HBIA 10-Q Quarterly Report March 31, 2016

HILLS BANCORPORATION

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10-Q 1 hbia201633110q.htm 10-Q 10-Q

Index

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 March 31, 2016

Commission file number: 0-12668

Hills Bancorporation



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

131 MAIN STREET, HILLS, IOWA 52235

Telephone number: (319) 679-2291

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

þ Yes o No

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

þ Yes o No

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act.



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

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

o Yes þ No

APPLICABLE ONLY TO CORPORATE ISSUERS:

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

Index



	SHARES OUTSTANDING
CLASS	April 30, 2016

Common Stock, no par value	9,289,887

Index

HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION



		Page
		Number

Item 1.	Financial Statements

	Consolidated balance sheets, March 31, 2016 (unaudited) and December 31, 2015	4
	Consolidated statements of income (unaudited) for three months ended March 31, 2016 and 2015	5
	Consolidated statements of comprehensive income (unaudited) for three months ended March 31, 2016 and 2015	6
	Consolidated statements of stockholders' equity (unaudited) for three months ended March 31, 2016 and 2015	7
	Consolidated statements of cash flows (unaudited) for three months ended March 31, 2016 and 2015	8
	Notes to consolidated financial statements (condensed)	10

Item 2.	Management Discussion and Analysis of Financial Condition and Results of Operations	37

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	50

Item 4.	Controls and Procedures	51

	Part II
	OTHER INFORMATION

Item 1.	Legal proceedings	52

Item 1A.	Risk factors	52

Item 2.	Unregistered sales of equity securities and use of proceeds	52

Item 3.	Defaults upon senior securities	52

Item 4.	Mine safety disclosures	52

Item 5.	Other information	53

Item 6.	Exhibits	54

	Signatures	55

	Exhibits Index	56

Page 3

Index

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



	March 31, 2016			December 31, 2015
ASSETS	(Unaudited)			December 31, 2015
Cash and cash equivalents	$	133,672		$	35,427
Investment securities available for sale at fair value (amortized cost March 31, 2016 $260,649; December 31, 2015 $261,991)	263,911			264,235
Stock of Federal Home Loan Bank	12,624			11,834
Loans held for sale	4,571			5,554
Loans, net of allowance for loan losses (March 31, 2016 $27,130; December 31, 2015 $26,510)	2,111,075			2,099,174
Property and equipment, net	34,414			33,522
Tax credit real estate investment	11,370			16,314
Accrued interest receivable	10,020			8,672
Deferred income taxes, net	12,456			11,695
Other real estate	340			439
Goodwill	2,500			2,500
Other assets	2,535			4,241
Total Assets	$	2,599,488		$	2,493,607

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities
Noninterest-bearing deposits	$	296,922		$	314,968
Interest-bearing deposits	1,682,659			1,575,734
Total deposits	$	1,979,581		$	1,890,702
Other borrowings	45,381			44,051
Federal Home Loan Bank borrowings	240,000			225,000
Accrued interest payable	838			846
Other liabilities	24,153			23,271
Total Liabilities	$	2,289,953		$	2,183,870

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	37,988		$	37,562

STOCKHOLDERS' EQUITY
Common stock, no par value; authorized 20,000,000 shares; issued March 31, 2016 10,202,503 shares; December 31, 2015 10,199,643 shares	$	—		$	—
Paid in capital	43,889			43,697
Retained earnings	296,127			294,487
Accumulated other comprehensive loss	(1,650		)	(1,195		)
Treasury stock at cost (March 31, 2016 912,841 shares; December 31, 2015 877,589 shares)	(28,831		)	(27,252		)
Total Stockholders' Equity	$	309,535		$	309,737
Less maximum cash obligation related to ESOP shares	37,988			37,562
Total Stockholders' Equity Less Maximum Cash Obligations Related to ESOP Shares	$	271,547		$	272,175
Total Liabilities & Stockholders' Equity	$	2,599,488		$	2,493,607

See Notes to Consolidated Financial Statements.

Page 4

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Amounts In Thousands, Except Per Share Amounts)



	Three Months Ended March 31,
	2016		2015
Interest income:
Loans, including fees	$	22,528	$	21,080
Investment securities:
Taxable	356		286
Nontaxable	828		843
Federal funds sold	44		5
Total interest income	$	23,756	$	22,214
Interest expense:
Deposits	$	1,921	$	2,164
Short-term borrowings	30		17
FHLB borrowings	2,132		1,454
Total interest expense	$	4,083	$	3,635
Net interest income	$	19,673	$	18,579
Provision for loan losses	549		(62		)
Net interest income after provision for loan losses	$	19,124	$	18,641
Noninterest income:
Net gain on sale of loans	$	289	$	308
Trust fees	1,728		1,569
Service charges and fees	2,055		1,946
Rental revenue on tax credit real estate	—		511
Net gain on sale of other real estate owned and other repossessed assets	34		7
Other noninterest income	767		649
	$	4,873	$	4,990

Noninterest expenses:
Salaries and employee benefits	$	6,984	$	6,651
Occupancy	1,001		1,015
Furniture and equipment	1,404		1,298
Office supplies and postage	401		441
Advertising and business development	786		774
Outside services	1,776		1,814
Rental expenses on tax credit real estate	—		602
FDIC insurance assessment	303		289
Other noninterest expense	397		315
	$	13,052	$	13,199
Income before income taxes	$	10,945	$	10,432
Income taxes	3,245		3,052
Net income	$	7,700	$	7,380

Earnings per share:
Basic	$	0.83	$	0.79
Diluted	$	0.83	$	0.79

See Notes to Consolidated Financial Statements.

Page 5

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited) (Amounts In Thousands)



	Three Months Ended March 31,
	2016			2015
Net income	$	7,700		$	7,380

Other comprehensive income (loss)
Securities:
Net change in unrealized gain on securities available for sale	$	1,018		$	1,133
Reclassification adjustment for net gains realized in net income	—			—
Income taxes	(390		)	(433		)
Other comprehensive income on securities available for sale	$	628		$	700
Derivatives used in cash flow hedging relationships:
Net change in unrealized loss on derivatives	$	(1,753	)	$	(1,092	)
Income taxes	670			418
Other comprehensive loss on cash flow hedges	$	(1,083	)	$	(674	)

Other comprehensive (loss) income, net of tax	$	(455	)	$	26

Comprehensive income	$	7,245		$	7,406

See Notes to Consolidated Financial Statements.

Page 6

Index

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



	Paid In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Unearned ESOP Shares			Treasury Stock			Maximum Cash Obligation Related To ESOP Shares			Total
Balance, December 31, 2014	$	42,925		$	271,924		$	(448	)	$	(504	)	$	(23,798	)	$	(34,571	)	$	255,528
Issuance of 292 shares of common stock	12			—			—			—			—			—			12
Issuance of 1,132 shares of common stock under the employee stock purchase plan	45			—			—			—			—			—			45
Unearned restricted stock compensation	89			—			—			—			—			—			89
Forfeiture of 682 shares of common stock	(22		)	—			—			—			—			—			(22		)
Share-based compensation	7			—			—			—			—			—			7
Income tax benefit related to share-based compensation	4			—			—			—			—			—			4
Change related to ESOP shares	—			—			—			—			—			(436		)	(436		)
Net income	—			7,380			—			—			—			—			7,380
Cash dividends ($0.625 per share)	—			(5,855		)	—			—			—			—			(5,855		)
Purchase of 4,728 shares of common stock	—			—			—			—			(195		)	—			(195		)
Other comprehensive income	—			—			26			—			—			—			26
Balance, March 31, 2015	$	43,060		$	273,449		$	(422	)	$	(504	)	$	(23,993	)	$	(35,007	)	$	256,583

Balance, December 31, 2015	$	43,697		$	294,487		$	(1,195	)	$	—		$	(27,252	)	$	(37,562	)	$	272,175
Issuance of 1,626 shares of common stock	73			—			—			—			—			—			73
Issuance of 1,234 shares of common stock under the employee stock purchase plan	54			—			—			—			—			—			54
Unearned restricted stock compensation	56			—			—			—			—			—			56
Share-based compensation	7			—			—			—			—			—			7
Income tax benefit related to share-based compensation	2			—			—			—			—			—			2
Change related to ESOP shares	—			—			—			—			—			(426		)	(426		)
Net income	—			7,700			—			—			—			—			7,700
Cash dividends ($0.65 per share)	—			(6,060		)	—			—			—			—			(6,060		)
Purchase of 35,252 shares of common stock	—			—			—			—			(1,579		)	—			(1,579		)
Other comprehensive loss	—			—			(455		)	—			—			—			(455		)
Balance, March 31, 2016	$	43,889		$	296,127		$	(1,650	)	$	—		$	(28,831	)	$	(37,988	)	$	271,547

See Notes to Consolidated Financial Statements.

