UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended ~~June~~September 30, 2014

Commission file number: 0-12668

Hills Bancorporation



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

131 MAIN STREET, HILLS, IOWA 52235

Telephone number: (319) 679-2291

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

þ Yes o No

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

þ Yes o No

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



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

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

o Yes þ No

APPLICABLE ONLY TO CORPORATE ISSUERS:

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



	SHARES OUTSTANDING
CLASS	~~July~~October 31, 2014

Common Stock, no par value	~~4,705,312~~4,694,840

Index

HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION



		Page
		Number

Item 1.	Financial Statements

	Consolidated balance sheets, ~~June~~September 30, 2014 (unaudited) and December 31, 2013	3
	Consolidated statements of income (unaudited) for three and ~~six~~nine months ended ~~June~~September 30, 2014 and 2013	4
	Consolidated statements of comprehensive income (unaudited) for three and ~~six~~nine months ended ~~June~~September 30, 2014 and 2013	5
	Consolidated statements of stockholders' equity (unaudited) for ~~six~~nine months ended ~~June~~September 30, 2014 and 2013	6
	Consolidated statements of cash flows (unaudited) for ~~six~~nine months ended ~~June~~September 30, 2014 and 2013	7
	Notes to consolidated financial statements (condensed)	9

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	52

Item 4.	Controls and Procedures	5253

	Part II
	OTHER INFORMATION

Item 1.	Legal proceedings	5354

Item 1A.	Risk factors	5354

Item 2.	Unregistered sales of equity securities and use of proceeds	5355

Item 3.	Defaults upon senior securities	5455

Item 4.	Mine safety disclosures	5455

Item 5.	Other information	5455

Item 6.	Exhibits	5456

Signatures		5557

Exhibits Index		5658

Page 2

Index

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


	June 30, 2014			December 31, 2013			September 30, 2014			December 31, 2013
ASSETS	(Unaudited)			December 31, 2013			(Unaudited)			December 31, 2013
Cash and cash equivalents	$	30,136		$	43,702		$	68,864		$	43,702
Investment securities available for sale at fair value (amortized cost June 30, 2014 $237,172; December 31, 2013 $236,702)	239,805			238,510
Investment securities available for sale at fair value (amortized cost September 30, 2014 $241,159; December 31, 2013 $236,702)							243,818			238,510
Stock of Federal Home Loan Bank	7,653			7,579			7,651			7,579
Loans held for sale	7,959			4,927			2,484			4,927
Loans, net of allowance for loan losses (June 30, 2014 $25,350; December 31, 2013 $25,550)	1,862,332			1,801,247
Loans, net of allowance for loan losses (September 30, 2014 $24,500; December 31, 2013 $25,550)							1,914,139			1,801,247
Property and equipment, net	28,827			29,836			28,623			29,836
Tax credit real estate	17,735			18,180			17,498			18,180
Accrued interest receivable	8,251			7,676			8,980			7,676
Deferred income taxes, net	9,230			8,605			9,090			8,605
Other real estate	1,533			541			1,084			541
Goodwill	2,500			2,500			2,500			2,500
Other assets	3,856			4,492			3,550			4,492
Total Assets	$	2,219,817		$	2,167,795		$	2,308,281		$	2,167,795

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities
Noninterest-bearing deposits	$	261,565		$	256,788		$	270,139		$	256,788
Interest-bearing deposits	1,464,759			1,453,089			1,569,357			1,453,089
Total deposits	$	1,726,324		$	1,709,877		$	1,839,496		$	1,709,877
Short-term borrowings	68,572			42,016			36,033			42,016
Federal Home Loan Bank borrowings	125,000			125,000			125,000			125,000
Accrued interest payable	930			1,102			906			1,102
Other liabilities	19,142			16,437			20,877			16,437
Total Liabilities	$	1,939,968		$	1,894,432		$	2,022,312		$	1,894,432

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	31,405		$	29,574		$	32,500		$	29,574

STOCKHOLDERS' EQUITY
Common stock, no par value; authorized 10,000,000 shares; issued June 30, 2014 5,079,719 shares; December 31, 2013 5,074,894 shares	$	—		$	—
Common stock, no par value; authorized 10,000,000 shares; issued September 30, 2014 5,081,004 shares; December 31, 2013 5,074,894 shares							$	—		$	—
Paid in capital	42,550			42,194			42,660			42,194
Retained earnings	258,875			250,370			266,774			250,370
Accumulated other comprehensive income	755			1,591			748			1,591
Unearned ESOP shares	(1,008		)	(1,008		)	(1,008		)	(1,008		)
Treasury stock at cost (June 30, 2014 367,498 shares; December 31, 2013 347,269 shares)	(21,323		)	(19,784		)
Treasury stock at cost (September 30, 2014 391,351 shares; December 31, 2013 347,269 shares)							(23,205		)	(19,784		)
Total Stockholders' Equity	$	279,849		$	273,363		$	285,969		$	273,363
Less maximum cash obligation related to ESOP shares	31,405			29,574			32,500			29,574
Total Stockholders' Equity Less Maximum Cash Obligations Related to ESOP Shares	$	248,444		$	243,789		$	253,469		$	243,789
Total Liabilities & Stockholders' Equity	$	2,219,817		$	2,167,795		$	2,308,281		$	2,167,795

See Notes to Consolidated Financial Statements.

Page 3

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Amounts In Thousands, Except Per Share Amounts)


	Three Months Ended June 30,						Six Months Ended June 30,						Three Months Ended September 30,					Nine Months Ended September 30,
	2014			2013			2014			2013			2014			2013		2014			2013
Interest income:
Loans, including fees	$	20,350		$	19,747		$	40,099		$	39,467		$	20,676		$	19,886	$	60,775		$	59,353
Investment securities:
Taxable	270			304			540			654			275			303		815			957
Nontaxable	837			831			1,673			1,674			840			823		2,513			2,497
Federal funds sold	16			25			26			46			3			11		29			57
Total interest income	$	21,473		$	20,907		$	42,338		$	41,841		$	21,794		$	21,023	$	64,132		$	62,864
Interest expense:
Deposits	$	2,322		$	2,839		$	4,791		$	5,804		$	2,245		$	2,684	$	7,036		$	8,488
Short-term borrowings	44			44			47			61			50			41		97			102
FHLB borrowings	1,394			1,394			2,772			2,772			1,409			1,409		4,181			4,181
Total interest expense	$	3,760		$	4,277		$	7,610		$	8,637		$	3,704		$	4,134	$	11,314		$	12,771
Net interest income	$	17,713		$	16,630		$	34,728		$	33,204		$	18,090		$	16,889	$	52,818		$	50,093
Provision for loan losses	(246		)	(250		)	(201		)	(421		)	(1,008		)	112		(1,209		)	(309		)
Net interest income after provision for loan losses	$	17,959		$	16,880		$	34,929		$	33,625		$	19,098		$	16,777	$	54,027		$	50,402
Noninterest income:
Net gain on sale of loans	$	189		$	521		$	300		$	1,262		$	338		$	531	$	638		$	1,793
Trust fees	1,439			1,295			2,899			2,555			1,595			1,185		4,494			3,740
Service charges and fees	2,012			2,262			3,849			4,376			2,152			2,240		6,001			6,616
Rental revenue on tax credit real estate	378			397			735			716			377			398		1,112			1,114
Net gain on sale of other real estate owned and other repossessed assets	168			110			240			150			186			18		426			168
Other noninterest income	761			734			1,345			1,348			599			591		1,944			1,939
	$	4,947		$	5,319		$	9,368		$	10,407		$	5,247		$	4,963	$	14,615		$	15,370

Noninterest expenses:
Salaries and employee benefits	$	6,385		$	6,191		$	12,642		$	12,154		$	6,400		$	6,158	$	19,042		$	18,312
Occupancy	944			931			1,953			1,873			947			907		2,900			2,780
Furniture and equipment	1,242			1,186			2,473			2,467			1,212			1,183		3,685			3,650
Office supplies and postage	385			386			767			766			390			445		1,157			1,163
Advertising and business development	813			651			1,441			1,271			775			624		2,216			1,895
Outside services	1,673			1,768			3,208			3,570			1,773			1,819		4,981			5,437
Rental expenses on tax credit real estate	553			613			1,083			957			552			614		1,635			1,571
FDIC insurance assessment	271			270			541			531			282			229		823			760
Other noninterest expense	271			426			687			866			490			432		1,177			1,298
	$	12,537		$	12,422		$	24,795		$	24,455		$	12,821		$	12,411	$	37,616		$	36,866
Income before income taxes	$	10,369		$	9,777		$	19,502		$	19,577		$	11,524		$	9,329	$	31,026		$	28,906
Income taxes	3,188			2,863			5,577			5,853			3,625			2,705		9,202			8,558
Net income	$	7,181		$	6,914		$	13,925		$	13,724		$	7,899		$	6,624	$	21,824		$	20,348

Earnings per share:
Basic	$	1.53		$	1.47		$	2.96		$	2.91		$	1.69		$	1.41	$	4.65		$	4.32
Diluted	$	1.53		$	1.47		$	2.96		$	2.91		$	1.68		$	1.40	$	4.64		$	4.31

See Notes to Consolidated Financial Statements.

Page 4

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited) (Amounts In Thousands)


	Three Months Ended June 30,						Six Months Ended June 30,						Three Months Ended September 30,						Nine Months Ended September 30,
	2014			2013			2014			2013			2014			2013			2014			2013
Net income	$	7,181		$	6,914		$	13,925		$	13,724		$	7,899		$	6,624		$	21,824		$	20,348

Other comprehensive loss
Securities:
Net change in unrealized gain (loss) on securities available for sale	$	741		$	(4,537	)	$	825		$	(5,320	)	$	26		$	(1,084	)	$	851		$	(4,236	)
Reclassification adjustment for net gains realized in net income	—			—			—			(17		)	—			—			—			(17		)
Income taxes	(283		)	1,735			(315		)	2,041			(10		)	414			(325		)	1,627
Other comprehensive income (loss) on securities available for sale	$	458		$	(2,802	)	$	510		$	(3,296	)	$	16		$	(670	)	$	526		$	(2,626	)
Derivatives used in cash flow hedging relationships:
Unrealized loss on derivatives	$	(1,100	)	$	—		$	(2,179	)	$	—		$	(37	)	$	—		$	(2,216	)	$	—
Income taxes	420			—			833			—			14			—			847			—
Other comprehensive loss on cash flow hedges	$	(680	)	$	—		$	(1,346	)	$	—		$	(23	)	$	—		$	(1,369	)	$	—

Other comprehensive loss, net of tax	$	(222	)	$	(2,802	)	$	(836	)	$	(3,296	)	$	(7	)	$	(670	)	$	(843	)	$	(2,626	)

Comprehensive income	$	6,959		$	4,112		$	13,089		$	10,428		$	7,892		$	5,954		$	20,981		$	17,722

See Notes to Consolidated Financial Statements.

Page 5

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			Paid In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Unearned ESOP Shares			Treasury Stock			Maximum Cash Obligation Related To ESOP Shares			Total
Balance, December 31, 2012	$	42,241		$	229,625		$	3,955		$	(1,513	)	$	(18,397	)	$	(30,715	)	$	225,196		$	42,241		$	229,625		$	3,955		$	(1,513	)	$	(18,397	)	$	(30,715	)	$	225,196
Issuance of 5,310 shares of common stock	203			—			—			—			—			—			203
Issuance of 1,040 shares of common stock under the employee stock purchase plan	72			—			—			—			—			—			72
Issuance of 6,180 shares of common stock																						240			—			—			—			—			—			240
Issuance of 1,592 shares of common stock under the employee stock purchase plan																						111			—			—			—			—			—			111
Unearned restricted stock compensation	(702		)	—			—			—			—			—			(702		)	(660		)	—			—			—			—			—			(660		)
Forfeiture of 375 shares of common stock	(25		)	—			—			—			—			—			(25		)	(25		)	—			—			—			—			—			(25		)
Share-based compensation	14			—			—			—			—			—			14			21			—			—			—			—			—			21
Income tax benefit related to share-based compensation	73			—			—			—			—			—			73			85			—			—			—			—			—			85
Change related to ESOP shares	—			—			—			—			—			2,993			2,993			—			—			—			—			—			2,575			2,575
Net income	—			13,724			—			—			—			—			13,724			—			20,348			—			—			—			—			20,348
Cash dividends ($1.10 per share)	—			(5,186		)	—			—			—			—			(5,186		)	—			(5,186		)	—			—			—			—			(5,186		)
Purchase of 9,393 shares of common stock	—			—			—			—			(670		)	—			(670		)
Purchase of 13,601 shares of common stock																						—			—			—			—			(976		)	—			(976		)
Other comprehensive loss	—			—			(3,296		)	—			—			—			(3,296		)	—			—			(2,626		)	—			—			—			(2,626		)
Balance, June 30, 2013	$	41,876		$	238,163		$	659		$	(1,513	)	$	(19,067	)	$	(27,722	)	$	232,396
Balance, September 30, 2013																						$	42,013		$	244,787		$	1,329		$	(1,513	)	$	(19,373	)	$	(28,140	)	$	239,103

Balance, December 31, 2013	$	42,194		$	250,370		$	1,591		$	(1,008	)	$	(19,784	)	$	(29,574	)	$	243,789		$	42,194		$	250,370		$	1,591		$	(1,008	)	$	(19,784	)	$	(29,574	)	$	243,789
Issuance of 4,233 shares of common stock	200			—			—			—			—			—			200
Issuance of 1,026 shares of common stock under the employee stock purchase plan	76			—			—			—			—			—			76
Issuance of 5,064 shares of common stock																						266			—			—			—			—			—			266
Issuance of 1,617 shares of common stock under the employee stock purchase plan																						121			—			—			—			—			—			121
Unearned restricted stock compensation	46			—			—			—			—			—			46			48			—			—			—			—			—			48
Forfeiture of 434 shares of common stock	(31		)	—			—			—			—			—			(31		)
Forfeiture of 571 shares of common stock																						(40		)	—			—			—			—			—			(40		)
Share-based compensation	14			—			—			—			—			—			14			21			—			—			—			—			—			21
Income tax benefit related to share-based compensation	51			—			—			—			—			—			51			50			—			—			—			—			—			50
Change related to ESOP shares	—			—			—			—			—			(1,831		)	(1,831		)	—			—			—			—			—			(2,926		)	(2,926		)
Net income	—			13,925			—			—			—			—			13,925			—			21,824			—			—			—			—			21,824
Cash dividends ($1.15 per share)	—			(5,420		)	—			—			—			—			(5,420		)	—			(5,420		)	—			—			—			—			(5,420		)
Purchase of 20,229 shares of common stock	—			—			—			—			(1,539		)	—			(1,539		)
Purchase of 44,082 shares of common stock																						—			—			—			—			(3,421		)	—			(3,421		)
Other comprehensive loss	—			—			(836		)	—			—			—			(836		)	—			—			(843		)	—			—			—			(843		)
Balance, June 30, 2014	$	42,550		$	258,875		$	755		$	(1,008	)	$	(21,323	)	$	(31,405	)	$	248,444
Balance, September 30, 2014																						$	42,660		$	266,774		$	748		$	(1,008	)	$	(23,205	)	$	(32,500	)	$	253,469

See Notes to Consolidated Financial Statements.

