relationships.

Service charges and fees decreased $0.25 million in the three months ended June 30, 2014 from their level for the comparable period in 2013.  Credit card merchant fees are included in service charges and fees, and that component decreased during the same period by $0.34 million due to a change to an agent program utilized by the Bank.

The net gain on sale of other real estate owned and other repossessed assets increased $0.06 million to a net gain of $0.17 million for the three months ended June 30, 2014 .  The total net gain on sale of other real estate owned for the three months ended June 30, 2014 consisted of a $0.17 million net gain on the sale of 6 properties.  During the same period in 2013, the gain consisted of a $0.12 net gain on sale of 6 properties and a $0.01 million loss on the sale of one property.


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HILLS BANCORPORATION

Discussion of operations for the three months ended June 30, 2014 and 2013

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended June 30, 2014 and 2013.

Three Months Ended
June 30,
2014
2013
$ Change
% Change
(Amounts in thousands)
Salaries and employee benefits
$
6,385

$
6,191

$
194

3.13
%
Occupancy
944

931

13

1.40

Furniture and equipment
1,242

1,186

56

4.72

Office supplies and postage
385

386

(1
)
—

Advertising and business development
813

651

162

24.88

Outside services
1,673

1,768

(95
)
(5.37
)
Rental expenses on tax credit real estate
553

613

(60
)
(9.79
)
FDIC insurance assessment
271

270

1

0.37

Other noninterest expense
271

426

(155
)
(36.38
)
$
12,537

$
12,422

$
115

0.93


Advertising and business development expenses increased $0.16 million in the three months ended June 30, 2014 from their level for the comparable period in 2013 as a result of a $0.04 increase in mail processing expense and $0.03 in charitable contributions. Most other noninterest expense categories experienced marginal period-to-period increases for the three months ended June 30, 2014 .

Income Taxes

Federal and state income tax expenses were $3.19 million and $2.86 million for the three months ended June 30, 2014 and 2013, respectively.  Income taxes as a percentage of income before taxes were 30.75% in 2014 and 29.28% in 2013.

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 10.80% of the Company’s total assets at June 30, 2014 compared to 11.00% at December 31, 2013.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position.  As of June 30, 2014 , the Company had borrowed $125 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 $443.06 million at June 30, 2014 .

As additional sources of liquidity, the Company has the ability to borrow up to $10.00 million from the Federal Reserve Bank of Chicago, and has lines of credit with three banks totaling 180.26 million.  The borrowings under these credit lines would be secured by the Bank’s investment securities.  The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at June 30, 2014 .

As of June 30, 2014 , investment securities with a carrying value of $68.57 million were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as permitted by law.  As of December 31, 2013, investment securities with a carrying value of $42.02 million were pledged.

Page 51

HILLS BANCORPORATION


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, 2013.

Item 3.
Quantitative and Qualitative Disclosures about Market Risk

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

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

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

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

Item 4.
Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission.  There have been no changes in the Company’s internal controls over financial reporting during the six months ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

Page 52

HILLS BANCORPORATION
PART II - OTHER INFORMATION

Item 1.
Legal Proceedings
In the normal course of business, the Company and its subsidiaries are subject to pending and threatened legal actions, some of which seek substantial relief or damages.  While the ultimate outcome of such legal proceedings cannot be predicted with certainty, after reviewing pending and threatened litigation with counsel, management believes at this time that the outcome of such litigation will not have a material adverse effect on the Company’s business, financial condition or results of operations.

On April 24 , 2014, a suit was filed against the Bank in the Iowa District Court for Johnson County by a customer alleging that the fees associated with the Bank’s automated overdraft program in connection with its debit and ATM cards constitute unlawful interest in violation of Iowa’s usury laws and that the collection of such interest violates the Iowa Debt Collection Practices Act.  The suit seeks class-action status for Bank customers who have paid overdraft fees arising from debit or ATM card transactions on their consumer accounts.  The Bank has filed a motion to dismiss, and litigation is ongoing.  At this stage of the litigation, it is not possible for management of the Bank to determine the probability of a material adverse outcome or reasonably estimate the amount of any potential loss.
Item 1A.
Risk Factors
There have been no material changes from the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2013.

Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended June 30, 2014 :

Period
Total number of shares
purchased
Average price paid per
share
Total number of shares
purchased as part of publicly
announced plans or programs
Maximum number of
shares that may yet be
purchased under the
plans or programs (1)
April 1 to April 30
6,407

$
76.00

360,531

389,469

May 1 to May 31
3,233

76.08

363,764

386,236

June 1 to June 30
3,734

77.50

367,498

382,502

Total
13,374

$
76.53

367,498

382,502

(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”).  The Company’s Board of Directors authorized the 2005 Stock Repurchase Program through December 31, 2015. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis.  All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis.  The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.

During the first six months of 2014, the Company issued 1,293 shares of restricted stock under the 2010 Stock Option and Incentive Plan.  The restricted shares were issued to officers of the company for no cash consideration and will vest over a five-year period from the date of grant.  The issuance of these shares was exempt from the registration requirements of the SEC pursuant to Section 4(2) of the Securities Act of 1933.


Page 53

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

Item 4.
Mine Safety Disclosure
Not applicable.

Item 5.
Other Information

None

I tem 6.
Exhibits

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.INS
XBRL Instance Document (1)
101.SCH
XBRL Taxonomy Extension Schema Document (1)
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document (1)
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document (1)
101.LAB
XBRL Taxonomy Extension Label Linkbase Document (1)
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document (1)
(1)
Users of this data are advised that, pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934, and are otherwise not subject to liability under these sections.

Page 54

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

HILLS BANCORPORATION
Date:
August 5, 2014
By:  /s/ Dwight O. Seegmiller
Dwight O. Seegmiller, Director, President and Chief Executive Officer
Date:
August 5, 2014
By:  /s/ Shari DeMaris
Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer


Page 55

HILLS BANCORPORATION
QUARTERLY REPORT OF FORM 10-Q FOR THE
QUARTER ENDED JUNE 30, 2014
Exhibit
Number
Description
Page Number In The Sequential
Numbering System June 30,
2014 Form 10-Q
31
Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
57-58

32
Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
59



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