Page 7

Index

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



	Three Months Ended March 31,
	2016			2015
Cash Flows from Operating Activities
Net income	$	7,700		$	7,380
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation	727			685
Provision for loan losses	549			(62		)
Share-based compensation	7			7
Forfeiture of common stock	—			(22		)
Compensation expensed through issuance of common stock	127			57
Excess tax benefits from share-based compensation	(2		)	(4		)
Provision for deferred income taxes	(481		)	(295		)
Net gain on sale of other real estate owned and other repossessed assets	(34		)	(7		)
Increase in accrued interest receivable	(1,348		)	(826		)
Amortization of premium on investment securities, net	148			172
Decrease (increase) in other assets	739			(413		)
Increase in accrued interest payable and other liabilities	1,567			4,750
Loans originated for sale	(32,243		)	(40,577		)
Proceeds on sales of loans	33,515			37,050
Net gain on sales of loans	(289		)	(308		)
Net cash and cash equivalents provided by operating activities	$	10,682		$	7,587

Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	11,031		$	11,906
Purchases of investment securities available for sale	(10,627		)	(12,029		)
Loans made to customers, net of collections	(8,995		)	(9,131		)
Proceeds on sale of other real estate owned and other repossessed assets	133			55
Purchases of property and equipment	(1,619		)	(4,080		)
Income from tax credit real estate, net	68			214
Net cash and cash equivalents used in investing activities	$	(10,009	)	$	(13,065	)

Cash Flows from Financing Activities
Net increase in deposits	$	88,879		$	72,266
Net increase (decrease) in other borrowings	1,330			(6,571		)
Net increase in FHLB borrowings	15,000			—
Excess tax benefits related to share-based compensation	2			4
Purchase of treasury stock	(1,579		)	(195		)
Dividends paid	(6,060		)	(5,855		)
Net cash and cash equivalents provided by financing activities	$	97,572		$	59,649

(Continued)

Page 8

Index

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

	Three Months Ended March 31,
	2016		2015
Increase in cash and cash equivalents	$	98,245	$	54,171
Cash and cash equivalents:
Beginning of period	35,427		29,174
End of period	$	133,672	$	83,345

Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	1,929	$	2,207
Interest paid on other obligations	2,162		1,471
Income taxes paid	342		120

Noncash activities:
Increase in maximum cash obligation related to ESOP shares	$	426	$	436
Transfers to other real estate owned	—		63
Sale and financing of other real estate owned	135		113

See Notes to Consolidated Financial Statements.

Page 9

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)


Note 1.	Summary of Significant Accounting Policies

Basis of Presentation:

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

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

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

Effect of New Financial Accounting Standards:

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

In February 2015, the FASB issued ASU No. 2015-02 (Topic 810), Consolidation . The ASU modifies the evaluation of whether limited partnerships and similar legal entities are variable interest entities (VIE) or voting interest entities (VOE). The standard relaxes existing criteria for determining when fees paid to a decision maker or service provider do not represent a variable interest by focusing on whether those fees are "at market". The ASU eliminates both the consolidation model specific to limited partnerships and the current presumption that a general partner controls a limited partnership. For public companies, ASU 2015-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. The Company adopted the accounting standard for the period ending March 31, 2016 and have changed the accounting for its tax credit limited partnership investments to the equity method. The impact of the change was determined to not be material.

In April 2015, the FASB issued ASU No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30), Simplifying the Presentation of Debt Issuance Costs. ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this update. For public companies, ASU 2015-03 is effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted. The Company adopted ASU 2015-03 for the period ending March 31, 2016. There was no material impact on the financial statements.

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

Page 10

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

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

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

In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718), Improvements to Employee Share-Based Payment Accounting . The ASU simplifies several aspects of the accounting for share-based payment transaction, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. For public companies, ASU 2016-09 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. The Company is currently reviewing the provisions of this standard to determine the impact on the Company's financial statements.

Page 11

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 2.	Earnings Per Share

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

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

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



	Three Months Ended March 31,
	2016			2015
Common shares outstanding at the beginning of the period	9,322,054			9,380,432
Weighted average number of net shares redeemed	(14,370		)	(17,136		)
Weighted average shares outstanding (basic)	9,307,684			9,363,296
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method	6,130			4,980
Weighted average number of shares (diluted)	9,313,814			9,368,276
Net income (In thousands)	$	7,700		$	7,380
Earnings per share:
Basic	$	0.83		$	0.79
Diluted	$	0.83		$	0.79


Note 3.	Other Comprehensive Income (Loss)

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



	March 31, 2016			December 31, 2015
	(amounts in thousands)
Net unrealized gain on available-for-sale securities	$	3,262		$	2,244
Net unrealized loss on derivatives used for cash flow hedges	(5,933		)	(4,180		)
Tax effect	$	1,021		$	741
Net-of-tax amount	$	(1,650	)	$	(1,195	)

Page 12

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 4.	Securities

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



	March 31, 2016				December 31, 2015
	Amount		Percent		Amount		Percent
Securities available for sale
U.S. Treasury	$	25,175	9.54	%	$	24,978	9.45	%
Other securities (FHLB, FHLMC and FNMA)	62,258		23.59		65,328		24.72
State and political subdivisions	176,478		66.87		173,929		65.83
Total securities available for sale	$	263,911	100.00	%	$	264,235	100.00	%

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



	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Estimated Fair Value
March 31, 2016:
U.S. Treasury	$	24,905	$	270	$	—		$	25,175
Other securities (FHLB, FHLMC and FNMA)	61,980		292		(14		)	62,258
State and political subdivisions	173,764		2,815		(101		)	176,478
Total	$	260,649	$	3,377	$	(115	)	$	263,911
December 31, 2015:
U.S. Treasury	$	24,893	$	92	$	(7	)	$	24,978
Other securities (FHLB, FHLMC and FNMA)	65,400		81		(153		)	65,328
State and political subdivisions	171,698		2,375		(144		)	173,929
Total	$	261,991	$	2,548	$	(304	)	$	264,235

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at March 31, 2016 , were as follows (in thousands):



	Amortized Cost		Fair Value
Due in one year or less	$	41,343	$	41,412
Due after one year through five years	149,479		151,349
Due after five years through ten years	67,533		68,847
Due over ten years	2,294		2,303
Total	$	260,649	$	263,911

As of March 31, 2016 investment securities with a carrying value of $71.79 million were pledged to collateralize repurchase agreements, derivative financial instruments, and other borrowings.