Page 6

Index

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


	Six Months Ended June 30,						Nine Months Ended September 30,
	2014			2013			2014			2013
Cash Flows from Operating Activities
Net income	$	13,925		$	13,724		$	21,824		$	20,348
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation	1,361			1,451			1,916			2,176
Provision for loan losses	(201		)	(421		)	(1,209		)	(309		)
Net gain on sale of investment securities	—			(17		)	—			(17		)
Share-based compensation	14			14			21			21
Forfeiture of common stock	(31		)	(25		)	(40		)	(25		)
Compensation expensed through issuance of common stock	175			126			286			176
Excess tax benefits from share-based compensation	(51		)	(73		)	(50		)	(85		)
Provision for deferred income taxes	(107		)	198			37			(103		)
Net gain on sale of other real estate owned and other repossessed assets	(240		)	(150		)	(426		)	(168		)
Increase in accrued interest receivable	(575		)	(361		)	(1,304		)	(609		)
Amortization of discount on investment securities, net	433			565			654			834
Decrease in prepaid FDIC insurance	—			2,957			—			2,957
(Increase) decrease in other assets	(82		)	3,153
Increase (decrease) in accrued interest payable and other liabilities	1,170			(84		)
Decrease in other assets							222			3,175
Increase in accrued interest payable and other liabilities							2,845			1,287
Loans originated for sale	(49,191		)	(136,340		)	(80,798		)	(178,872		)
Proceeds on sales of loans	46,459			139,810			83,879			206,110
Net gain on sales of loans	(300		)	(1,262		)	(638		)	(1,793		)
Net cash and cash equivalents provided by operating activities	$	12,759		$	23,265		$	27,219		$	55,103

Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	37,774		$	14,920		$	46,252		$	21,070
Proceeds from sales of investment securities available for sale	—			566			—			566
Purchases of investment securities available for sale	(38,752		)	(19,822		)	(51,434		)	(27,721		)
Loans made to customers, net of collections	(62,599		)	(20,943		)	(113,409		)	(71,241		)
Proceeds on sale of other real estate owned and other repossessed assets	963			896			1,609			1,275
Purchases of property and equipment	(352		)	(862		)	(703		)	(1,428		)
Income from tax credit real estate, net	445			192			682			478
Net cash and cash equivalents used in investing activities	$	(62,521	)	$	(25,053	)	$	(117,003	)	$	(77,001	)

Cash Flows from Financing Activities
Net increase (decrease) in deposits	$	16,447		$	(24,397	)
Net increase (decrease) in short-term borrowings	26,556			(7,856		)
Net increase in deposits							$	129,619		$	30,761
Net decrease in short-term borrowings							(5,983		)	(9,620		)
Stock options exercised	101			149			101			175
Excess tax benefits related to share-based compensation	51			73			50			85
Purchase of treasury stock	(1,539		)	(670		)	(3,421		)	(976		)
Dividends paid	(5,420		)	(5,186		)	(5,420		)	(5,186		)
Net cash and cash equivalents provided by (used in) financing activities	$	36,196		$	(37,887	)
Net cash and cash equivalents provided by financing activities							$	114,946		$	15,239

(Continued)

Page 7

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued) (Amounts In Thousands)
	Six Months Ended June 30,						Nine Months Ended September 30,
	2014			2013			2014		2013
Decrease in cash and cash equivalents	$	(13,566	)	$	(39,675	)
Increase (decrease) in cash and cash equivalents							$	25,162	$	(6,659	)
Cash and cash equivalents:
Beginning of year	43,702			63,582			43,702		63,582
End of period	$	30,136		$	23,907		$	68,864	$	56,923

Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	4,963		$	5,987		$	7,232	$	8,757
Interest paid on other obligations	2,819			2,833			4,278		4,283
Income taxes paid	5,268			3,974			8,072		6,800

Noncash activities:
Increase (decrease) in maximum cash obligation related to ESOP shares	$	1,831		$	(2,993	)	$	2,926	$	(2,575	)
Transfers to other real estate owned	1,715			467			1,726		949

See Notes to Consolidated Financial Statements.

Page 8

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 ~~six~~nine month period ended ~~June~~September 30, 2014 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2014. For further information, refer to the consolidated financial statements and footnotes thereto included in the Form 10-K Annual Report of Hills Bancorporation and subsidiary (the “Company”) for the year ended December 31, 2013 filed with the Securities Exchange Commission on March 11, 2014. The consolidated balance sheet as of December 31, 2013, has been derived from the audited consolidated financial statements for that period.

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

Effect of New Financial Accounting Standards:

In January 2014, the FASB issued ASU No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects", to amend FASB ASC Topic 323, Investments – Equity Method and Joint Ventures. The objective of this standard is to provide guidance on accounting for investments by a reporting entity in flow-through limited liability entities that manage or invest in affordable housing projects that qualify for the low-income housing tax credit. The amendments in the standard permit, but do not require, reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit). The standard will be effective for the Company beginning January 1, 2015; however, early adoption is permitted. The Company does have significant investments in such qualified affordable housing projects and is currently reviewing the provisions of this standard to determine what, if any, impacts it may have on the Company’s financial position or results of operations.

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

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

Page 9

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 2.	Earnings Per Share

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

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


	Three Months Ended June 30,						Six Months Ended June 30,					Three Months Ended September 30,						Nine Months Ended September 30,
	2014			2013			2014			2013		2014			2013			2014			2013
Common shares outstanding at the beginning of the period	4,708,576			4,714,694			4,711,995			4,712,328		4,696,591			4,708,910			4,711,995			4,712,328
Weighted average number of net shares (redeemed) issued	(6,471		)	(1,842		)	(5,696		)	1,523
Weighted average number of net shares redeemed												(10,673		)	(720		)	(12,490		)	(364		)
Weighted average shares outstanding (basic)	4,702,105			4,712,852			4,706,299			4,713,851		4,685,918			4,708,190			4,699,505			4,711,964
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method	2,060			3,327			2,425			3,981		2,139			3,220			2,365			3,755
Weighted average number of shares (diluted)	4,704,165			4,716,179			4,708,724			4,717,832		4,688,057			4,711,410			4,701,870			4,715,719
Net income (In thousands)	$	7,181		$	6,914		$	13,925		$	13,724	$	7,899		$	6,624		$	21,824		$	20,348
Earnings per share:
Basic	$	1.53		$	1.47		$	2.96		$	2.91	$	1.69		$	1.41		$	4.65		$	4.32
Diluted	$	1.53		$	1.47		$	2.96		$	2.91	$	1.68		$	1.40		$	4.64		$	4.31

Page 10

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 3.	Other Comprehensive Income

The following table summarizes the ~~changes in the~~ balances of each component of accumulated other comprehensive income (AOCI), included in stockholders’ equity, at ~~June~~September 30, 2014 and December 31, 2013:


	June 30, 2014			December 31, 2013			September 30, 2014			December 31, 2013
��	(amounts in thousands)
							(amounts in thousands)
Net unrealized gain on available-for-sale securities	$	2,633		$	1,808		$	2,659		$	1,808
Net unrealized (loss) gain on derivatives used for cash flow hedges	(1,410		)	769			(1,447		)	769
Tax effect	(468		)	(986		)	(464		)	(986		)
Net-of-tax amount	$	755		$	1,591		$	748		$	1,591

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


	Amounts reclassifed from AOCI						Amounts reclassifed from AOCI
	Three Months Ended June 30,						Three Months Ended September 30,
	2014		2013			Affected Line Item in the Statements of Income	2014		2013			Affected Line Item in the Statements of Income
	(amounts in thousands)						(amounts in thousands)
Unrealized gains on available-for-sale securities	$	—	$	—		Other noninterest income	$	—	$	—		Other noninterest income
Tax effect	—		—			Tax (expense) benefit	—		—			Tax (expense) benefit
Total reclassification out of AOCI	$	—	$	—			$	—	$	—

	Six Months Ended June 30,						Nine Months Ended September 30,
	2014		2013			Affected Line Item in the Statements of Income	2014		2013			Affected Line Item in the Statements of Income
	(amounts in thousands)						(amounts in thousands)
Unrealized gains on available-for-sale securities	$	—	$	17		Other noninterest income	$	—	$	17		Other noninterest income
Tax effect	—		(7		)	Tax (expense) benefit	—		(7		)	Tax (expense) benefit
Total reclassification out of AOCI	$	—	$	10			$	—	$	10

Page 11

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 4.	Securities

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


	June 30, 2014				December 31, 2013				September 30, 2014				December 31, 2013
	Amount		Percent		Amount		Percent		Amount		Percent		Amount		Percent
Securities available for sale
U.S. Treasury	$	12,358	5.15	%	$	—	—	%	$	19,794	8.12	%	$	—	—	%
State and political subdivisions	151,954		63.37		151,366		63.46		154,198		63.24		151,366		63.46
Other securities (FHLB, FHLMC and FNMA)	75,493		31.48		87,144		36.54		69,826		28.64		87,144		36.54
Total securities available for sale	$	239,805	100.00	%	$	238,510	100.00	%	$	243,818	100.00	%	$	238,510	100.00	%

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


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Estimated Fair Value		Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Estimated Fair Value
June 30, 2014:
September 30, 2014:
U.S. Treasury	$	12,363	$	14	$	(19	)	$	12,358	$	19,828	$	6	$	(40	)	$	19,794
State and political subdivisions	149,511		3,078		(635		)	151,954		151,632		2,969		(403		)	154,198
Other securities (FHLB, FHLMC and FNMA)	75,298		264		(69		)	75,493		69,699		191		(64		)	69,826
Total	$	237,172	$	3,356	$	(723	)	$	239,805	$	241,159	$	3,166	$	(507	)	$	243,818
December 31, 2013:
U.S. Treasury	$	—	$	—	$	—		$	—	$	—	$	—	$	—		$	—
State and political subdivisions	149,704		3,182		(1,520		)	151,366		149,704		3,182		(1,520		)	151,366
Other securities (FHLB, FHLMC and FNMA)	86,998		316		(170		)	87,144		86,998		316		(170		)	87,144
Total	$	236,702	$	3,498	$	(1,690	)	$	238,510	$	236,702	$	3,498	$	(1,690	)	$	238,510

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at ~~June~~September 30, 2014, were as follows (in thousands):


	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due in one year or less	$	35,796	$	36,056	$	35,464	$	35,621
Due after one year through five years	135,486		137,795		136,084		138,213
Due after five years through ten years	65,890		65,954		69,611		69,984
Due over ten years	—		—		—		—
Total	$	237,172	$	239,805	$	241,159	$	243,818

As of ~~June~~September 30, 2014 investment securities with a carrying value of ~~$68.57~~$36.03 million were pledged to collateralize short-term borrowings.