Page 13

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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 March 31, 2016 and December 31, 2015 (in thousands):



	Less than 12 months								12 months or more								Total
March 31, 2016 Description of Securities	#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
U.S. Treasury	—	$	—	$	—		—	%	—	$	—	$	—		—	%	—	$	—	$	—		—	%

Other securities (FHLB, FHLMC and FNMA)	4	8,924		(14		)	0.16		—	—		—			—		4	8,924		(14		)	0.16

State and political subdivisions	44	11,020		(73		)	0.66		14	2,650		(28		)	1.06		58	13,670		(101		)	0.74

Total temporarily impaired securities	48	$	19,944	$	(87	)	0.44	%	14	$	2,650	$	(28	)	1.06	%	62	$	22,594	$	(115	)	0.51	%



	Less than 12 months								12 months or more								Total
December 31, 2015 Description of Securities	#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
U.S. Treasury	3	$	7,455	$	(7	)	0.09	%	—	$	—	$	—		—	%	3	$	7,455	$	(7	)	0.09	%

Other securities (FHLB, FHLMC and FNMA)	15	36,830		(153		)	0.42		—	—		—			—		15	36,830		(153		)	0.42

State and political subdivisions	56	13,557		(70		)	0.52		27	5,633		(74		)	1.31		83	19,190		(144		)	0.75

Total temporarily impaired securities	74	$	57,842	$	(230	)	0.40	%	27	$	5,633	$	(74	)	1.31	%	101	$	63,475	$	(304	)	0.48	%

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

Page 14

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 5.	Loans

Classes of loans are as follows:



	March 31, 2016		December 31, 2015
	(Amounts In Thousands)
Agricultural	$	90,620	$	101,588
Commercial and financial	173,736		184,199
Real estate:
Construction, 1 to 4 family residential	58,293		51,346
Construction, land development and commercial	105,607		83,121
Mortgage, farmland	189,882		187,856
Mortgage, 1 to 4 family first liens	725,924		727,160
Mortgage, 1 to 4 family junior liens	118,115		117,873
Mortgage, multi-family	284,715		271,974
Mortgage, commercial	315,965		323,409
Loans to individuals	22,959		24,019
Obligations of state and political subdivisions	51,623		52,371
	$	2,137,439	$	2,124,916
Net unamortized fees and costs	766		768
	$	2,138,205	$	2,125,684
Less allowance for loan losses	27,130		26,510
	$	2,111,075	$	2,099,174

Page 15

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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 months ended March 31, 2016 were as follows:



	Three Months Ended March 31, 2016
	Agricultural			Commercial and Financial			Real Estate: Construction and land development		Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	3,082		$	4,517		$	2,280	$	3,342		$	8,172		$	4,223		$	894		$	26,510
Charge-offs	—			(55		)	—		(10		)	(344		)	(66		)	(169		)	(644		)
Recoveries	142			253			52		—			213			11			44			715
Provision	(270		)	(404		)	427		612			(5		)	22			167			549

Ending balance	$	2,954		$	4,311		$	2,759	$	3,944		$	8,036		$	4,190		$	936		$	27,130

Ending balance, individually evaluated for impairment	$	868		$	268		$	32	$	670		$	310		$	88		$	22		$	2,258

Ending balance, collectively evaluated for impairment	$	2,086		$	4,043		$	2,727	$	3,274		$	7,726		$	4,102		$	914		$	24,872

Loans:

Ending balance	$	90,620		$	173,736		$	163,900	$	189,882		$	844,039		$	600,680		$	74,582		$	2,137,439

Ending balance, individually evaluated for impairment	$	12,647		$	2,406		$	1,450	$	8,098		$	5,594		$	3,649		$	22		$	33,866

Ending balance, collectively evaluated for impairment	$	77,973		$	171,330		$	162,450	$	181,784		$	838,445		$	597,031		$	74,560		$	2,103,573

Page 16

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Changes in the allowance for loan losses for the three months ended March 31, 2015 were as follows:



	Three Months Ended March 31, 2015
	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,515		$	4,231		$	2,241		$	2,672	$	7,419		$	4,195		$	747		$	24,020
Charge-offs	(43		)	(66		)	(84		)	—		(347		)	(179		)	(48		)	(767		)
Recoveries	82			401			151			6		413			70			46			1,169
Provision	(10		)	(208		)	(58		)	99		(29		)	39			105			(62		)

Ending balance	$	2,544		$	4,358		$	2,250		$	2,777	$	7,456		$	4,125		$	850		$	24,360

Ending balance, individually evaluated for impairment	$	13		$	7		$	33		$	26	$	68		$	8		$	—		$	155

Ending balance, collectively evaluated for impairment	$	2,531		$	4,351		$	2,217		$	2,751	$	7,388		$	4,117		$	850		$	24,205

Loans:

Ending balance	$	88,574		$	180,392		$	126,544		$	169,058	$	788,782		$	564,657		$	76,163		$	1,994,170

Ending balance, individually evaluated for impairment	$	1,851		$	2,284		$	954		$	2,464	$	3,559		$	9,536		$	—		$	20,648

Ending balance, collectively evaluated for impairment	$	86,723		$	178,108		$	125,590		$	166,594	$	785,223		$	555,121		$	76,163		$	1,973,522

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

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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
March 31, 2016
Grade:
Excellent	$	1,773	$	3,050	$	—	$	255
Good	18,163		27,861		2,771		12,653
Satisfactory	34,358		101,014		37,546		70,736
Monitor	17,368		25,804		11,144		15,110
Special Mention	4,534		11,664		5,768		6,392
Substandard	14,424		4,343		1,064		461
Total	$	90,620	$	173,736	$	58,293	$	105,607



	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
March 31, 2016
Grade:
Excellent	$	2,517	$	563	$	—	$	6,560
Good	33,497		14,525		2,654		67,078
Satisfactory	115,190		622,556		107,567		175,070
Monitor	26,787		53,133		4,227		30,733
Special Mention	2,261		16,510		1,867		4,700
Substandard	9,630		18,637		1,800		574
Total	$	189,882	$	725,924	$	118,115	$	284,715



	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
March 31, 2016
Grade:
Excellent	$	15,990	$	—	$	2,346	$	33,054
Good	80,891		92		36,454		296,639
Satisfactory	183,139		22,205		12,287		1,481,668
Monitor	26,456		237		518		211,517
Special Mention	5,522		209		18		59,445
Substandard	3,967		216		—		55,116
Total	$	315,965	$	22,959	$	51,623	$	2,137,439

Page 18

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)



	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
December 31, 2015
Grade:
Excellent	$	1,786	$	3,298	$	—	$	260
Good	15,959		38,764		1,898		11,570
Satisfactory	36,819		102,188		34,357		52,731
Monitor	18,064		27,181		8,684		11,550
Special Mention	25,356		8,231		5,842		6,542
Substandard	3,604		4,537		565		468
Total	$	101,588	$	184,199	$	51,346	$	83,121



	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family
December 31, 2015
Grade:
Excellent	$	2,559	$	426	$	—	$	6,651
Good	31,186		15,773		2,992		64,002
Satisfactory	112,038		620,731		107,091		166,193
Monitor	27,304		55,499		4,198		29,732
Special Mention	11,181		16,237		1,846		4,873
Substandard	3,588		18,494		1,746		523
Total	$	187,856	$	727,160	$	117,873	$	271,974



	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
December 31, 2015
Grade:
Excellent	$	12,484	$	—	$	2,365	$	29,829
Good	81,305		70		37,045		300,564
Satisfactory	187,728		23,197		12,425		1,455,498
Monitor	32,141		285		518		215,156
Special Mention	6,183		198		—		86,489
Substandard	3,568		269		18		37,380
Total	$	323,409	$	24,019	$	52,371	$	2,124,916

Page 19

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The below are descriptions of the credit quality indicators:

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

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

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

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

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

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

Page 20

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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



	30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Loans Receivable		Accruing Loans Past Due 90 Days or More
	(Amounts In Thousands)
March 31, 2016
Agricultural	$	7,275	$	149	$	1,264	$	8,688	$	81,932	$	90,620	$	283
Commercial and financial	697		1,074		1,158		2,929		170,807		173,736		50
Real estate:
Construction, 1 to 4 family residential	767		—		173		940		57,353		58,293		—
Construction, land development and commercial	1,145		121		—		1,266		104,341		105,607		—
Mortgage, farmland	519		—		—		519		189,363		189,882		—
Mortgage, 1 to 4 family first liens	5,290		213		1,629		7,132		718,792		725,924		331
Mortgage, 1 to 4 family junior liens	131		50		49		230		117,885		118,115		—
Mortgage, multi-family	—		135		40		175		284,540		284,715		—
Mortgage, commercial	426		474		173		1,073		314,892		315,965		—
Loans to individuals	86		29		—		115		22,844		22,959		—
Obligations of state and political subdivisions	—		—		—		—		51,623		51,623		—
	$	16,336	$	2,245	$	4,486	$	23,067	$	2,114,372	$	2,137,439	$	664

December 31, 2015
Agricultural	$	3,064	$	961	$	—	$	4,025	$	97,563	$	101,588	$	—
Commercial and financial	854		71		1,312		2,237		181,962		184,199		—
Real estate:
Construction, 1 to 4 family residential	—		—		214		214		51,132		51,346		—
Construction, land development and commercial	—		—		88		88		$	83,033	83,121		—
Mortgage, farmland	320		88		—		408		187,448		187,856		—
Mortgage, 1 to 4 family first liens	4,526		1,192		2,085		7,803		$	719,357	727,160		406
Mortgage, 1 to 4 family junior liens	250		13		110		373		117,500		117,873		—
Mortgage, multi-family	135		—		113		248		$	271,726	271,974		—
Mortgage, commercial	1,033		—		331		1,364		322,045		323,409		61
Loans to individuals	158		40		—		198		$	23,821	24,019		—
Obligations of state and political subdivisions	—		—		—		—		52,371		52,371		—
	$	10,340	$	2,365	$	4,253	$	16,958	$	2,107,958	$	2,124,916	$	467

Page 21

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

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



	March 31, 2016						December 31, 2015
	Non-accrual loans (1)		Accruing loans past due 90 days or more		TDR loans		Non- accrual loans (1)		Accruing loans past due 90 days or more		TDR loans
	(Amounts In Thousands)						(Amounts In Thousands)
Agricultural	$	1,659	$	283	$	225	$	—	$	—	$	1,710
Commercial and financial	1,493		50		863		1,498		—		612
Real estate:
Construction, 1 to 4 family residential	173		—		1,016		214		—		473
Construction, land development and commercial	141		—		121		145		—		122
Mortgage, farmland	1,281		—		1,074		—		—		2,233
Mortgage, 1 to 4 family first liens	3,677		331		1,356		3,845		406		1,369
Mortgage, 1 to 4 family junior liens	201		—		26		279		—		27
Mortgage, multi-family	367		—		—		449		—		—
Mortgage, commercial	1,133		—		2,150		985		61		1,733
	$	10,125	$	664	$	6,831	$	7,415	$	467	$	8,279


(1)	There were $5.11 million and $2.31 million of TDR loans included within nonaccrual loans as of March 31, 2016 and December 31, 2015 , respectively.

Loans 90 days or more past due that are still accruing interest increased $0.20 million from December 31, 2015 to March 31, 2016 due to an increase in the number of loans past due greater than 90 days. As of March 31, 2016 there were 6 accruing loans past due 90 days or more. The average accruing loans past due as of March 31, 2016 are $0.11 million . The average accruing loans past due 90 days or more as of December 31, 2015 was $0.09 million . The accruing loans past due 90 days or more balances are believed to be adequately collateralized and the Company expects to collect all principal and interest as contractually due under these loans.

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

Page 22

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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



	March 31, 2016					December 31, 2015
	Number of contracts	Recorded investment		Commitments outstanding		Number of contracts	Recorded investment		Commitments outstanding
		(Amounts In Thousands)					(Amounts In Thousands)
Agricultural	7	$	1,666	$	31	7	$	1,710	$	32
Commercial and financial	12	2,059		319		8	1,818		241
Real estate:
Construction, 1 to 4 family residential	5	1,188		—		3	646		138
Construction, land development and commercial	1	121		—		1	122		—
Mortgage, farmland	6	2,355		—		5	2,233		—
Mortgage, 1 to 4 family first liens	13	1,557		—		13	1,575		—
Mortgage, 1 to 4 family junior liens	2	33		93		2	36		—
Mortgage, multi-family	—	—		—		1	71		—
Mortgage, commercial	13	2,965		—		10	2,381		—
Loans to individuals	—	—		—		—	—		—
	59	$	11,944	$	443	50	$	10,592	$	411

The following is a summary of TDR loans that were modified during the three months ended March 31, 2016 :



	Three Months Ended March 31, 2016
	Number of contracts	Pre-modification recorded investment		Post-modification recorded investment
		(Amounts In Thousands)
Agricultural	—	$	—	$	—
Commercial and financial	4	349		349
Real estate:
Construction, 1 to 4 family residential	2	543		543
Construction, land development and commercial	—	—		—
Mortgage, farmland	1	132		132
Mortgage, 1 to 4 family first lien	—	—		—
Mortgage, 1 to 4 family junior liens	—	—		—
Mortgage, multi-family	—	—		—
Mortgage, commercial	3	629		629
	10	$	1,653	$	1,653

Page 23

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The Company had commitments to lend $0.44 million in additional borrowings to restructured loan customers as of March 31, 2016 . The Company had commitments to lend $0.41 million in additional borrowings to restructured loan customers as of December 31, 2015 . These commitments were in the normal course of business. The additional borrowings were not used to facilitate payments on these loans.

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

Page 24

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Information regarding impaired loans as of and for the three months ended March 31, 2016 is as follows:



	March 31, 2016						Three Months Ended March 31, 2016
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	126	$	278	$	—	$	133	$	2
Commercial and financial	1,552		2,275		—		1,574		6
Real estate:
Construction, 1 to 4 family residential	739		739		—		739		8
Construction, land development and commercial	206		293		—		208		1
Mortgage, farmland	527		645		—		530		6
Mortgage, 1 to 4 family first liens	3,633		4,507		—		3,668		13
Mortgage, 1 to 4 family junior liens	150		450		—		157		—
Mortgage, multi-family	151		262		—		190		—
Mortgage, commercial	2,409		3,673		—		2,416		20
Loans to individuals	—		20		—		—		—
	$	9,493	$	13,142	$	—	$	9,615	$	56

With an allowance recorded:
Agricultural	$	12,521	$	12,524	$	868	$	12,570	$	140
Commercial and financial	854		880		268		907		7
Real estate:
Construction, 1 to 4 family residential	449		461		20		449		3
Construction, land development and commercial	56		57		12		56		—
Mortgage, farmland	7,571		7,571		670		7,578		83
Mortgage, 1 to 4 family first liens	1,733		1,846		294		1,762		6
Mortgage, 1 to 4 family junior liens	78		233		16		80		—
Mortgage, multi-family	216		221		46		218		—
Mortgage, commercial	873		906		42		880		9
Loans to individuals	22		22		22		36		1
	$	24,373	$	24,721	$	2,258	$	24,536	$	249

Total:
Agricultural	$	12,647	$	12,802	$	868	$	12,703	$	142
Commercial and financial	2,406		3,155		268		2,481		13
Real estate:
Construction, 1 to 4 family residential	1,188		1,200		20		1,188		11
Construction, land development and commercial	262		350		12		264		1
Mortgage, farmland	8,098		8,216		670		8,108		89
Mortgage, 1 to 4 family first liens	5,366		6,353		294		5,430		19
Mortgage, 1 to 4 family junior liens	228		683		16		237		—
Mortgage, multi-family	367		483		46		408		—
Mortgage, commercial	3,282		4,579		42		3,296		29
Loans to individuals	22		42		22		36		1
	$	33,866	$	37,863	$	2,258	$	34,151	$	305

Page 25

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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



	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	1,609	$	1,773	$	—
Commercial and financial	1,263		1,981		—
Real estate:
Construction, 1 to 4 family residential	238		238		—
Construction, land development and commercial	210		314		—
Mortgage, farmland	2,233		2,351		—
Mortgage, 1 to 4 family first liens	3,558		4,419		—
Mortgage, 1 to 4 family junior liens	189		500		—
Mortgage, multi-family	157		226		—
Mortgage, commercial	1,831		3,018		—
Loans to individuals	—		20		—
	$	11,288	$	14,840	$	—

With an allowance recorded:
Agricultural	$	101	$	101	$	1
Commercial and financial	847		847		324
Real estate:
Construction, 1 to 4 family residential	449		461		9
Construction, land development and commercial	57		58		13
Mortgage, farmland	—		—		—
Mortgage, 1 to 4 family first liens	2,062		2,156		306
Mortgage, 1 to 4 family junior liens	117		270		20
Mortgage, multi-family	292		332		58
Mortgage, commercial	948		1,030		52
Loans to individuals	100		100		100
	$	4,973	$	5,355	$	883

Total:
Agricultural	$	1,710	$	1,874	$	1
Commercial and financial	2,110		2,828		324
Real estate:
Construction, 1 to 4 family residential	687		699		9
Construction, land development and commercial	267		372		13
Mortgage, farmland	2,233		2,351		—
Mortgage, 1 to 4 family first liens	5,620		6,575		306
Mortgage, 1 to 4 family junior liens	306		770		20
Mortgage, multi-family	449		558		58
Mortgage, commercial	2,779		4,048		52
Loans to individuals	100		120		100
	$	16,261	$	20,195	$	883

Page 26

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Impaired loans increased $17.61 million from December 31, 2015 to March 31, 2016 . Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans. Impaired loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement. Impaired loans were 1.58% of loans held for investment as of March 31, 2016 and 0.76% as of December 31, 2015 . The increase in impaired loans is due mainly to an increase in nonaccrual loans of $2.71 million , a $16.22 million agricultural and farmland real estate relationship with a specific allowance for losses, and a decrease in TDR loans of $1.45 million from December 31, 2015 to March 31, 2016 .