Page 12

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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


	Less than 12 months								12 months or more								Total								Less than 12 months								12 months or more								Total
June 30, 2014 Description of Securities	#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
September 30, 2014 Description of Securities																									#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%		#	Fair Value		Unrealized Loss			%
U.S. Treasury	3	$	7,414	$	(19	)	0.26	%	—	$	—	$	—		—	%	3	$	7,414	$	(19	)	0.26	%	4	$	9,876	$	(40	)	0.41	%	—	$	—	$	—		—	%	4	$	9,876	$	(40	)	0.41	%

State and political subdivisions	66	16,971		(116		)	0.68	%	111	24,089		(519		)	2.15	%	177	41,060		(635		)	1.55	%	57	14,490		(76		)	0.52	%	95	19,873		(327		)	1.65	%	152	34,363		(403		)	1.17	%

Other securities (FHLB, FHLMC and FNMA)	5	10,525		(30		)	0.29	%	3	8,351		(39		)	0.47	%	8	18,876		(69		)	0.37	%	5	10,505		(46		)	0.44	%	2	4,359		(18		)	0.41	%	7	14,864		(64		)	0.43	%

Total temporarily impaired securities	74	$	34,910	$	(165	)	0.47	%	114	$	32,440	$	(558	)	1.72	%	188	$	67,350	$	(723	)	1.07	%	66	$	34,871	$	(162	)	0.46	%	97	$	24,232	$	(345	)	1.42	%	163	$	59,103	$	(507	)	0.86	%



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

State and political subdivisions	164	36,212		(1,259		)	3.48	%	25	5,565		(261		)	4.69	%	189	41,777		(1,520		)	3.64	%

Other securities (FHLB, FHLMC and FNMA)	10	21,810		(149		)	0.68	%	1	2,557		(21		)	0.82	%	11	24,367		(170		)	0.70	%

Total temporarily impaired securities	174	$	58,022	$	(1,408	)	2.43	%	26	$	8,122	$	(282	)	3.47	%	200	$	66,144	$	(1,690	)	2.56	%

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

Page 13

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 5.	Loans

Classes of loans are as follows:


	June 30, 2014		December 31, 2013		September 30, 2014		December 31, 2013
	(Amounts In Thousands)				(Amounts In Thousands)
Agricultural	$	85,204	$	82,138	$	86,243	$	82,138
Commercial and financial	178,227		166,102		179,872		166,102
Real estate:
Construction, 1 to 4 family residential	33,942		30,309		39,551		30,309
Construction, land development and commercial	76,735		69,182		80,273		69,182
Mortgage, farmland	144,050		142,685		145,070		142,685
Mortgage, 1 to 4 family first liens	628,914		605,687		658,766		605,687
Mortgage, 1 to 4 family junior liens	107,949		105,785		107,443		105,785
Mortgage, multi-family	237,919		244,090		241,768		244,090
Mortgage, commercial	318,142		315,187		322,714		315,187
Loans to individuals	20,874		19,824		20,324		19,824
Obligations of state and political subdivisions	55,069		45,167		55,940		45,167
	$	1,887,025	$	1,826,156	$	1,937,964	$	1,826,156
Net unamortized fees and costs	657		641		675		641
	$	1,887,682	$	1,826,797	$	1,938,639	$	1,826,797
Less allowance for loan losses	25,350		25,550		24,500		25,550
	$	1,862,332	$	1,801,247	$	1,914,139	$	1,801,247

Page 14

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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


	Three Months Ended June 30, 2014																								Three Months Ended September 30, 2014
	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland			Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total			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)																								(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	4,062		$	4,519		$	2,961		$	2,782		$	6,621		$	4,264		$	651		$	25,860		$	3,036		$	4,832		$	3,431		$	2,749		$	6,831		$	3,739		$	732		$	25,350
Charge-offs	(25		)	(370		)	(245		)	—			(185		)	(48		)	(173		)	(1,046		)	—			(60		)	—			—			(471		)	—			(50		)	(581		)
Recoveries	2			259			88			—			273			119			41			782			60			258			37			—			244			99			41			739
Provision	(1,003		)	424			627			(33		)	122			(596		)	213			(246		)	(402		)	(328		)	(483		)	(173		)	497			(98		)	(21		)	(1,008		)

Ending balance	$	3,036		$	4,832		$	3,431		$	2,749		$	6,831		$	3,739		$	732		$	25,350		$	2,694		$	4,702		$	2,985		$	2,576		$	7,101		$	3,740		$	702		$	24,500


	Six Months Ended June 30, 2014																							Nine Months Ended September 30, 2014
	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total			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)																							(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,852		$	4,733		$	2,918		$	2,557	$	7,064		$	4,787		$	639		$	25,550		$	2,852		$	4,733		$	2,918		$	2,557	$	7,064		$	4,787		$	639		$	25,550
Charge-offs	(125		)	(455		)	(247		)	—		(492		)	(48		)	(205		)	(1,572		)	(125		)	(515		)	(247		)	—		(963		)	(48		)	(255		)	(2,153		)
Recoveries	5			609			274			—		452			160			73			1,573			65			867			311			—		696			259			114			2,312
Provision	304			(55		)	486			192		(193		)	(1,160		)	225			(201		)	(98		)	(383		)	3			19		304			(1,258		)	204			(1,209		)

Ending balance	$	3,036		$	4,832		$	3,431		$	2,749	$	6,831		$	3,739		$	732		$	25,350		$	2,694		$	4,702		$	2,985		$	2,576	$	7,101		$	3,740		$	702		$	24,500

Ending balance, individually evaluated for impairment	$	3		$	11		$	28		$	15	$	23		$	14		$	—		$	94		$	2		$	10		$	28		$	21	$	73		$	11		$	—		$	145

Ending balance, collectively evaluated for impairment	$	3,033		$	4,821		$	3,403		$	2,734	$	6,808		$	3,725		$	732		$	25,256		$	2,692		$	4,692		$	2,957		$	2,555	$	7,028		$	3,729		$	702		$	24,355

Loans:

Ending balance	$	85,204		$	178,227		$	110,677		$	144,050	$	736,863		$	556,061		$	75,943		$	1,887,025		$	86,243		$	179,872		$	119,824		$	145,070	$	766,209		$	564,482		$	76,264		$	1,937,964

Ending balance, individually evaluated for impairment	$	292		$	2,585		$	846		$	387	$	4,087		$	18,021		$	—		$	26,218		$	1,772		$	2,737		$	475		$	2,267	$	5,117		$	17,847		$	—		$	30,215

Ending balance, collectively evaluated for impairment	$	84,912		$	175,642		$	109,831		$	143,663	$	732,776		$	538,040		$	75,943		$	1,860,807		$	84,471		$	177,135		$	119,349		$	142,803	$	761,092		$	546,635		$	76,264		$	1,907,749

Page 15

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Changes in the allowance for loan losses for the three and ~~six~~nine months ended ~~June~~September 30, 2013 were as follows:


	Three Months Ended June 30, 2013																						Three Months Ended September 30, 2013
	Agricultural		Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total			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)																						(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,158	$	4,468		$	3,247		$	2,065	$	7,276		$	4,711		$	695		$	24,620		$	2,379	$	4,878		$	2,988		$	2,150	$	6,984		$	4,370		$	651		$	24,400
Charge-offs	—		(380		)	(12		)	—		(298		)	(54		)	(82		)	(826		)	—		(283		)	—			—		(103		)	(44		)	(19		)	(449		)
Recoveries	3		301			135			—		272			107			38			856			12		220			76			—		85			258			36			687
Provision	218		489			(382		)	85		(266		)	(394		)	—			(250		)	150		58			(258		)	139		105			(12		)	(70		)	112

Ending balance	$	2,379	$	4,878		$	2,988		$	2,150	$	6,984		$	4,370		$	651		$	24,400		$	2,541	$	4,873		$	2,806		$	2,289	$	7,071		$	4,572		$	598		$	24,750


	Six Months Ended June 30, 2013																						Nine Months Ended September 30, 2013
	Agricultural		Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total			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)																						(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	1,653	$	4,573		$	3,175		$	1,746	$	8,088		$	5,104		$	821		$	25,160		$	1,653	$	4,573		$	3,175		$	1,746	$	8,088		$	5,104		$	821		$	25,160
Charge-offs	—		(495		)	(220		)	—		(548		)	(283		)	(124		)	$	(1,670	)	—		(778		)	(220		)	—		(651		)	(327		)	(143		)	$	(2,119	)
Recoveries	18		552			166			—		349			156			90			$	1,331		30		772			242			—		434			414			126			$	2,018
Provision	708		248			(133		)	404		(905		)	(607		)	(136		)	$	(421	)	858		306			(391		)	543		(800		)	(619		)	(206		)	$	(309	)

Ending balance	$	2,379	$	4,878		$	2,988		$	2,150	$	6,984		$	4,370		$	651		$	24,400		$	2,541	$	4,873		$	2,806		$	2,289	$	7,071		$	4,572		$	598		$	24,750

Ending balance, individually evaluated for impairment	$	3	$	22		$	9		$	9	$	76		$	237		$	—		$	356		$	3	$	13		$	—		$	4	$	69		$	218		$	1		$	308

Ending balance, collectively evaluated for impairment	$	2,376	$	4,856		$	2,979		$	2,141	$	6,908		$	4,133		$	651		$	24,044		$	2,538	$	4,860		$	2,806		$	2,285	$	7,002		$	4,354		$	597		$	24,442

Loans:

Ending balance	$	76,419	$	170,985		$	105,458		$	126,767	$	678,185		$	522,379		$	61,498		$	1,741,691		$	82,740	$	166,175		$	99,154		$	131,105	$	700,116		$	550,642		$	61,795		$	1,791,727

Ending balance, individually evaluated for impairment	$	125	$	2,057		$	2,630		$	540	$	4,228		$	18,442		$	—		$	28,022		$	123	$	1,868		$	1,722		$	459	$	4,519		$	17,912		$	12		$	26,615

Ending balance, collectively evaluated for impairment	$	76,294	$	168,928		$	102,828		$	126,227	$	673,957		$	503,937		$	61,498		$	1,713,669		$	82,617	$	164,307		$	97,432		$	130,646	$	695,597		$	532,730		$	61,783		$	1,765,112

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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


	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial		Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
June 30, 2014
September 30, 2014
Grade:
Pass	$	60,842	$	139,704	$	28,002	$	59,506	$	62,482	$	141,198	$	32,670	$	66,560
Monitor	12,688		19,311		2,318		6,255		14,386		18,511		3,881		4,289
Special Mention	8,167		12,017		1,685		9,592		6,159		13,010		2,625		8,983
Substandard	3,507		7,195		1,937		1,382		3,216		7,153		375		441
Total	$	85,204	$	178,227	$	33,942	$	76,735	$	86,243	$	179,872	$	39,551	$	80,273


	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		Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family
June 30, 2014
September 30, 2014
Grade:
Pass	$	126,967	$	550,560	$	100,399	$	191,591	$	124,813	$	580,005	$	100,191	$	187,591
Monitor	11,344		39,276		2,779		33,143		12,834		41,707		2,783		36,089
Special Mention	1,632		19,740		2,659		12,359		2,115		17,718		2,404		17,715
Substandard	4,107		19,338		2,112		826		5,308		19,336		2,065		373
Total	$	144,050	$	628,914	$	107,949	$	237,919	$	145,070	$	658,766	$	107,443	$	241,768


	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total		Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
June 30, 2014
September 30, 2014
Grade:
Pass	$	266,939	$	20,269	$	54,030	$	1,598,809	$	274,011	$	19,682	$	54,913	$	1,644,116
Monitor	32,446		191		1,039		160,790		33,471		210		1,027		169,188
Special Mention	11,944		274		—		80,069		8,835		324		—		79,888
Substandard	6,813		140		—		47,357		6,397		108		—		44,772
Total	$	318,142	$	20,874	$	55,069	$	1,887,025	$	322,714	$	20,324	$	55,940	$	1,937,964

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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, 2013
Grade:
Pass	$	71,370	$	134,605	$	26,519	$	56,555
Monitor	3,579		12,469		758		3,963
Special Mention	1,076		12,971		2,242		6,854
Substandard	6,113		6,057		790		1,810
Total	$	82,138	$	166,102	$	30,309	$	69,182



	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family
December 31, 2013
Grade:
Pass	$	132,988	$	532,921	$	98,142	$	196,616
Monitor	5,413		30,454		2,273		28,438
Special Mention	1,795		22,097		3,187		18,161
Substandard	2,489		20,215		2,183		875
Total	$	142,685	$	605,687	$	105,785	$	244,090



	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
December 31, 2013
Grade:
Pass	$	262,252	$	19,263	$	43,047	$	1,574,278
Monitor	30,140		117		1,061		118,665
Special Mention	14,749		316		1,059		84,507
Substandard	8,046		128		—		48,706
Total	$	315,187	$	19,824	$	45,167	$	1,826,156

Page 18

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The below are descriptions of the credit quality indicators:

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

Monitor – Monitor rated loans are supported by adequate payment capacity, are adequately collateralized and are performing according to the established terms and conditions. However, the loan requires more than average monitoring due to a potential weakness. The monitor indicator assists the Company in identifying and monitoring loans for which credit quality could deteriorate. This grade was labeled potential watch in previous reports; the Company changed the label only and has not changed the overall description of the credit quality indicator.