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

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

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

Page 27

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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 March 31, 2016 are as follows:



	March 31, 2016
	Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)
	(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents	$	135,553	$	135,553	$	135,553	$	—	$	—
Investment securities	276,535		276,535		—		276,535		—
Loans held for sale	4,571		4,571		—		4,571		—
Loans
Agricultural	87,666		87,695		—		—		87,695
Commercial and financial	169,425		169,412		—		—		169,412
Real estate:
Construction, 1 to 4 family residential	57,302		57,303		—		—		57,303
Construction, land development and commercial	103,839		103,842		—		—		103,842
Mortgage, farmland	185,938		186,148		—		—		186,148
Mortgage, 1 to 4 family first liens	719,119		716,974		—		—		716,974
Mortgage, 1 to 4 family junior liens	116,884		122,408		—		—		122,408
Mortgage, multi-family	282,957		285,700		—		—		285,700
Mortgage, commercial	313,533		312,448		—		—		312,448
Loans to individuals	22,410		22,400		—		—		22,400
Obligations of state and political subdivisions	51,236		50,461		—		—		50,461
Accrued interest receivable	10,020		10,020		—		10,020		—
Total financial instrument assets	$	2,536,988	$	2,541,470	$	135,553	$	291,126	$	2,114,791
Financial instrument liabilities
Deposits
Noninterest-bearing deposits	$	296,922	$	296,922	$	—	$	296,922	$	—
Interest-bearing deposits	1,682,659		1,684,108		—		1,684,108		—
Other borrowings	45,381		45,381		—		45,381		—
Federal Home Loan Bank borrowings	240,000		240,044		—		240,044		—
Interest rate swaps	5,933		5,933		—		5,933		—
Accrued interest payable	838		838		—		838		—
Total financial instrument liabilities	$	2,271,733	$	2,273,226	$	—	$	2,273,226	$	—

	Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	367,666	$	—	$	—	$	—	$	—
Letters of credit	12,293		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	379,959	$	—	$	—	$	—	$	—


(1)	Considered Level 1 under Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”).


(2)	Considered Level 2 under ASC 820.


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

Page 28

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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



	December 31, 2015
	Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)
	(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents	$	35,427	$	35,427	$	35,427	$	—	$	—
Investment securities	276,069		276,069		—		276,069		—
Loans held for sale	5,554		5,554		—		5,554		—
Loans
Agricultural	98,506		98,530		—		—		98,530
Commercial and financial	179,682		179,649		—		—		179,649
Real estate:
Construction, 1 to 4 family residential	50,480		50,487		—		—		50,487
Construction, land development and commercial	81,707		81,705		—		—		81,705
Mortgage, farmland	184,514		184,640		—		—		184,640
Mortgage, 1 to 4 family first liens	720,229		718,566		—		—		718,566
Mortgage, 1 to 4 family junior liens	116,632		122,173		—		—		122,173
Mortgage, multi-family	270,261		272,446		—		—		272,446
Mortgage, commercial	320,899		319,090		—		—		319,090
Loans to individuals	23,518		23,509		—		—		23,509
Obligations of state and political subdivisions	51,978		51,073		—		—		51,073
Accrued interest receivable	8,672		8,672		—		8,672		—
Total financial instrument assets	$	2,424,128	$	2,427,590	$	35,427	$	290,295	$	2,101,868
Financial instrument liabilities:
Deposits
Noninterest-bearing deposits	$	314,968	$	314,968	$	—	$	314,968	$	—
Interest-bearing deposits	1,575,734		1,577,684		—		1,577,684		—
Other borrowings	44,051		44,051		—		44,051		—
Federal Home Loan Bank borrowings	225,000		226,157		—		226,157		—
Interest rate swaps	4,180		4,180				4,180
Accrued interest payable	846		846		—		846		—
Total financial instrument liabilities	$	2,164,779	$	2,167,886	$	—	$	2,167,886	$	—

	Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	344,602	$	—	$	—	$	—	$	—
Letters of credit	11,718		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	356,320	$	—	$	—	$	—	$	—


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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

Page 29

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

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



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



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



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

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

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

ASSETS

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

Investment securities available for sale : Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If a quoted price is not available, the fair value is obtained from benchmarking the security against similar securities. All of 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 three months ended March 31, 2016 . If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.

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

Page 30

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

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

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

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

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

LIABILITIES

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

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

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

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

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

Page 31

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

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



	March 31, 2016
	Readily Available Market Prices(1)		Observable Market Prices(2)			Company Determined Market Prices(3)		Total at Fair Value
Securities available for sale	(Amounts In Thousands)
U.S. Treasury	$	—	$	25,175		$	—	$	25,175
State and political subdivisions	—		176,478			—		176,478
Other securities (FHLB, FHLMC and FNMA)	—		62,258			—		62,258
Derivative Financial Instruments
Interest rate swaps	$	—	(5,933		)	$	—	(5,933		)
Total	$	—	$	257,978		$	—	$	257,978



	December 31, 2015
	Readily Available Market Prices(1)		Observable Market Prices(2)			Company Determined Market Prices(3)		Total at Fair Value
Securities available for sale	(Amounts In Thousands)
U.S. Treasury	$	—	$	24,978		$	—	$	24,978
State and political subdivisions	—		173,929			—		173,929
Other securities (FHLB, FHLMC and FNMA)	—		65,328			—		65,328
Derivative Financial Instruments
Interest rate swaps	—		(4,180		)	—		(4,180		)
Total	$	—	$	260,055		$	—	$	260,055


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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

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

Page 32

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

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



	March 31, 2016								Three Months Ended March 31, 2016
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses
	(Amounts in Thousands)
Loans (4)
Agricultural	$	—	$	—	$	1,937	$	1,937	$	—
Commercial and financial	—		—		1,438		1,438		20
Real Estate:
Construction, 1 to 4 family residential	—		—		972		972		—
Construction, land development and commercial	—		—		129		129		—
Mortgage, farmland	—		—		1,959		1,959		—
Mortgage, 1 to 4 family first liens	—		—		4,321		4,321		275
Mortgage, 1 to 4 family junior liens	—		—		212		212		—
Mortgage, multi-family	—		—		321		321		—
Mortgage, commercial	—		—		1,307		1,307		65
Loans to individuals	—		—		—		—		—
Foreclosed assets (5)	—		—		—		—		—
Total	$	—	$	—	$	12,596	$	12,596	$	360


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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


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


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

Page 33

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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



	December 31, 2015								Year Ended December 31, 2015
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses
	(Amounts in Thousands)
Loans (4)
Agricultural	$	—	$	—	$	1,470	$	1,470	$	116
Commercial and financial	—		—		1,178		1,178		56
Real Estate:
Construction, 1 to 4 family residential	—		—		482		482		161
Construction, land development and commercial	—		—		132		132		35
Mortgage, farmland	—		—		2,233		2,233		—
Mortgage, 1 to 4 family first liens	—		—		4,487		4,487		529
Mortgage, 1 to 4 family junior liens	—		—		286		286		166
Mortgage, multi-family	—		—		391		391		38
Mortgage, commercial	—		—		1,152		1,152		140
Loans to individuals	—		—		—		—		—
Foreclosed assets (5)	—		—		100		100		69
Total	$	—	$	—	$	11,911	$	11,911	$	1,310


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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


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


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


Note 7.	Stock Repurchase Program

On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 1,500,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2017. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors. The Company has purchased 912,841 shares of its common stock in privately negotiated transactions from August 1, 2005 through March 31, 2016 . Of these 912,841 shares, 35,252 shares were purchased during the quarter ended March 31, 2016 , at an average price per share of $44.79 .

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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 $91.98 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 March 31, 2016 and December 31, 2015 is as follows:



	March 31, 2016		December 31, 2015
	(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	46,610	$	44,376
Credit cards	43,260		41,518
Commercial, real estate and home construction	100,509		98,613
Commercial lines and real estate purchase loans	177,287		160,095
Outstanding letters of credit	12,293		11,718


Note 9.	Income Taxes

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

Income taxes as a percentage of income before taxes were 29.65% for the three months ended March 31, 2016 and 29.26% for the same period in 2015 . The increase in the effective tax rate is due to a decrease in the amount of low-income housing tax credits earned by the Company in 2016 .

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 10.	Derivative Financial Instruments

In the normal course of business, the Bank may use derivative financial instruments to manage its interest rate risk. These instruments carry varying degrees of credit, interest rate and market or liquidity risks. Derivative instruments are recognized as either assets or liabilities in the accompanying financial statement and are measured at fair value. The Bank’s objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates. The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amount to be exchanged between the counterparties. The Bank is exposed to credit risk in the event of nonperformance by counterparties to financial instruments. The Bank minimizes this risk by entering into derivative contracts with large, stable financial institutions. The Bank has not experienced any losses from nonperformance by counterparties. The Bank monitors counterparty risk in accordance with the provisions of ASC 815. In addition, the Bank’s interest rate-related derivative instruments contain language outlining collateral pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty. The Bank was required to pledge $5.93 million of collateral as of March 31, 2016 .

Cash Flow Hedges:

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

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



	Notional Amount		Fair Value			Balance Sheet Category	Maturity
	(Amounts in Thousands)
March 31, 2016
Interest rate swap	$	25,000	$	(2,073	)	Other Liabilities	11/9/2020
Interest rate swap	25,000		(3,860		)	Other Liabilities	11/7/2023

December 31, 2015
Interest rate swap	$	25,000	$	(1,501	)	Other Liabilities	11/9/2020
Interest rate swap	25,000		(2,679		)	Other Liabilities	11/7/2023

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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 March 31, 2016 and December 31, 2015 :



	Effective Portion						Ineffective Portion
	Recognized in OCI			Reclassifed from AOCI into Income			Recognized in Income on Derivatives
	Amount of Gain (Loss)			Category	Amount of Gain (Loss)		Category	Amount of Gain (Loss)
	(Amounts in Thousands)
March 31, 2016
Interest rate swap	$	(353	)	Interest Expense	$	—	Other Income	$	—
Interest rate swap	(730		)	Interest Expense	—		Other Income	—

December 31, 2015
Interest rate swap	$	(394	)	Interest Expense	$	—	Other Income	$	—
Interest rate swap	(461		)	Interest Expense	—		Other Income	—



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

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

Special Note Regarding Forward Looking Statements

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

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


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


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


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

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


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


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


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


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


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


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


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


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


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


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


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


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


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


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

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

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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 March 31, 2016 and December 31, 2015 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

Overview

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

The Company is a holding company engaged in the business of commercial banking. The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids, Marion, and Washington, Iowa. At March 31, 2016 , the Bank has eighteen full-service locations.

Net income for the three month period ended March 31, 2016 was $7.70 million compared to $7.38 million for the same three months of 2015 , an increase of 4.34% . The $0.32 million increase in net income was caused by a number of factors. The principal factors in the increase in net income for the first three months of 2016 are an increase in net interest income of $1.09 million and a decrease in noninterest expenses of $0.15 million. These changes were offset by an increase in income tax expense of $0.19 million , a decrease in noninterest income of $0.12 million, and an increase in the provision for loan losses of $0.61 million .

The Company achieved a return on average assets of 1.19% and a return on average equity of 11.19% for the twelve months ended March 31, 2016 , compared to the twelve months ended March 31, 2015 , which were 1.22% and 11.02%, respectively. Dividends of $0.65 per share were paid in January 2016 to 2,334 shareholders. The 2015 dividend was $0.625 per share.

The Company’s net interest income is the largest component of revenue and it is primarily a function of the average earning assets and the net interest margin percentage. The Company achieved a net interest margin on a tax-equivalent basis of 3.40% for the three months ended March 31, 2016 compared to 3.50% for the same three months of 2015 . Average earning assets were $2.406 billion year to date in 2016 and $2.234 billion in 2015 .

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Highlights noted on the balance sheet as of March 31, 2016 for the Company included the following:


•	Total assets were $2.599 billion , an increase of $105.88 million since December 31, 2015 .


•	Cash and cash equivalents were $133.67 million , an increase of $98.25 million since December 31, 2015 . Cash and cash equivalents growth included approximately $80.00 million of temporary public funds.


•	Net loans were $2.116 billion , an increase of $10.92 million since December 31, 2015 . Loans held for sale decreased $0.98 million since December 31, 2015 .


•	Deposits increased $88.88 million since December 31, 2015 . Deposit growth included approximately $80.00 million of temporary public funds.


•	Federal Home Loan Bank borrowings increased $15.00 million since December 31, 2015 .

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

Financial Condition

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



	March 31, 2016				December 31, 2015
	Amount		Percent		Amount		Percent
	(Amounts In Thousands)				(Amounts In Thousands)
Agricultural	$	90,620	4.24	%	$	101,588	4.78	%
Commercial and financial	173,736		8.13		184,199		8.67
Real estate:
Construction, 1 to 4 family residential	58,293		2.73		51,346		2.42
Construction, land development and commercial	105,607		4.94		83,121		3.91
Mortgage, farmland	189,882		8.88		187,856		8.84
Mortgage, 1 to 4 family first liens	725,924		33.96		727,160		34.22
Mortgage, 1 to 4 family junior liens	118,115		5.53		117,873		5.55
Mortgage, multi-family	284,715		13.32		271,974		12.80
Mortgage, commercial	315,965		14.78		323,409		15.22
Loans to individuals	22,959		1.07		24,019		1.13
Obligations of state and political subdivisions	51,623		2.42		52,371		2.46
	$	2,137,439	100.00	%	$	2,124,916	100.00	%
Net unamortized fees and costs	766				768
	$	2,138,205			$	2,125,684
Less allowance for loan losses	27,130				26,510
	$	2,111,075			$	2,099,174

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

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

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

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

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

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The following table presents the allowance for loan losses on loans by loan category, the percentage of the allowance for each category to the total allowance, and the percentage of all loans in each category to total loans as of March 31, 2016 and December 31, 2015 :



	March 31, 2016						December 31, 2015
	Amount		% of Total Allowance		% of Loans to Total Loans		Amount		% of Total Allowance		% of Loans to Total Loans
	(In Thousands)						(In Thousands)
Agricultural	$	2,954	10.89	%	4.24	%	$	3,082	11.63	%	4.78	%
Commercial and financial	4,311		15.89		8.13		4,517		17.04		8.67
Real estate:
Construction, 1 to 4 family residential	991		3.65		2.73		866		3.27		2.42
Construction, land development and commercial	1,768		6.52		4.94		1,414		5.33		3.91
Mortgage, farmland	3,944		14.54		8.88		3,342		12.61		8.84
Mortgage, 1 to 4 family first liens	6,805		25.08		33.96		6,931		26.14		34.22
Mortgage, 1 to 4 family junior liens	1,231		4.54		5.53		1,241		4.68		5.55
Mortgage, multi-family	1,758		6.48		13.32		1,713		6.46		12.80
Mortgage, commercial	2,432		8.96		14.78		2,510		9.47		15.22
Loans to individuals	549		2.02		1.07		501		1.89		1.13
Obligations of state and political subdivisions	387		1.43		2.42		393		1.48		2.46
	$	27,130	100.00	%	100.00	%	$	26,510	100.00	%	100.00	%

The allowance for loan losses totaled $27.13 million at March 31, 2016 compared to $26.51 million at December 31, 2015 . The percentage of the allowance to outstanding loans was 1.27% and 1.25% at March 31, 2016 and December 31, 2015 , respectively. The allowance was based on management’s consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks and the overall amount of loans outstanding. The increase in the allowance in 2016 is the result of an increase in net loans and a change in the composition and allocation of loans within credit quality ratings.