Special Mention – Special mention rated loans are supported by a marginal payment capacity and may be marginally collateralized. There are identified weaknesses that if not monitored and corrected may adversely affect the Company’s credit position. A special mention credit would typically have a weakness in one of the general categories (cash flow, collateral position or payment history) but not in all categories. This grade was labeled watch in previous reports; the Company changed the label only and has not changed the overall description of the credit quality indicator

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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


	30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Loans Receivable		Accruing Loans Past Due 90 Days or More		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)														(Amounts In Thousands)
June 30, 2014:
September 30, 2014
Agricultural	$	8	$	—	$	—	$	8	$	85,196	$	85,204	$	—	$	—	$	43	$	—	$	43	$	86,200	$	86,243	$	—
Commercial and financial	350		74		952		1,376		176,851		178,227		—		988		98		951		2,037		177,835		179,872		—
Real estate:
Construction, 1 to 4 family residential	484		—		—		484		33,458		33,942		—		—		—		—		—		39,551		39,551		—
Construction, land development and commercial	1,244		—		144		1,388		75,347		76,735		—		265		—		132		397		79,876		80,273		—
Mortgage, farmland	147		310		105		562		143,488		144,050		105		289		—		—		289		144,781		145,070		—
Mortgage, 1 to 4 family first liens	476		1,814		1,179		3,469		625,445		628,914		367		347		1,437		1,947		3,731		655,035		658,766		996
Mortgage, 1 to 4 family junior liens	360		444		—		804		107,145		107,949		—		247		82		492		821		106,622		107,443		103
Mortgage, multi-family	26		—		—		26		237,893		237,919		—		23		—		—		23		241,745		241,768		—
Mortgage, commercial	121		178		1,089		1,388		316,754		318,142		—		1,020		622		197		1,839		320,875		322,714		—
Loans to individuals	12		—		—		12		20,862		20,874		—		8		1		—		9		20,315		20,324		—
Obligations of state and political subdivisions	—		—		—		—		55,069		55,069		—		—		—		—		—		55,940		55,940		—
	$	3,228	$	2,820	$	3,469	$	9,517	$	1,877,508	$	1,887,025	$	472	$	3,187	$	2,283	$	3,719	$	9,189	$	1,928,775	$	1,937,964	$	1,099

December 31, 2013:
Agricultural	$	8	$	10	$	—	$	18	$	82,120	$	82,138	$	—	$	8	$	10	$	—	$	18	$	82,120	$	82,138	$	—
Commercial and financial	526		177		951		1,654		164,448		166,102		—		526		177		951		1,654		164,448		166,102		—
Real estate:
Construction, 1 to 4 family residential	—		—		—		—		30,309		30,309		—		—		—		—		—		30,309		30,309		—
Construction, land development and commercial	276		144		731		1,151		68,031		69,182		—		276		144		731		1,151		68,031		69,182		—
Mortgage, farmland	108		—		—		108		142,577		142,685		—		108		—		—		108		142,577		142,685		—
Mortgage, 1 to 4 family first liens	4,418		1,649		2,223		8,290		597,397		605,687		959		4,418		1,649		2,223		8,290		597,397		605,687		959
Mortgage, 1 to 4 family junior liens	835		43		29		907		104,878		105,785		—		835		43		29		907		104,878		105,785		—
Mortgage, multi-family	—		150		—		150		243,940		244,090		—		—		150		—		150		243,940		244,090		—
Mortgage, commercial	1,350		—		493		1,843		313,344		315,187		—		1,350		—		493		1,843		313,344		315,187		—
Loans to individuals	7		4		—		11		19,813		19,824		—		7		4		—		11		19,813		19,824		—
Obligations of state and political subdivisions	14		—		—		14		45,153		45,167		—		14		—		—		14		45,153		45,167		—
	$	7,542	$	2,177	$	4,427	$	14,146	$	1,812,010	$	1,826,156	$	959	$	7,542	$	2,177	$	4,427	$	14,146	$	1,812,010	$	1,826,156	$	959

Page 20

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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

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


	June 30, 2014						December 31, 2013						September 30, 2014						December 31, 2013
	Non-accrual loans (1)		Accruing loans past due 90 days or more (2)		TDR loans		Non- accrual loans (1)		Accruing loans past due 90 days or more (2)		TDR loans		Non-accrual loans (1)		Accruing loans past due 90 days or more (2)		TDR loans		Non- accrual loans (1)		Accruing loans past due 90 days or more (2)		TDR loans
	(Amounts In Thousands)						(Amounts In Thousands)						(Amounts In Thousands)						(Amounts In Thousands)
Agricultural	$	—	$	—	$	291	$	—	$	—	$	120	$	—	$	—	$	1,772	$	—	$	—	$	120
Commercial and financial	1,068		—		1,518		1,462		—		945		1,170		—		1,567		1,462		—		945
Real estate:
Construction, 1 to 4 family residential	144		—		170		—		—		—		—		—		170		—		—		—
Construction, land development and commercial	359		—		173		1,319		—		—		132		—		173		1,319		—		—
Mortgage, farmland	—		105		282		—		—		284		—		—		2,267		—		—		284
Mortgage, 1 to 4 family first liens	1,905		367		1,421		2,209		959		1,272		2,025		996		1,604		2,209		959		1,272
Mortgage, 1 to 4 family junior liens	394		—		—		178		—		—		389		103		—		178		—		—
Mortgage, multi-family	424		—		5,627		456		—		5,608		58		—		5,932		456		—		5,608
Mortgage, commercial	1,914		—		10,056		1,568		—		10,146		1,884		—		9,973		1,568		—		10,146
Loans to individuals	—		—		—		—		—		—		—		—		—		—		—		—
	$	6,208	$	472	$	19,538	$	7,192	$	959	$	18,375	$	5,658	$	1,099	$	23,458	$	7,192	$	959	$	18,375


(1)	There were ~~$2.42~~$2.03 million and $2.72 million of TDR loans included within nonaccrual loans as of ~~June~~September 30, 2014 and December 31, 2013, respectively.


(2)	There were no TDR loans within accruing loans past due 90 days or more as of ~~June~~September 30, 2014 and December 31, 2013, respectively.

Loans 90 days or more past due that are still accruing interest ~~decreased $0.49~~increased $0.14 million from December 31, 2013 to ~~June~~September 30, 2014 due to ~~a decrease~~an increase in the number of loans past due greater than 90 days. The average accruing loans past due 90 days or more balance was ~~$0.09~~$0.08 million as of ~~June~~September 30, 2014 and $0.08 million as of December 31, 2013. The accruing loans past due 90 days or more balances are believed to be adequately collateralized and the Company expects to collect all principal and interest as contractually due under these loans.

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

Page 21

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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


	June 30, 2014					December 31, 2013					September 30, 2014					December 31, 2013
	Number of contracts	Recorded investment		Commitments outstanding		Number of contracts	Recorded investment		Commitments outstanding		Number of contracts	Recorded investment		Commitments outstanding		Number of contracts	Recorded investment		Commitments outstanding
		(Amounts In Thousands)					(Amounts In Thousands)					(Amounts In Thousands)					(Amounts In Thousands)
Agricultural	4	$	291	$	252	1	$	120	$	4	9	$	1,772	$	13	1	$	120	$	4
Commercial and financial	15	2,361		149		12	2,214		101		15	2,408		157		12	2,214		101
Real estate:
Construction, 1 to 4 family residential	1	170		—		—	—		—		1	170		—		—	—		—
Construction, land development and commercial	1	173		—		1	13		—		1	173		—		1	13		—
Mortgage, farmland	1	282		—		1	284		—		4	2,267		—		1	284		—
Mortgage, 1 to 4 family first liens	14	225		—		12	1,697		—		15	1,881		—		12	1,697		—
Mortgage, 1 to 4 family junior liens	1	1,701		—		—	—		177		1	225		45		—	—		177
Mortgage, multi-family	4	5,992		—		3	6,000		—		4	5,932		—		3	6,000		—
Mortgage, commercial	10	10,758		—		9	10,766		10		10	10,659		—		9	10,766		10
Loans to individuals	—	—		—		—	—		—		—	—		—		—	—		—
	51	$	21,953	$	401	39	$	21,094	$	292	60	$	25,487	$	215	39	$	21,094	$	292

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


	Three Months Ended June 30, 2014					Six Months Ended June 30, 2014					Three Months Ended September 30, 2014					Nine Months Ended September 30, 2014
	Number of contracts	Pre-modification recorded investment		Post-modification recorded investment		Number of contracts	Pre-modification recorded investment		Post-modification recorded investment		Number of contracts	Pre-modification recorded investment		Post-modification recorded investment		Number of contracts	Pre-modification recorded investment		Post-modification recorded investment
		(Amounts In Thousands)										(Amounts In Thousands)
Agricultural	1	$	40	$	40	3	$	243	$	196	6	$	1,874	$	1,874	9	$	2,033	$	2,033
Commercial and financial	1	63		63		7	775		775		1	85		85		8	882		882
Real estate:
Construction, 1 to 4 family residential	1	170		170		1	170		170		—	—		—		1	170		170
Construction, land development and commercial	1	184		173		1	184		173		—	—		—		1	184		173
Mortgage, farmland											3	2,007		2,007		3	2,007		2,007
Mortgage, 1 to 4 family first lien	1	100		100		3	181		181		2	333		333		5	514		514
Mortgage, 1 to 4 family junior liens	—	—		—		1	225		225		—	—		—		1	225		225
Mortgage, multi-family	—	—		—		1	89		89		—	—		—		1	89		89
Mortgage, commercial	—	—		—		2	269		269		—	—		—		2	269		269
	5	$	557	$	546	19	$	2,136	$	2,078	12	$	4,299	$	4,299	31	$	6,373	$	6,362

Page 22

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The Company had commitments to lend ~~$0.40~~$0.22 million in additional borrowings to restructured loan customers as of ~~June~~September 30, 2014. The Company had commitments to lend $0.29 million in additional borrowings to restructured loan customers as of December 31, 2013. These commitments were in the normal course of business. The additional borrowings were not used to facilitate payments on these loans.

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

Page 23

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Information regarding impaired loans as of and for the three and ~~six~~nine months ended ~~June~~September 30, 2014 is as follows:


	June 30, 2014						Three Months Ended June 30, 2014				Six Months Ended June 30, 2014				September 30, 2014						Three Months Ended September 30, 2014				Nine Months Ended September 30, 2014
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:	(Amounts In Thousands)														(Amounts In Thousands)
Agricultural	$	176	$	276	$	—	$	199	$	3	$	238	$	6	$	1,659	$	1,756	$	—	$	1,812	$	22	$	1,674	$	60
Commercial and financial	1,890		3,393		—		1,876		10		1,923		21		2,068		3,655		—		1,839		9		1,832		25
Real estate:
Construction, 1 to 4 family residential	—		—		—		—		—		—		—		—		—		—		—		—		—		—
Construction, land development and commercial	503		1,778		—		529		—		618		—		132		222		—		138		—		144		—
Mortgage, farmland	—		—		—		—		—		—		—		977		977		—		977		12		1,047		37
Mortgage, 1 to 4 family first liens	3,226		4,352		—		3,248		15		3,288		32		3,470		4,672		—		3,450		16		3,515		47
Mortgage, 1 to 4 family junior liens	394		680		—		398		3		398		5		389		682		—		392		—		396		—
Mortgage, multi-family	6,051		6,683		—		6,078		63		6,102		126		5,990		6,643		—		6,020		66		6,071		201
Mortgage, commercial	2,935		5,604		—		3,000		15		3,060		31		10,996		13,745		—		11,069		103		11,245		311
Loans to individuals	—		20		—		—		—		—		—		—		20		—		—		—		—		—
	$	15,175	$	22,786	$	—	$	15,328	$	109	$	15,627	$	221	$	25,681	$	32,372	$	—	$	25,697	$	228	$	25,924	$	681

With an allowance recorded:
Agricultural	$	116	$	116	$	3	$	117	$	1	$	118	$	2	$	113	$	113	$	2	$	114	$	1	$	117	$	4
Commercial and financial	695		695		11		710		9		725		19		669		669		10		683		9		712		28
Real estate:
Construction, 1 to 4 family residential	170		170		20		170		2		170		4		170		170		20		170		2		170		6
Construction, land development and commercial	173		184		8		178		2		178		5		173		184		8		173		2		178		7
Mortgage, farmland	387		387		15		388		5		388		9		1,290		1,290		21		1,271		15		994		36
Mortgage, 1 to 4 family first liens	467		519		23		472		5		475		11		1,155		1,347		69		1,195		13		1,216		38
Mortgage, 1 to 4 family junior liens	—		—		—		—		—		—		—		103		158		4		105		1		105		3
Mortgage, multi-family	—		—		—		—		—		—		—		—		—		—		—		—		—		—
Mortgage, commercial	9,035		9,048		14		9,063		129		9,092		260		861		875		11		864		9		873		28
Loans to individuals	—		—		—		—		—		—		—		—		—		—		—		—		—		—
	$	11,043	$	11,119	$	94	$	11,098	$	153	$	11,146	$	310	$	4,534	$	4,806	$	145	$	4,575	$	52	$	4,365	$	150

Total:
Agricultural	$	292	$	392	$	3	$	316	$	4	$	356	$	8	$	1,772	$	1,869	$	2	$	1,926	$	23	$	1,791	$	64
Commercial and financial	2,585		4,088		11		2,586		19		2,648		40		2,737		4,324		10		2,522		18		2,544		53
Real estate:
Construction, 1 to 4 family residential	170		170		20		170		2		170		4		170		170		20		170		2		170		6
Construction, land development and commercial	676		1,962		8		707		2		796		5		305		406		8		311		2		322		7
Mortgage, farmland	387		387		15		388		5		388		9		2,267		2,267		21		2,248		27		2,041		73
Mortgage, 1 to 4 family first liens	3,693		4,871		23		3,720		20		3,763		43		4,625		6,019		69		4,645		29		4,731		85
Mortgage, 1 to 4 family junior liens	394		680		—		398		3		398		5		492		840		4		497		1		501		3
Mortgage, multi-family	6,051		6,683		—		6,078		63		6,102		126		5,990		6,643		—		6,020		66		6,071		201
Mortgage, commercial	11,970		14,652		14		12,063		144		12,152		291		11,857		14,620		11		11,933		112		12,118		339
Loans to individuals	—		20		—		—		—		—		—		—		20		—		—		—		—		—
	$	26,218	$	33,905	$	94	$	26,426	$	262	$	26,773	$	531	$	30,215	$	37,178	$	145	$	30,272	$	280	$	30,289	$	831

Page 24

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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



	Recorded Investment		Unpaid Principal Balance		Related Allowance
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	—	$	—	$	—
Commercial and financial	1,602		3,140		—
Real estate:
Construction, 1 to 4 family residential	1,270		2,974		—
Construction, land development and commercial	140		140		—
Mortgage, farmland	—		—		—
Mortgage, 1 to 4 family first liens	2,597		3,542		—
Mortgage, 1 to 4 family junior liens	177		451		—
Mortgage, multi-family	456		1,068		—
Mortgage, commercial	2,494		5,303		—
Loans to individuals	—		20		—
	$	8,736	$	16,638	$	—

With an allowance recorded:
Agricultural	$	120	$	120	$	3
Commercial and financial	805		838		16
Real estate:
Construction, 1 to 4 family residential	—		—		—
Construction, land development and commercial	—		—		—
Mortgage, farmland	284		284		14
Mortgage, 1 to 4 family first liens	1,768		1,897		66
Mortgage, 1 to 4 family junior liens	—		—		—
Mortgage, multi-family	5,608		5,608		188
Mortgage, commercial	9,205		9,205		17
Loans to individuals	—		—		—
	$	17,790	$	17,952	$	304

Total:
Agricultural	$	120	$	120	$	3
Commercial and financial	2,407		3,978		16
Real estate:
Construction, 1 to 4 family residential	1,270		2,974		—
Construction, land development and commercial	140		140		—
Mortgage, farmland	284		284		14
Mortgage, 1 to 4 family first liens	4,365		5,439		66
Mortgage, 1 to 4 family junior liens	177		451		—
Mortgage, multi-family	6,064		6,676		188
Mortgage, commercial	11,699		14,508		17
Loans to individuals	—		20		—
	$	26,526	$	34,590	$	304

Page 25

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Impaired loans ~~decreased $0.31~~increased $3.52 million from December 31, 2013 to ~~June~~September 30, 2014. Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans. Impaired loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement. Impaired loans were ~~1.39%~~1.56% of loans held for investment as of ~~June~~September 30, 2014 and 1.45% as of December 31, 2013. The ~~decrease~~increase in impaired loans is due mainly to ~~a decrease~~an increase in ~~nonaccrual~~TDR loans of ~~$0.98~~$5.08 million from December 31, 2013 to ~~June~~September 30, 2014.