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

Management has determined that the allowance for loan losses was appropriate at March 31, 2016 , and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for loan losses is based on a comprehensive, well documented, and consistently applied analysis of the Company’s loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for loan losses is reviewed and compared to industry data. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.

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

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Investment securities available for sale held by the Company decreased by $0.32 million from December 31, 2015 to March 31, 2016 . The fair value of securities available for sale was $3.26 million more than the amortized cost of such securities as of March 31, 2016 . At December 31, 2015 , the fair value of the securities available for sale was $2.24 million more than the amortized cost of such securities.

Deposits increased $88.88 million in the first three months of 2016 . Deposit growth included approximately $80.00 million of temporary public funds. Repurchase agreements increased $1.33 million and Federal Home Loan Bank borrowings increased $15.00 million since December 31, 2015 . In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Brokered deposits are included in total deposits and totaled $67.01 million as of March 31, 2016 with an average rate of 0.53%. Brokered deposits were $62.74 million as of December 31, 2015 with an average interest rate of 0.42%. As of March 31, 2016 and December 31, 2015 , brokered deposits were 3.38% and 3.32% of total deposits, respectively.

Dividends and Equity

In January 2016 , Hills Bancorporation paid a dividend of $6.06 million or $0.65 per share. The dividend was $0.625 per share in January 2015 . After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of March 31, 2016 totaled $271.55 million . On January 1, 2015, the final rules of the Federal Reserve Board went into effect implementing in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision. The final rule also adopted changes to the agencies’ regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Under the BASEL III rules, the minimum capital ratios are 4% for Tier 1 Leverage Capital Ratio, 4.5% for the Common Equity Tier 1 Capital Ratio, 6% for the Tier 1 Risk-Based Capital Ratio and 8% for the Total Risk-Based Capital Ratio. As of March 31, 2016 and December 31, 2015 , the Company had regulatory capital in excess of the Federal Reserve’s minimum and well-capitalized definition requirements. The actual amounts and capital ratios as of March 31, 2016 and December 31, 2015 are presented below (amounts in thousands):



	Actual				For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Ratio		Ratio
As of March 31, 2016:
Company:
Total risk-based capital	$	335,003	15.92	%	8.625	%	10.000	%
Tier 1 risk-based capital	308,685		14.67		6.625		8.000
Tier 1 common equity	308,685		14.67		5.125		6.500
Leverage ratio	308,685		12.29		4.000		5.000
Bank:
Total risk-based capital	334,982		15.93		8.625		10.000
Tier 1 risk-based capital	308,686		14.68		6.625		8.000
Tier 1 common equity	308,686		14.68		5.125		6.500
Leverage ratio	308,686		12.30		4.000		5.000

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	Actual				For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Ratio		Ratio
As of December 31, 2015:
Company:
Total risk-based capital	$	334,899	15.82	%	8.00	%	10.00	%
Tier 1 risk-based capital	308,432		14.57		6.00		8.00
Tier 1 common equity	308,432		14.57		4.50		6.50
Leverage ratio	308,432		12.53		4.00		5.00
Bank:
Total risk-based capital	335,010		15.83		8.00		10.00
Tier 1 risk-based capital	308,562		14.58		6.00		8.00
Tier 1 common equity	308,562		14.58		4.50		6.50
Leverage ratio	308,562		12.54		4.00		5.00

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Discussion of operations for the three months ended March 31, 2016 and 2015

Net Income Overview

Net income increased $0.32 million for the three months ended March 31, 2016 compared to the first three months of 2015 . Total net income was $7.70 million in 2016 and $7.38 million in the comparable period in 2015 , an increase of 4.34% . The changes in net income in 2016 from the first three months of 2015 were primarily the result of the following:


•	Net interest income increased by $1.09 million , before provision expense. Total interest income increased by $1.54 million as a result of growth in the volume of earning assets. Total interest expense increased by $0.45 million as a result of $0.68 million in additional FHLB borrowings interest expense.


•	The provision for loan losses increased by $0.61 million .


•	Noninterest income decreased by $0.12 million.


•	Noninterest expenses decreased by $0.15 million.


•	Income tax expense increased by $0.19 million .

For the three month period ended March 31, 2016 and March 31, 2015 basic earning per share was $0.83 and $0.79 , respectively. Diluted earnings per share was $0.83 for the three months ended March 31, 2016 compared to $ 0.79 for the same period in 2015 .

The Company’s net income continues to be driven primarily by three important factors. The first important factor is the interaction between changes in net interest margin and changes in average volumes of the Bank's earnings assets. Net interest income of $19.67 million for the first three months of 2016 was derived from the Company’s $2.406 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.40%. Average earning assets in the three months ended March 31, 2015 were $2.234 billion and the tax-equivalent net interest margin was 3.50%. 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 $0.60 million change in income before income taxes in the three month period ended March 31, 2016 . Net interest income for the Company increased as a result of growth in the volume of earning assets and 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 net interest compression to continue to impact earnings for the foreseeable future. The Company believes growth in net interest income will be contingent on the growth of the Company’s earnings assets.

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than $2.116 billion at March 31, 2016 . The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historically higher credit risk. The provision for loan losses was an expense of $0.55 million in 2016 compared to a reduction of expense of $0.06 million in 2015 . The Company believes that the provision for loan losses will steadily increase for the foreseeable future resulting from projected increases in the size of the Company’s loan portfolio.

The third significant factor affecting the Company’s net income is income tax expense. Federal and state income tax expenses were $3.25 million and $3.05 million for the three months ended March 31, 2016 and 2015 , respectively. Income taxes as a percentage of income before taxes were 29.65% in 2016 and 29.26% in 2015 .

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HILLS BANCORPORATION

Discussion of operations for the three months ended March 31, 2016 and 2015

Net Interest Income

Net interest income increased for the three months ended March 31, 2016 compared to the comparable period in 2015 . The increase was as a result of growth in the average volume of earning assets and 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 average volume of earning assets for the period and the net interest margin. The net interest margin for the first three months of 2016 was 3.40% compared to 3.50% in 2015 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2016 compared to the comparable period in 2015 are shown in the following table:



						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	$	135,244		(0.05	)%	$	1,746		$	(311	)	$	1,435
Taxable securities	5,512			0.21		33			37			70
Nontaxable securities	4,913			(0.14	)	38			(62		)	(24		)
Federal funds sold	26,141			0.25		17			22			39
	$	171,810				$	1,834		$	(314	)	$	1,520

Interest expense:
Interest-bearing demand deposits	$	44,224		—	%	$	(18	)	$	(5	)	$	(23	)
Savings deposits	61,815			0.04		(32		)	(55		)	(87		)
Time deposits	(57,866		)	(0.16	)	180			173			353
Other borrowings	(44		)	(0.60	)	—			(17		)	(17		)
FHLB borrowings	96,685			(0.01	)	5			(1		)	4
Interest-bearing other liabilities	(4,346		)	(0.64	)	(1,054		)	376			(678		)
	$	140,468				$	(919	)	$	471		$	(448	)
Change in net interest income						$	915		$	157		$	1,072

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

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



(Tax Equivalent Basis)	2016		2015
Yield on average interest-earning assets	4.07	%	4.16	%
Rate on average interest-bearing liabilities	0.86		0.84
Net interest spread	3.21	%	3.32	%
Effect of noninterest-bearing funds	0.19		0.18
Net interest margin (tax equivalent interest income divided by average interest-earning assets)	3.40	%	3.50	%

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HILLS BANCORPORATION

Discussion of operations for the three months ended March 31, 2016 and 2015

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. The Federal Open Market Committee met two times during the first three months of 2016 . The target rate remains unchanged since December, 2015 at 0.50%. Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate. As of March 31, 2016 , the rate indexes for the one, three and five year indexes were 0.59%, 0.87% and 1.21%, respectively. The one year index increased 126.92% from 0.26% at March 31, 2015 , the three year index decreased 7.45% and the five year index decreased 14.79%. The three year index was 0.94% and the five year index was 1.42% at March 31, 2015 . The targeted federal funds rate was 0.50% and 0.25% at March 31, 2016 and 2015 , respectively. The Company anticipates possible increases in short term and long term rates in the indexes for 2016 .