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

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

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

Page 26

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)


Note 6.	Fair Value Measurements

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


	June 30, 2014										September 30, 2014
	Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)
	(Amounts In Thousands)										(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents	$	30,136	$	30,136	$	30,136	$	—	$	—	$	68,864	$	68,864	$	68,864	$	—	$	—
Investment securities	247,458		247,458		—		247,458		—		251,469		251,469		—		251,469		—
Loans held for sale	7,959		7,959				7,959				2,484		2,484				2,484
Loans
Agricultural	82,168		89,378		—		—		89,378		83,549		83,530		—		—		83,530
Commercial and financial	173,395		190,186		—		—		190,186		175,170		176,122		—		—		176,122
Real estate:
Construction, 1 to 4 family residential	32,641		31,408		—		—		31,408		38,471		38,311		—		—		38,311
Construction, land development and commercial	74,605		72,631		—		—		72,631		78,368		78,338		—		—		78,338
Mortgage, farmland	141,301		138,847		—		—		138,847		142,494		142,785		—		—		142,785
Mortgage, 1 to 4 family first liens	623,000		618,387		—		—		618,387		652,582		655,991		—		—		655,991
Mortgage, 1 to 4 family junior liens	107,032		106,338		—		—		106,338		106,526		110,723		—		—		110,723
Mortgage, multi-family	236,512		235,599		—		—		235,599		240,235		243,133		—		—		243,133
Mortgage, commercial	315,810		314,137		—		—		314,137		320,507		319,958		—		—		319,958
Loans to individuals	20,510		20,654		—		—		20,654		19,974		19,922		—		—		19,922
Obligations of state and political subdivisions	54,701		54,929		—		—		54,929		55,588		54,717		—		—		54,717
Accrued interest receivable	8,251		8,251		—		8,251		—		8,980		8,980		—		8,980		—
Total financial instrument assets	$	2,155,479	$	2,166,298	$	30,136	$	263,668	$	1,872,494	$	2,245,261	$	2,255,327	$	68,864	$	262,933	$	1,923,530
Financial instrument liabilities
Deposits
Noninterest-bearing deposits	$	261,565	$	261,565	$	—	$	261,565	$	—	$	270,139	$	270,139	$	—	$	270,139	$	—
Interest-bearing deposits	1,464,759		1,468,410		—		1,468,410		—		1,569,357		1,573,833		—		1,573,833		—
Short-term borrowings	68,572		68,572		—		68,572		—		36,033		36,033		—		36,033		—
Federal Home Loan Bank borrowings	125,000		131,356		—		131,356		—		125,000		130,785		—		130,785		—
Accrued interest payable	930		930		—		930		—		906		906		—		906		—
Total financial instrument liabilities	$	1,920,826	$	1,930,833	$	—	$	1,930,833	$	—	$	2,001,435	$	2,011,696	$	—	$	2,011,696	$	—

	Face Amount										Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	394,585	$	—	$	—	$	—	$	—	$	380,570	$	—	$	—	$	—	$	—
Letters of credit	14,417		—		—		—		—		14,131		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	409,002	$	—	$	—	$	—	$	—	$	394,701	$	—	$	—	$	—	$	—


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


(2)	Considered Level 2 under ASC 820.


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

Page 27

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, 2013 are as follows:



	December 31, 2013
	Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)
	(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents	$	43,702	$	43,702	$	43,702	$	—	$	—
Investment securities	246,089		246,089		—		246,089		—
Loans held for sale	4,927		4,927		—		4,927		—
Loans
Agricultural	79,286		86,137		—		—		86,137
Commercial and financial	161,369		176,385		—		—		176,385
Real estate:
Construction, 1 to 4 family residential	29,298		28,364		—		—		28,364
Construction, land development and commercial	67,275		65,544		—		—		65,544
Mortgage, farmland	140,128		137,938		—		—		137,938
Mortgage, 1 to 4 family first liens	599,586		595,054		—		—		595,054
Mortgage, 1 to 4 family junior liens	104,822		104,133		—		—		104,133
Mortgage, multi-family	242,026		240,595		—		—		240,595
Mortgage, commercial	312,464		310,558		—		—		310,558
Loans to individuals	19,554		19,710		—		—		19,710
Obligations of state and political subdivisions	44,798		45,184		—		—		45,184
Accrued interest receivable	7,676		7,676		—		7,676		—
Total financial instrument assets	$	2,103,000	$	2,111,996	$	43,702	$	258,692	$	1,809,602
Financial instrument liabilities:
Deposits
Noninterest-bearing deposits	$	256,788	$	256,788	$	—	$	256,788	$	—
Interest-bearing deposits	1,453,089		1,461,454		—		1,461,454		—
Short-term borrowings	42,016		42,016		—		42,016		—
Federal Home Loan Bank borrowings	125,000		132,469		—		132,469		—
Accrued interest payable	1,102		1,102		—		1,102		—
Total financial instrument liabilities	$	1,877,995	$	1,893,829	$	—	$	1,893,829	$	—

	Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	360,945	$	—	$	—	$	—	$	—
Letters of credit	11,019		—		—		—		—
Total financial instrument liabilities with off-balance-sheet risk	$	371,964	$	—	$	—	$	—	$	—


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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

Page 28

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 ~~six~~nine months ended ~~June~~September 30, 2014. If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.

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

Page 29

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.

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

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

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

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


	June 30, 2014								September 30, 2014
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value
	(Amounts In Thousands)								(Amounts In Thousands)
U.S. Treasury	$	—	$	12,358	$	—	$	12,358	$	—	$	19,794	$	—	$	19,794
State and political subdivisions	—		151,954		—		151,954		—		154,198		—		154,198
Other securities (FHLB, FHLMC and FNMA)	—		75,493		—		75,493		—		69,826		—		69,826
Total	$	—	$	239,805	$	—	$	239,805	$	—	$	243,818	$	—	$	243,818



	December 31, 2013
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value
	(Amounts In Thousands)
U.S. Treasury	$	—	$	—	$	—	$	—
State and political subdivisions	—		151,366		—		151,366
Other securities (FHLB, FHLMC and FNMA)	—		87,144		—		87,144
Total	$	—	$	238,510	$	—	$	238,510


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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

There were no transfers between Levels 1, 2 or 3 during the ~~six~~nine months ended ~~June~~September 30, ~~2014.~~2014 and the year ended December 31, 2013.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

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


	June 30, 2014								Three Months Ended June 30, 2014		Six Months Ended June 30, 2014		September 30, 2014								Three Months Ended September 30, 2014		Nine Months Ended September 30, 2014
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses		Total Losses		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses		Total Losses
	(Amounts in Thousands)												(Amounts in Thousands)
Loans (4)
Agricultural	$	—	$	—	$	289	$	289	$	25	$	25	$	—	$	—	$	1,770	$	1,770	$	—	$	25
Commercial and financial	—		—		2,574		2,574		60		60		—		—		2,727		2,727		50		110
Real Estate:
Construction, 1 to 4 family residential	—		—		150		150		—		—		—		—		150		150		—		—
Construction, land development and commercial	—		—		668		668		—		—		—		—		297		297		—		—
Mortgage, farmland	—		—		372		372		—		—		—		—		2,246		2,246		—		—
Mortgage, 1 to 4 family first liens	—		—		3,670		3,670		83		98		—		—		4,556		4,556		310		408
Mortgage, 1 to 4 family junior liens	—		—		394		394		—		24		—		—		488		488		—		24
Mortgage, multi-family	—		—		6,051		6,051		—		—		—		—		5,990		5,990		—		—
Mortgage, commercial	—		—		11,956		11,956		40		140		—		—		11,846		11,846		—		140
Loans to individuals	—		—		—		—		—		—		—		—		—		—		—		—
Foreclosed assets (5)	—		—		20		20		—		23		—		—		38		38		54		77
Total	$	—	$	—	$	26,144	$	26,144	$	208	$	370	$	—	$	—	$	30,108	$	30,108	$	414	$	784


(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.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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



	December 31, 2013								Year Ended December 31, 2013
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value		Total Losses
	(Amounts in Thousands)
Loans (4)
Agricultural	$	—	$	—	$	117	$	117	$	—
Commercial and financial	—		—		2,391		2,391		53
Real Estate:
Construction, 1 to 4 family residential	—		—		1,270		1,270		—
Construction, land development and commercial	—		—		140		140		—
Mortgage, farmland	—		—		270		270		—
Mortgage, 1 to 4 family first liens	—		—		4,299		4,299		424
Mortgage, 1 to 4 family junior liens	—		—		177		177		59
Mortgage, multi-family	—		—		5,876		5,876		69
Mortgage, commercial	—		—		11,682		11,682		229
Loans to individuals	—		—		—		—		—
Foreclosed assets (5)	—		—		427		427		68
Total	$	—	$	—	$	26,649	$	26,649	$	902


(1)	Considered Level 1 under ASC 820.


(2)	Considered Level 2 under ASC 820.


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


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


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


Note 7.	Stock Repurchase Program

On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2015. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis. The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors. The Company has purchased ~~367,498~~391,351 shares of its common stock in privately negotiated transactions from August 1, 2005 through ~~June~~September 30, 2014. Of these ~~367,498~~391,351 shares, ~~13,374~~23,853 shares were purchased during the quarter ended ~~June~~September 30, 2014, at an average price per share of ~~$76.53.~~$78.78.

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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 ~~$68.46~~$70.62 million. The concentrations of credit by type of loan are set forth in Note 5 to the Consolidated Financial Statements. Outstanding letters of credit were granted primarily to commercial borrowers. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the economic conditions in Johnson, Linn and Washington Counties, Iowa.

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

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

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, credit card participations and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments at ~~June~~September 30, 2014 and December 31, 2013 is as follows:


	June 30, 2014		December 31, 2013		September 30, 2014		December 31, 2013
	(Amounts In Thousands)				(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	40,413	$	38,243	$	40,553	$	38,243
Credit cards	42,887		44,326		46,452		44,326
Commercial, real estate and home construction	112,898		106,241		113,481		106,241
Commercial lines and real estate purchase loans	198,387		172,135		180,084		172,135
Outstanding letters of credit	14,417		11,019		14,131		11,019


Note 9.	Income Taxes

Federal income tax expense for the ~~six~~nine months ended ~~June~~September 30, 2014 and 2013 was computed using the consolidated effective federal tax rate. The Company also recognized income tax expense pertaining to state franchise taxes payable individually by the subsidiary bank. The Company files a consolidated tax return for federal purposes and separate tax returns for State of Iowa purposes. The tax years ended December 31, 2013, 2012, and 2011 remain subject to examination by the Internal Revenue Service. For state tax purposes, the tax years ended December 31, 2013, 2012, and 2011 remain open for examination. There were no material unrecognized tax benefits at ~~June~~September 30, 2014 and December 31, 2013 and therefore no interest or penalties on unrecognized tax benefits has been recorded. As of ~~June~~September 30, 2014, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending ~~June~~September 30, 2015.

Income taxes as a percentage of income before taxes were ~~28.60%~~29.66% for the ~~six~~nine months ended ~~June~~September 30, 2014 and ~~29.90%~~29.61% for the same period in 2013. The ~~decrease~~slight increase in the effective tax rate is due to ~~tax-exempt interest income and~~a decrease in the ~~relationship to total income before income taxes.~~amount of low-income housing tax credits earned by the Company in 2014.

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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 ~~not~~ required to pledge ~~any~~$1.50 million of collateral as of ~~June~~September 30, 2014.

Cash Flow Hedges:

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

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


	Notional Amount		Fair Value			Balance Sheet Category	Maturity	Notional Amount		Fair Value			Balance Sheet Category	Maturity
	(Amounts in Thousands)							(Amounts in Thousands)
June 30, 2014
September 30, 2014
Interest rate swap	$	25,000	$	(456	)	Other Liabilities	11/9/2020	$	25,000	$	(372	)	Other Liabilities	11/9/2020
Interest rate swap	25,000		(954		)	Other Liabilities	11/7/2023	25,000		(1,075		)	Other Liabilities	11/7/2023

December 31, 2013
Interest rate swap	$	25,000	$	357		Other Assets	11/9/2020	$	25,000	$	357		Other Assets	11/9/2020
Interest rate swap	25,000		412			Other Assets	11/7/2023	25,000		412			Other Assets	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 ~~June~~September 30, 2014 and December 31, 2013:


	Effective Portion						Ineffective Portion			Effective Portion						Ineffective Portion
	Recognized in OCI			Reclassifed from AOCI into Income			Recognized in Income on Derivatives			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)		Amount of Gain (Loss)			Category	Amount of Gain (Loss)		Category	Amount of Gain (Loss)
	(Amounts in Thousands)									(Amounts in Thousands)
June 30, 2014
September 30, 2014
Interest rate swap	$	(502	)	Interest Expense	$	—	Other Income	$	—	$	(450	)	Interest Expense	$	—	Other Income	$	—
Interest rate swap	(844		)	Interest Expense	—		Other Income	—		(919		)	Interest Expense	—		Other Income	—

December 31, 2013
Interest rate swap	$	220		Interest Expense	$	—	Other Income	$	—	$	220		Interest Expense	$	—	Other Income	$	—
Interest rate swap	255			Interest Expense	—		Other Income	—		255			Interest Expense	—		Other Income	—

Note 11. Subsequent Events

On October 29, 2014, a potential commercial and financial loan impairment was brought to the Company’s attention related to one of the Company's borrowing relationships. The Company is in the early stages of determining what, if any, loss might exist within that relationship. The Company is in the process of working with the borrower to verify and gather collateral to mitigate any potential loss. The borrower relationship consists of 7 loans totaling $1.97 million. At this time, the Company does not anticipate that the total outstanding loan balance will be a loss but cannot reasonably estimate the amount of any loss as of the date of this filing. If, after management's review of the overall lending relationship, including the fair value of the collateral and consideration of other payment sources, the Company does not believe the loans will be fully repaid, additional specific reserves may be necessary in the future.

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

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

Special Note Regarding Forward Looking Statements

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these financial statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses. The Company's allowance for loan losses methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company's markets, including economic conditions throughout the Midwest and the state of certain industries. Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position. Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations. Although management believes the levels of the allowance as of ~~June~~September 30, 2014 and December 31, 2013 were adequate to absorb probable losses inherent in the loan portfolio, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

Overview

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

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

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Net income for the ~~six~~nine month period ended ~~June~~September 30, 2014 was ~~$13.93~~$21.82 million compared to ~~$13.72~~$20.35 million for the same ~~six~~nine months of 2013, an increase of ~~1.46%~~7.25%. The ~~$0.21.~~$1.48 million increase in net income was caused by a number of factors. The principal factors in the increase in net income for the first ~~six~~nine months of 2014 are an increase in net interest income of ~~$1.52~~$2.73 million and a decrease in ~~income tax expense~~the provision for loan losses of ~~$0.28~~$0.90 million. These changes were offset by an increase in ~~the provision for loan losses~~income tax expense of ~~$0.22~~$0.64 million, a decrease in noninterest income of ~~$1.04~~$0.76 million and an increase in noninterest expenses of ~~$0.34~~$0.75 million.

The Company achieved a return on average assets of ~~1.22%~~1.26% and a return on average equity of ~~11.22%~~11.58% for the twelve months ended ~~June~~September 30, 2014, compared to the twelve months ended ~~June~~September 30, 2013, which were ~~1.18%~~1.23% and ~~11.06%~~11.36%, respectively. Dividends of $1.15 per share were paid in January 2014 to 2,204 shareholders. The 2013 dividend was $1.10 per share.

The Company’s net interest income is the largest component of revenue and it is primarily a function of the average earning assets and the net interest margin percentage. The Company achieved a net interest margin on a tax-equivalent basis of ~~3.48%~~3.49% for the ~~six~~nine months ended ~~June~~September 30, 2014 compared to ~~3.52%~~3.51% for the same ~~six~~nine months of 2013. Average earning assets were ~~$2.090~~$2.106 billion in 2014 and ~~$1.980~~$1.985 billion in 2013.

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

Total assets were ~~$2.220~~$2.308 billion, an increase of ~~$52.02~~$140.49 million since December 31, 2013.

Cash and cash equivalents were ~~$30.14~~$68.86 million, ~~a decrease~~an increase of ~~$13.57~~$25.16 million since December 31, 2013.

Net loans were ~~$1.870~~$1.917 billion, an increase of ~~$64.12~~$110.45 million since December 31, 2013. Loans held for sale ~~increased $3.03~~decreased $2.44 million since December 31, 2013.

Deposit growth of ~~$16.45~~$129.62 million since December 31, 2013. Deposit growth included $58.36 million of temporary public funds.

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

Financial Condition

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


	June 30, 2014				December 31, 2013				September 30, 2014				December 31, 2013
	Amount		Percent		Amount		Percent		Amount		Percent		Amount		Percent
	(Amounts In Thousands)				(Amounts In Thousands)				(Amounts In Thousands)				(Amounts In Thousands)
Agricultural	$	85,204	4.52	%	$	82,138	4.50	%	$	86,243	4.45	%	$	82,138	4.50	%
Commercial and financial	178,227		9.44		166,102		9.10		179,872		9.28		166,102		9.10
Real estate:
Construction, 1 to 4 family residential	33,942		1.80		30,309		1.66		39,551		2.04		30,309		1.66
Construction, land development and commercial	76,735		4.07		69,182		3.79		80,273		4.14		69,182		3.79
Mortgage, farmland	144,050		7.63		142,685		7.81		145,070		7.49		142,685		7.81
Mortgage, 1 to 4 family first liens	628,914		33.32		605,687		33.16		658,766		33.99		605,687		33.16
Mortgage, 1 to 4 family junior liens	107,949		5.72		105,785		5.79		107,443		5.54		105,785		5.79
Mortgage, multi-family	237,919		12.61		244,090		13.37		241,768		12.48		244,090		13.37
Mortgage, commercial	318,142		16.86		315,187		17.26		322,714		16.65		315,187		17.26
Loans to individuals	20,874		1.11		19,824		1.09		20,324		1.05		19,824		1.09
Obligations of state and political subdivisions	55,069		2.92		45,167		2.47		55,940		2.89		45,167		2.47
	$	1,887,025	100.00	%	$	1,826,156	100.00	%	$	1,937,964	100.00	%	$	1,826,156	100.00	%
Net unamortized fees and costs	657				641				675				641
	$	1,887,682			$	1,826,797			$	1,938,639			$	1,826,797
Less allowance for loan losses	25,350				25,550				24,500				25,550
	$	1,862,332			$	1,801,247			$	1,914,139			$	1,801,247

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Loan demand has been steady and is expected to remain steady or increase throughout the year ~~ended~~ending December 31, ~~2014.~~2014 and into 2015. As indicated above growth in the ~~agricultural,~~commercial and financial, construction, 1 to 4 family real estate loans, obligation of state and political subdivisions loan portfolios as well as real estate loans secured by ~~farmland~~commercial property have been primarily responsible for the increase in total loans. Management expects overall portfolio loan growth to increase as a result of general improvement in market ~~conditions.~~conditions resulting in increased loan demand.

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

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

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

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

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The following table presents the allowance for loan losses on loans by type of loans and the percentage in each category to total loans as of ~~June~~September 30, 2014 and December 31, 2013:


	June 30, 2014						December 31, 2013						September 30, 2014						December 31, 2013
	Amount		% of Total Allowance		% of Loans to Total Loans		Amount		% of Total Allowance		% of Loans to Total Loans		Amount		% of Total Allowance		% of Loans to Total Loans		Amount		% of Total Allowance		% of Loans to Total Loans
	(In Thousands)						(In Thousands)						(In Thousands)						(In Thousands)
Agricultural	$	3,036	11.98	%	4.52	%	$	2,852	11.17	%	4.50	%	$	2,694	11.00	%	4.45	%	$	2,852	11.17	%	4.50	%
Commercial and financial	4,832		19.06		9.44		4,733		18.52		9.10		4,702		19.19		9.28		4,733		18.52		9.10
Real estate:
Construction, 1 to 4 family residential	1,301		5.13		1.80		1,011		3.96		1.66		1,080		4.41		2.04		1,011		3.96		1.66
Construction, land development and commercial	2,130		8.40		4.07		1,907		7.46		3.79		1,905		7.77		4.14		1,907		7.46		3.79
Mortgage, farmland	2,749		10.84		7.63		2,557		10.01		7.81		2,576		10.51		7.49		2,557		10.01		7.81
Mortgage, 1 to 4 family first liens	5,914		23.33		33.32		6,101		23.87		33.16		6,184		25.24		33.99		6,101		23.87		33.16
Mortgage, 1 to 4 family junior liens	917		3.62		5.72		963		3.77		5.79		917		3.74		5.54		963		3.77		5.79
Mortgage, multi-family	1,407		5.55		12.61		2,064		8.08		13.37		1,533		6.26		12.48		2,064		8.08		13.37
Mortgage, commercial	2,332		9.20		16.86		2,723		10.66		17.26		2,207		9.01		16.65		2,723		10.66		17.26
Loans to individuals	364		1.44		1.11		369		1.44		1.09		352		1.44		1.05		369		1.44		1.09
Obligations of state and political subdivisions	368		1.45		2.92		270		1.06		2.47		350		1.43		2.89		270		1.06		2.47
	$	25,350	100.00	%	100.00	%	$	25,550	100.00	%	100.00	%	$	24,500	100.00	%	100.00	%	$	25,550	100.00	%	100.00	%

The allowance for loan losses totaled ~~$25.35~~$24.50 million at ~~June~~September 30, 2014 compared to $25.55 million at December 31, 2013. The percentage of the allowance to outstanding loans was ~~1.34%~~1.26% and 1.40% at ~~June~~September 30, 2014 and December 31, 2013, respectively. The allowance was based on management’s consideration of a number of factors, including composition of the loan portfolio, loans with higher credit risks and the overall amount of loans outstanding. The decrease in the allowance in 2014 is the result of a change in the composition and allocation of loans within credit quality ratings.

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

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

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

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Investment securities available for sale held by the Company increased by ~~$1.30~~$5.31 million from December 31, 2013 to ~~June~~September 30, 2014. The fair value of securities available for sale was ~~$2.63~~$2.66 million more than the amortized cost of such securities as of ~~June~~September 30, 2014. At December 31, 2013, the fair value of the securities available for sale was $1.81 million more than the amortized cost of such securities.

Deposit growth was ~~$16.45~~$129.62 million in the first ~~six~~nine months of 2014. ~~Federal funds borrowed increased $31.63 million and repurchase~~Repurchase agreements decreased ~~$5.07~~$5.98 million ~~in the same period resulting in a net increase of $26.56 in short term borrowings.~~since December 31, 2014. In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Brokered deposits are included in total deposits and totaled ~~$60.65~~$59.18 million as of ~~June~~September 30, 2014 with an average rate of ~~0.41%~~0.39%. Brokered deposits were $57.77 million as of December 31, 2013 with an average interest rate of 0.44%. As of ~~June~~September 30, 2014 and December 31, 2013, brokered deposits were ~~3.51%~~3.22% and 3.38% of total deposits, respectively.

Dividends and Equity

In January 2014, Hills Bancorporation paid a dividend of $5.42 million or $1.15 per share. The dividend was $1.10 per share in January 2013. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders’ equity as of ~~June~~September 30, 2014 totaled ~~$248.44~~$253.47 million. Under risk-based capital rules, the total amount of Tier 1 risk-based capital was ~~16.25%~~16.22% and 16.19% as of ~~June~~September 30, 2014 and December 31, 2013, respectively. The Tier 1 risk-based capital was in excess of the required minimum of 8.00%. Risk-based capital was ~~17.50%~~17.47% and 17.44% as of ~~June~~September 30, 2014 and December 31, 2013, respectively. As of ~~June~~September 30, 2014, the most recent notifications from the Federal Reserve System categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company’s category.

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

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

Net Income Overview

Net income increased ~~$0.21~~$1.48 million for the ~~six~~nine months ended ~~June~~September 30, 2014 compared to the first ~~six~~nine months of 2013. Total net income was ~~$13.93~~$21.82 million in 2014 and ~~$13.72~~$20.35 million in the comparable period in 2013, an increase of ~~1.46%~~7.25%. The changes in net income in 2014 from the first ~~six~~nine months of 2013 were primarily the result of the following:

Net interest income increased by ~~$1.52~~$2.73 million, before provision expense, ~~primarily~~ as a result of ~~total interest expense reductions significantly outpacing~~growth in the volume of earning assets and reductions in ~~total~~ interest ~~income.~~expense.

The provision for loan losses ~~increased~~decreased by ~~$0.22~~$0.90 million.

Noninterest income decreased by ~~$1.04~~$0.76 million.

Noninterest expenses increased by ~~$0.34~~$0.75 million.

Income tax expense ~~decreased~~increased by ~~$0.28~~$0.64 million.

For the ~~six~~nine~~-month~~ month period ended ~~June~~September 30, 2014 and September 30, 2013 basic earning per share was $4.65 and ~~diluted~~$4.32, respectively. Diluted earnings per share ~~were $2.96. For~~was $4.64 for the ~~six~~nine months ended ~~June~~September 30, ~~2013 basic and diluted earnings per share were both $2.91.~~2014 compared to $4.31 for the same period in 2013.