Provision for Loan Losses

The provision for loan losses was an expense of $0.55 million for the three months ended March 31, 2016 compared to a reduction of expense of $0.06 million in 2015 , an expense increase of $0.61 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 2016 is the result of an increase in net loans, a change in the composition and allocation of loans within credit quality ratings and a specific allowance recorded for a $16.22 agricultural and farmland real estate loan relationship.

The allowance for loan losses increased $0.62 million during the first three months of 2016 . In the first three months of 2016 , there was an increase of $0.21 million due to the volume and composition of loans outstanding and a $0.41 million increase in the amount allocated to the allowance due to credit quality.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the three months ended March 31, 2016 and 2015 , recoveries were $0.72 million and $1.17 million, respectively; and charge-offs were $0.64 million in 2016 and $0.77 million in 2015 . The allowance for loan losses totaled $27.13 million at March 31, 2016 compared to $26.51 million at December 31, 2015 . The allowance represented 1.27% and 1.25% of loans held for investment at March 31, 2016 and December 31, 2015 .

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HILLS BANCORPORATION

Discussion of operations for the three months ended March 31, 2016 and 2015

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended March 31, 2016 and 2015 .



	Three Months Ended March 31,
	2016		2015		$ Change			% Change
	(Amounts in thousands)
Net gain on sale of loans	$	289	$	308	$	(19	)	(6.17	)%
Trust fees	1,728		1,569		159			10.13
Service charges and fees	2,055		1,946		109			5.60
Rental revenue on tax credit real estate	—		511		(511		)	(100.00	)
Net gain on sale of other real estate owned and other repossessed assets	34		7		27			385.71
Other noninterest income	767		649		118			18.18
	$	4,873	$	4,990	$	(117	)	(2.34	)

Loans originated for sale in the first three months of 2016 totaled $32.24 million compared to $40.58 million in the same period in 2015 , a decrease of 20.55%. In the three months ended March 31, 2016 and 2015 , the net gain on sale of loans was $0.29 million and $0.31 million , respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income. The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

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

The net gain on sale of other real estate owned and other repossessed assets increased $0.03 million to a net gain of $0.03 million for the three months ended March 31, 2016 . The total net gain on sale of other real estate owned for the three months ended consisted of a $0.03 million net gain on the sale of five properties. During the same period in 2015 , the gain consisted of a $0.04 million net gain on sale of three properties offset by a $0.03 million fair market value adjustment on 3 properties.

Trust fees increased $0.16 million in the three months ended March 31, 2016 compared to March 31, 2015 due to new trust relationships.

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HILLS BANCORPORATION

Discussion of operations for the three months ended March 31, 2016 and 2015

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended March 31, 2016 and 2015 .



	Three Months Ended March 31,
	2016		2015		$ Change			% Change
	(Amounts in thousands)
Salaries and employee benefits	$	6,984	$	6,651	$	333		5.01	%
Occupancy	1,001		1,015		(14		)	(1.38	)
Furniture and equipment	1,404		1,298		106			8.17
Office supplies and postage	401		441		(40		)	(9.07	)
Advertising and business development	786		774		12			1.55
Outside services	1,776		1,814		(38		)	(2.09	)
Rental expenses on tax credit real estate	—		602		(602		)	(100.00	)
FDIC insurance assessment	303		289		14			4.84
Other noninterest expense	397		315		82			26.03
	$	13,052	$	13,199	$	(147	)	(1.11	)

In the three months ended March 31, 2016 and 2015 , salaries and employee benefits expense increased $0.33 million . The increase is primarily the result of annual salary adjustments and additional employees. Other noninterest expense categories experienced marginal period-to-period fluctuations for the three months ended March 31, 2016 .

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

Income Taxes

Federal and state income tax expenses were $3.25 million and $3.05 million for the three months ended March 31, 2016 and 2015 , respectively. Income taxes as a percentage of income before taxes were 29.65% in 2016 and 29.26% in 2015 .

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HILLS BANCORPORATION

Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs. Federal funds sold and investment securities available for sale are readily marketable assets. Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position. Investment securities available for sale comprised 10.15% of the Company’s total assets at March 31, 2016 compared to 10.60% at December 31, 2015 .

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position. As of March 31, 2016 , the Company had borrowed $240.00 million from the Federal Home Loan Bank (“FHLB”) of Des Moines. Advances are used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk. The Company had additional borrowing capacity available from the FHLB of approximately $394.83 million at March 31, 2016 .

As additional sources of liquidity, the Company has the ability to borrow up to $10.00 million from the Federal Reserve Bank of Chicago, and has lines of credit with three banks totaling $209.34 million. The borrowings under these credit lines would be secured by the Bank’s investment securities. The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at March 31, 2016 .

As of March 31, 2016 , investment securities with a carrying value of $71.79 million were pledged to collateralize public and trust deposits, repurchase agreements, derivative financial instruments, and other borrowings. As of December 31, 2015 , investment securities with a carrying value of $69.52 million were pledged.

Contractual Obligations

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



Item 3.	Quantitative and Qualitative Disclosures about Market Risk

The Company's primary market risk exposure is to changes in interest rates. Interest rate risk is the risk to current or anticipated earnings or capital arising from movements in interest rates. Interest rate risk arises from repricing risk, basis risk, yield curve risk and options risk. Repricing risk is the difference between the timing of rate changes and the timing of cash flows. Basis risk is the difference from changing rate relationships among different yield curve affecting Bank activities. Yield curve risk is the difference from changing rate relationships across the spectrum of maturities. Option risk is the difference resulting from interest-related options imbedded in Bank products. The Bank’s primary source of interest rate risk exposure arises from repricing risk. To measure this risk the Bank uses a static gap measurement system that identifies the repricing gaps across the full maturity spectrum of the Bank’s assets and liabilities and an earnings simulation approach. The gap schedule is known as the interest rate sensitivity report. The report reflects the repricing characteristics of the Bank’s assets and liabilities. The report details the calculation of the gap ratio. This ratio indicates the amount 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.

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HILLS BANCORPORATION

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

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

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



Item 4.	Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports it files with the Securities and Exchange Commission. There have been no changes in the Company’s internal controls over financial reporting during the three months ended March 31, 2016 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

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HILLS BANCORPORATION

PART II - OTHER INFORMATION



Item 1.	Legal Proceedings

None



Item 1A.	Risk Factors

There have been no material changes from the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2015 .



Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds

The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended March 31, 2016 :



Period	Total number of shares purchased	Average price paid per share		Total number of shares purchased as part of publicly announced plans or programs	Maximum number of shares that may yet be purchased under the plans or programs (1)
January 1 to January 31	3,166	$	44.50	3,166	619,245
February 1 to February 29	23,590	44.76		23,590	595,655
March 1 to March 31	8,496	45.00		8,496	587,159
Total	35,252	$	44.79	35,252	587,159

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

During the first three months of 2016 , the Company issued 1,626 shares of restricted stock under the 2010 Stock Option and Incentive Plan. The restricted shares were issued to officers of the company for no cash consideration and will vest over a five-year period from the date of grant. The issuance of these shares was exempt from the registration requirements of the SEC pursuant to Section 4(a)(2) of the Securities Act of 1933.



Item 3.	Defaults upon Senior Securities

Hills Bancorporation has no senior securities.



Item 4.	Mine Safety Disclosure

Not applicable.

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Item 5.	Other Information

None

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Item 6.	Exhibits



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


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

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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:	May 5, 2016	By: /s/ Dwight O. Seegmiller
		Dwight O. Seegmiller, Director, President and Chief Executive Officer

Date:	May 5, 2016	By: /s/ Shari DeMaris
		Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer

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HILLS BANCORPORATION

QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED MARCH 31, 2016



Exhibit Number	Description	Page Number In The Sequential Numbering System March 31, 2016 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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HBIA 10-Q Quarter ended March 31, 2016