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

The Company’s net income continues to be driven primarily by three important factors. The first important factor is the interaction between changes in net interest margin and changes in average volumes of the Bank's earnings assets. Net interest income of ~~$34.73~~$52.82 million for the first ~~six~~nine months of 2014 was derived from the Company’s ~~$2.090~~$2.106 billion of average earning assets during that period and its tax-equivalent net interest margin of ~~3.48%~~3.49%. Average earning assets in the ~~six~~nine months ended ~~June~~September 30, 2013 were ~~$1.980~~$1.985 billion and the tax-equivalent net interest margin was ~~3.52%~~3.55%. The importance of net interest margin is illustrated by the fact that an increase or decrease in the net interest margin of 10 basis points would have resulted approximately in a ~~$1.04~~$1.58 million change in income before income taxes in the ~~six~~nine month period ended ~~June~~September 30, 2014 . 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 continued net interest compression to impact earnings for the foreseeable future. The Company believes growth in net interest income will be contingent on the growth of the Company’s earnings assets.

The second significant factor affecting the Company’s net income is the provision for loan losses. The majority of the Company’s interest-earning assets are in loans outstanding, which amounted to more than ~~$1.870~~$1.917 billion at ~~June~~September 30, 2014. The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historically higher credit risk. The provision for loan losses was a reduction of expense of ~~$0.20~~$1.21 million in 2014 compared to a reduction of expense of ~~$0.42~~$0.31 million in 2013. The Company believes that the provision for loan losses will ~~increase~~remain stable for the foreseeable future resulting from projected increases in the size of the Company’s loan portfolio ~~as well as stabilization of~~offset by continued improvement in credit ~~quality.~~quality subject to the circumstances discussed in Note 11.

The third significant factor affecting the Company’s net income is income tax expense. Federal and state income tax expenses were ~~$5.58~~$9.20 million and ~~$5.85~~$8.56 million for the ~~six~~nine months ended ~~June~~September 30, 2014 and 2013, respectively. Income taxes as a percentage of income before taxes were ~~28.60%~~29.66% in 2014 and ~~29.90%~~29.61% in 2013.

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

Net Interest Income

Net interest income increased for the ~~six~~nine months ended ~~June~~September 30, 2014 compared to the comparable period in 2013. The increase was ~~primarily~~as a result of growth in the ~~result~~volume of earning assets and a decrease in net interest expense due to the mix of interest bearing liabilities of the ~~bank~~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 ~~six~~nine months of 2014 was ~~3.48%~~3.49% compared to ~~3.52%~~3.51% in 2013 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the ~~six~~nine months ended in 2014 compared to the comparable period in 2013 are shown in the following table:


						Increase (Decrease) in Net Interest Income														Increase (Decrease) in Net Interest Income
	Change in Average Balance			Change in Average Rate		Volume Changes			Rate Changes			Net Change			Change in Average Balance			Change in Average Rate		Volume Changes			Rate Changes			Net Change
	(Amounts in Thousands)														(Amounts in Thousands)
Interest income:
Loans, net	$	112,244		(0.22	)%	$	2,561		$	(1,885	)	$	676		$	121,405		(0.20	)%	$	4,199		$	(2,689	)	$	1,510
Taxable securities	(4,491		)	(0.18	)	(29		)	(85		)	(114		)	(4,471		)	(0.14	)	(33		)	(109		)	(142		)
Nontaxable securities	18,249			(0.50	)	363			(364		)	(1		)	18,514			(0.47	)	547			(521		)	26
Federal funds sold	(16,148		)	—		(20		)	—			(20		)	(14,697		)	—		(28		)	—			(28		)
	$	109,854				$	2,875		$	(2,334	)	$	541		$	120,751				$	4,685		$	(3,319	)	$	1,366

Interest expense:
Interest-bearing demand deposits	$	35,851		(0.05	)%	$	(38	)	$	113		$	75		$	33,512		(0.06	)%	$	(52	)	$	177		$	125
Savings deposits	89,265			(0.02	)	(102		)	54			(48		)	90,144			(0.03	)	(154		)	111			(43		)
Time deposits	(54,277		)	(0.21	)	462			524			986			(49,830		)	(0.19	)	625			745			1,370
Short-term borrowings	4,555			(0.02	)	(11		)	8			(3		)	10,015			(0.01	)	(27		)	8			(19		)
FHLB borrowings	—			—		—			—			—			—			—		—			—			—
Interest-bearing other liabilities	(50		)	(1.30	)	—			17			17			(53		)	(1.16	)	—			24			24
	$	75,344				$	311		$	716		$	1,027		$	83,788				$	392		$	1,065		$	1,457
Change in net interest income						$	3,186		$	(1,618	)	$	1,568							$	5,077		$	(2,254	)	$	2,823

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

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


(Tax Equivalent Basis)	2014		2013		2014		2013
Yield on average interest-earning assets	4.21	%	4.39	%	4.20	%	4.36	%
Rate on average interest-bearing liabilities	0.92		1.10		0.91		1.08
Net interest spread	3.29	%	3.29	%	3.29	%	3.28	%
Effect of noninterest-bearing funds	0.19		0.23		0.20		0.23
Net interest margin (tax equivalent interest income divided by average interest-earning assets)	3.48	%	3.52	%	3.49	%	3.51	%

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

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates. The Federal Open Market Committee met ~~five~~seven times during the first ~~six~~nine months of 2014. The target rate remains unchanged since December 31, 2008 at 0.25%. Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally increase or decrease when the Federal Reserve Board raises or lowers the federal funds rate. As of ~~June~~September 30, 2014, the rate indexes for the one, three and five year indexes were ~~0.11%~~0.10%, ~~0.92%~~1.06% and ~~1.68%~~1.79%, respectively. The one year index decreased ~~15.39%~~9.09% from ~~0.13%~~0.11% at ~~June~~September 30, 2013, the three year index increased ~~61.40%~~45.21% and the five year index increased ~~37.70%~~16.23%. The three year index was ~~0.57%~~0.73% and the five year index was ~~1.22%~~1.54% at ~~June~~September 30, 2013. The targeted federal funds rate was 0.25% at ~~June~~September 30, 2014 and 2013. The Company anticipates no increases in short term rates and possible increases in long term rates in the indexes for 2014.

Provision for Loan Losses

The provision for loan losses was a reduction of expense of ~~$0.20~~$1.21 million in 2014 compared to a reduction of expense of ~~$0.42~~$0.31 million in 2013, an ~~increase~~expense reduction of ~~$0.22~~$0.90 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~~decrease in expense in 2014 is the result of ~~an increase in loan volume as well as~~ a change in the composition and allocation of ~~balances~~loans within ~~the~~ credit quality ratings.

The allowance for loan losses decreased ~~$0.20~~$1.05 million during the first ~~six~~nine months of 2014. In the first ~~six~~nine months of 2014, there was an increase of ~~$0.07~~$0.05 million due to the volume and composition of loans outstanding and a ~~$0.27~~$1.10 million decrease in the amount allocated to the allowance due to a combination of credit quality improvements.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the ~~six~~nine months ended ~~June~~September 30, 2014 and 2013, recoveries were ~~$1.57~~$2.31 million and ~~$1.33~~$2.02 million, respectively; and charge-offs were ~~$1.57~~$2.15 million in 2014 and ~~$1.67~~$2.12 million in 2013. The allowance for loan losses totaled ~~$25.35~~$24.50 million at ~~June~~September 30, 2014 compared to $25.55 million at December 31, 2013. The allowance represented ~~1.34%~~1.26% and 1.40% of loans held for investment at ~~June~~September 30, 2014 and December 31, 2013, respectively.

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

Noninterest Income

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


	Six Months Ended June 30,									Nine Months Ended September 30,
	2014		2013		$ Change			% Change		2014		2013		$ Change			% Change
	(Amounts in thousands)									(Amounts in thousands)
Net gain on sale of loans	$	300	$	1,262	$	(962	)	(76.23	)%	$	638	$	1,793	$	(1,155	)	(64.42	)%
Trust fees	2,899		2,555		344			13.46		4,494		3,740		754			20.16
Service charges and fees	3,849		4,376		(527		)	(12.04	)	6,001		6,616		(615		)	(9.30	)
Rental revenue on tax credit real estate	735		716		19			2.65		1,112		1,114		(2		)	(0.18	)
Net gain on sale of other real estate owned and other reposessed assets	240		150		90			60.00		426		168		258			153.57
Other noninterest income	1,345		1,348		(3		)	(0.22	)	1,944		1,939		5			0.26
	$	9,368	$	10,407	$	(1,039	)	(9.98	)	$	14,615	$	15,370	$	(755	)	(4.91	)

Loans originated for sale in the first ~~six~~nine months of 2014 totaled ~~$49.19~~$80.80 million compared to ~~$136.34~~$178.87 million in the same period in 2013, a decrease of ~~63.92%~~54.83%. In the ~~six~~nine months ended ~~June~~September 30, 2014 and 2013, the net gain on sale of loans was ~~$0.30~~$0.64 million and ~~$1.26~~$1.79 million, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income. The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

Trust fees increased ~~$0.34~~$0.75 million in the first ~~six~~nine months of 2014 as a result of assets under management increasing to ~~$1.249~~$1.251 billion as of ~~June~~September 30, 2014 from ~~$1.086~~$1.126 billion as of ~~June~~September 30, 2013 due to market conditions and new trust relationships.

Service charges and fees decreased ~~$0.53~~$0.62 million in the first ~~six~~nine months of 2014 from their level for the comparable period in 2013. Credit card merchant fees are included in service charges and fees, and that component decreased during the same period by ~~$0.67~~$0.98 million due to a change to an agent program utilized by the Bank. This decrease was offset by an increase of ~~$0.15~~$0.32 million in credit card, debit card and POS Pin interchange income due to increased volume in transactions during the period.

The net gain on sale of other real estate owned and other repossessed assets increased ~~$0.09~~$0.26 million to a net gain of ~~$0.24~~$0.43 million for the ~~six~~nine months ended ~~June~~September 30, 2014. The total net gain on sale of other real estate owned for the ~~six~~nine months ended consisted of a ~~$0.26~~$0.50 million net gain on the sale of 913 properties offset by a ~~$0.02~~$0.07 million fair market value adjustment on one property. During the same period in 2013, the gain consisted of a ~~$0.16~~$0.19 million net gain on sale of 711 properties offset by a ~~$0.01~~$0.02 million ~~loss~~fair market value adjustment on ~~sale of~~ one property.

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HILLS BANCORPORATION

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

Noninterest Expenses

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


	Six Months Ended June 30,									Nine Months Ended September 30,
	2014		2013		$ Change			% Change		2014		2013		$ Change			% Change
	(Amounts in thousands)									(Amounts in thousands)
Salaries and employee benefits	$	12,642	$	12,154	$	488		4.02	%	$	19,042	$	18,312	$	730		3.99	%
Occupancy	1,953		1,873		80			4.27		2,900		2,780		120			4.32
Furniture and equipment	2,473		2,467		6			0.24		3,685		3,650		35			0.96
Office supplies and postage	767		766		1			—		1,157		1,163		(6		)	(1	)
Advertising and business development	1,441		1,271		170			13.38		2,216		1,895		321			16.94
Outside services	3,208		3,570		(362		)	(10.14	)	4,981		5,437		(456		)	(8.39	)
Rental expenses on tax credit real estate	1,083		957		126			13.17		1,635		1,571		64			4.07
FDIC insurance assessment	541		531		10			1.88		823		760		63			8.29
Other noninterest expense	687		866		(179		)	(20.67	)	1,177		1,298		(121		)	(9.32	)
	$	24,795	$	24,455	$	340		1.39		$	37,616	$	36,866	$	750		2.03

Advertising and business development expense increased ~~$0.17~~$0.32 million in the first ~~six~~nine months of 2014 compared to 2013 as a result of ~~$0.11~~$0.07 million increase in mail processing expense, $0.12 million in business promotions and ~~$0.06~~$0.08 million in charitable contributions. Outside services expenses decreased ~~$0.36~~$0.46 million in the first ~~six~~nine months of 2014 from their level for the comparable period in 2013. Merchant card processing charges are included in outside services expense, and that component decreased during the same period by ~~$0.62~~$0.91 million due to a change to an agent program utilized by the Bank. Most other noninterest expense categories experienced marginal period-to-period fluctuations for the ~~six~~nine months ended ~~June~~September 30, 2014.

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HILLS BANCORPORATION

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

Net Income Overview

Net income increased ~~$0.27~~$1.28 million for the three months ended ~~June~~September 30, 2014 compared to the same period in ~~2012.~~2013. Total net income was ~~$7.18~~$7.90 million in 2014 and ~~$6.91~~$6.62 million in the comparable period in 2013, an increase of ~~3.86%~~19.25%. For the ~~three-month~~three month period ended ~~June~~September 30, 2014 and September 30, 2013 basic earning per share was $1.69 and ~~diluted~~$1.41, respectively. Diluted earnings per share ~~were $1.53 and $1.47, respectively.~~was $1.68 for the three months ended September 30, 2014 compared to $1.40 for the same period in 2013.

Net Interest Income

Net interest income increased for the three months ended ~~June~~September 30, 2014 compared to the comparable period in 2013. The increase was primarily the 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.~~deposits Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin. The net interest margin for the three months ended ~~June~~September 30, 2014 was 3.49% ~~compared to 3.48% in 2013 for~~, which remained unchanged from the same ~~period.~~period for 2013. The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2014 compared to the comparable period in 2013 are shown in the following table:


						Increase (Decrease) in Net Interest Income														Increase (Decrease) in Net Interest Income
	Change in Average Balance			Change in Average Rate		Volume Changes			Rate Changes			Net Change			Change in Average Balance			Change in Average Rate		Volume Changes			Rate Changes			Net Change
	(Amounts in Thousands)														(Amounts in Thousands)
Interest income:
Loans, net	$	123,096		(0.17	)%	$	1,391		$	(753	)	$	638		$	139,727		(0.17	)%	$	1,643		$	(810	)	$	833
Taxable securities	(4,206		)	(0.09	)	(9		)	(25		)	(34		)	(4,431		)	(0.06	)	(3		)	(25		)	(28		)
Nontaxable securities	17,618			(0.44	)	172			(162		)	10			19,043			(0.42	)	185			(157		)	28
Federal funds sold	(15,731		)	—		(9		)	—			(9		)	(11,796		)	—		(8		)	—			(8		)
	$	120,777				$	1,545		$	(940	)	$	605		$	142,543				$	1,817		$	(992	)	$	825

Interest expense:
Interest-bearing demand deposits	$	35,979		(0.06	)%	$	(19	)	$	70		$	51		$	28,825		(0.06	)%	$	(14	)	$	64		$	50
Savings deposits	90,947			(0.03	)	(51		)	45			(6		)	91,902			(0.04	)	(53		)	57			4
Time deposits	(52,273		)	(0.20	)	219			253			472			(40,929		)	(0.17	)	165			220			385
Short-term borrowings	7,645			0.01		(9		)	3			(6		)	20,935			—		(9		)	(6		)	(15		)
FHLB borrowings	—			—		—			—			—			—			—		—			—			—
Interest-bearing other liabilities	(45		)	(0.88	)	—			6			6			(57		)	(0.86	)	—			6			6
	$	82,253				$	140		$	377		$	517		$	100,676				$	89		$	341		$	430
Change in net interest income						$	1,685		$	(563	)	$	1,122							$	1,906		$	(651	)	$	1,255

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HILLS BANCORPORATION

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

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


(Tax Equivalent Basis)	2014		2013		2014		2013
Yield on average interest-earning assets	4.20	%	4.34	%	4.18	%	4.31	%
Rate on average interest-bearing liabilities	0.90		1.08		0.88		1.04
Net interest spread	3.30	%	3.26	%	3.30	%	3.27	%
Effect of noninterest-bearing funds	0.19		0.22		0.19		0.22
Net interest margin (tax equivalent interest income divided by average interest-earning assets)	3.49	%	3.48	%	3.49	%	3.49	%

Provision for Loan Losses

The provision for loan losses was a reduction of expense of ~~$0.25~~$1.01 million in 2014 ~~as well as~~compared to an expense of $0.11 million in ~~2013.~~2013, an expense reduction of $1.12 million. The loan loss provision is the amount necessary to adjust the allowance for loan losses to the level considered by management to appropriately account for the estimated impairment to the Bank's loan portfolio. The provision expense taken to fund the allowance for loan losses is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio. The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more. In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks.

The allowance for loan losses decreased ~~$0.51~~$0.85 million during the three months ended ~~June~~September 30, 2014. In the three months ended ~~June~~September 30, 2014, there was ~~an increase~~a decrease of ~~$0.40~~$0.02 million due to the volume and composition of loans outstanding and a ~~$0.91~~$0.83 million decrease in the amount allocated to the allowance due to an improvement in credit quality.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented. For the three months ended ~~June~~September 30, 2014 and 2013, recoveries were ~~$0.78~~$0.74 million and ~~$0.86~~$0.69 million, respectively; and charge-offs were ~~$1.05~~$0.58 million in 2014 and ~~$0.83~~$0.45 million in 2013. The allowance for loan losses totaled ~~$25.35~~$24.50 million at ~~June~~September 30, 2014 compared to $25.55 million at December 31, 2013. The allowance represented ~~1.34%~~1.26% and 1.40% of loans held for investment at ~~June~~September 30, 2014 and December 31, 2013, respectively.

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HILLS BANCORPORATION

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

Noninterest Income

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


	Three Months Ended June 30, 2014									Three Months Ended September 30, 2014
	2014		2013		$ Change			% Change		2014		2013		$ Change			% Change
	(Amounts in thousands)									(Amounts in thousands)
Net gain on sale of loans	$	189	$	521	$	(332	)	(63.72	)%	$	338	$	531	$	(193	)	(36.35	)%
Trust fees	1,439		1,295		144			11.12		1,595		1,185		410			34.60
Service charges and fees	2,012		2,262		(250		)	(11.05	)	2,152		2,240		(88		)	(3.93	)
Rental revenue on tax credit real estate	378		397		(19		)	(4.79	)	377		398		(21		)	(5.28	)
Net gain on sale of other real estate owned and other reposessed assets	168		110		58			52.73		186		18		168			933.33
Other noninterest income	761		734		27			3.68		599		591		8			1.35
	$	4,947	$	5,319	$	(372	)	(6.99	)	$	5,247	$	4,963	$	284		5.72

In the three months ended ~~June~~September 30, 2014 and 2013, the net gain on sale of loans was ~~$0.19~~$0.34 million and ~~$0.52~~$0.53 million, respectively. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. The servicing of the loans sold into the secondary market is not retained by the Company so these loans do not provide an ongoing stream of income. The Company believes residential mortgage interest rates will continue to rise for the foreseeable future resulting in decreased net gain on sale of loan income.

Trust fees increased ~~$0.14~~$0.41 million in the three months ended ~~June~~September 30, 2014 as a result of assets under management increasing to ~~$1.085~~$1.251 billion as of ~~June~~September 30, 2014 from ~~$1.054~~$1.126 billion as of ~~June~~September 30, 2013 due to market conditions and new trust relationships.

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

The net gain on sale of other real estate owned and other repossessed assets increased ~~$0.06~~$0.17 million to a net gain of ~~$0.17~~$0.19 million for the three months ended ~~June~~September 30, 2014. The total net gain on sale of other real estate owned for the three months ended ~~June~~September 30, 2014 consisted of a ~~$0.17~~$0.24 million net gain on the sale of 64 properties and a $0.05 million fair market value adjustment on three properties. During the same period in 2013, the gain consisted of a ~~$0.12~~$0.04 net gain on sale of 63 properties and a ~~$0.01~~$0.02 million ~~loss~~fair market value adjustment on ~~the sale of~~ one property.

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HILLS BANCORPORATION

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

Noninterest Expenses

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


	Three Months Ended June 30,									Three Months Ended September 30,
	2014		2013		$ Change			% Change		2014		2013		$ Change			% Change
	(Amounts in thousands)									(Amounts in thousands)
Salaries and employee benefits	$	6,385	$	6,191	$	194		3.13	%	$	6,400	$	6,158	$	242		3.93	%
Occupancy	944		931		13			1.40		947		907		40			4.41
Furniture and equipment	1,242		1,186		56			4.72		1,212		1,183		29			2.45
Office supplies and postage	385		386		(1		)	—		390		445		(55		)	(12	)
Advertising and business development	813		651		162			24.88		775		624		151			24.20
Outside services	1,673		1,768		(95		)	(5.37	)	1,773		1,819		(46		)	(2.53	)
Rental expenses on tax credit real estate	553		613		(60		)	(9.79	)	552		614		(62		)	(10.10	)
FDIC insurance assessment	271		270		1			0.37		282		229		53			23.14
Other noninterest expense	271		426		(155		)	(36.38	)	490		432		58			13.43
	$	12,537	$	12,422	$	115		0.93		$	12,821	$	12,411	$	410		3.30

Advertising and business development expenses increased ~~$0.16~~$0.15 million in the three months ended ~~June~~September 30, 2014 from their level for the comparable period in 2013 as a result of a ~~$0.04~~$0.07 increase in mail processing expense and ~~$0.03~~$0.11 in ~~charitable contributions.~~business promotions. Most other noninterest expense categories experienced marginal period-to-period increases for the three months ended ~~June~~September 30, 2014.

Income Taxes

Federal and state income tax expenses were ~~$3.19~~$3.63 million and ~~$2.86~~$2.71 million for the three months ended ~~June~~September 30, 2014 and 2013, respectively. Income taxes as a percentage of income before taxes were ~~30.75%~~31.46% in 2014 and ~~29.28%~~29.00% in 2013.

Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs. Federal funds sold and investment securities available for sale are readily marketable assets. Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position. Investment securities available for sale comprised ~~10.80%~~10.56% of the Company’s total assets at ~~June~~September 30, 2014 compared to 11.00% at December 31, 2013.

The Company has historically maintained a stable deposit base and a relatively low level of large deposits, which has mitigated the volatility in the Company’s liquidity position. As of ~~June~~September 30, 2014, the Company had borrowed ~~$125~~$125.00 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 ~~$443.06~~$478.73 million at ~~June~~September 30, 2014.

As additional sources of liquidity, the Company has the ability to borrow up to $10.00 million from the Federal Reserve Bank of Chicago, and has lines of credit with three banks totaling ~~180.26~~$216.65 million. The borrowings under these credit lines would be secured by the Bank’s investment securities. The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at ~~June~~September 30, 2014.

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HILLS BANCORPORATION

As of ~~June~~September 30, 2014, investment securities with a carrying value of ~~$68.57~~$36.03 million were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as permitted by law. As of December 31, 2013, investment securities with a carrying value of $42.02 million were pledged.

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~~HILLS BANCORPORATION~~

Contractual Obligations

There have been no material changes with regard to contractual obligations disclosed in the Company’s Form 10-K for the year ended December 31, 2013.



Item 3.	Quantitative and Qualitative Disclosures about Market Risk

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

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

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

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

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HILLS BANCORPORATION



Item 4.	Controls and Procedures

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

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

On April 24, , 2014, a suit was filed against the Bank in the Iowa District Court for Johnson County by a customer alleging that the fees associated with the Bank’s automated overdraft program in connection with its debit and ATM cards constitute unlawful interest in violation of Iowa’s usury laws and that the collection of such interest violates the Iowa Debt Collection Practices Act. The suit seeks class-action status for Bank customers who have paid overdraft fees arising from debit or ATM card transactions on their consumer accounts. The Bank ~~has~~ filed a motion to dismiss ~~and litigation~~the case, which the Court denied. The Bank is ~~ongoing.~~appealing the District Court's ruling on the motion to dismiss through the filing of an application for interlocutory appeal to the Iowa Supreme Court. At this stage of the ~~litigation,~~proceedings, it is not possible for management of the Bank to determine the probability of a material adverse outcome or reasonably estimate the amount of any potential loss.



Item 1A.	Risk Factors

There have been no material changes from the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2013.

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

The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended ~~June~~September 30, 2014:

Period
Total number of shares
purchased
Average price paid per
share
Total number of shares
purchased as part of publicly
announced plans or programs
Maximum number of
shares that may yet be
purchased under the
plans or programs (1)
April 1 to April 30 6,407
$ 76.00
360,531
389,469
May 1 to May 31 3,233
76.08
363,764
386,236
June 1 to June 30 3,734
77.50
367,498
382,502
Total 13,374
$ 76.53
367,498
382,502



Period	Total number of shares purchased	Average price paid per share		Total number of shares purchased as part of publicly announced plans or programs	Maximum number of shares that may yet be purchased under the plans or programs (1)
July 1 to July 31	7,480	$	77.50	374,978	375,022
August 1 to August 31	7,159	78.83		382,137	367,863
September 1 to September 30	9,214	80.00		391,351	358,649
Total	23,853	$	78.78	391,351	358,649

(1) On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). The Company’s Board of Directors authorized the 2005 Stock Repurchase Program through December 31, 2015. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common ~~stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis.~~stock. 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 Board reviews the overall results of the 2005 Stock Repurchase Program on a quarterly basis.

During the first ~~six~~nine months of 2014, the Company issued ~~1,293~~2,124 shares of restricted stock under the 2010 Stock Option and Incentive ~~Plan.~~Plan, 831 shares of which were issued in the third quarter. The restricted shares were issued to officers of the company for no cash consideration and will vest over a five-year period from the date of grant. The issuance of these shares was exempt from the registration requirements of the SEC pursuant to Section 4(2) of the Securities Act of 1933.

~~Page 53~~

~~Index~~



Item 3.	Defaults upon Senior Securities

Hills Bancorporation has no senior securities.



Item 4.	Mine Safety Disclosure

Not applicable.



Item 5.	Other Information

None

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Item 6.	Exhibits



3.1	Articles of Incorporation of Hills Bancorporation, incorporated by reference to Exhibit 3.1 to the Company’s Form S-3 filed with the Commission on May 12, 2011.
3.2	By-laws of Hills Bancorporation, incorporated by reference to Exhibit 3.2 to the Company’s Form S-3 filed with the Commission on May 12, 2011.
31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
101.INS	XBRL Instance Document (1)
101.SCH	XBRL Taxonomy Extension Schema Document (1)
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document (1)
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document (1)
101.LAB	XBRL Taxonomy Extension Label Linkbase Document (1)
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document (1)


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

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Index

SIGNATURES

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



		HILLS BANCORPORATION

Date:	~~August 5,~~November 6, 2014	By: /s/ Dwight O. Seegmiller
		Dwight O. Seegmiller, Director, President and Chief Executive Officer

Date:	~~August 5,~~November 6, 2014	By: /s/ Shari DeMaris
		Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer

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Index

HILLS BANCORPORATION

QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED ~~JUNE~~SEPTEMBER 30, 2014


Exhibit Number	Description	Page Number In The Sequential Numbering System June 30, 2014 Form 10-Q	Description	Page Number In The Sequential Numbering System September 30, 2014 Form 10-Q

31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	57-58	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	60-61

32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	59	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	62

Page 5658