HILLS BANCORPORATION [HBIA] Filings

10-Q 1 hbia-20230331.htm 10-Q hbia-20230331

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


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

For the quarterly period ended March 31, 2023


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

For the transition period from ___________ to ___________

Commission file number: 0-12668

Hills Bancorporation


(State or other jurisdiction of incorporation or organization)			I.R.S. Employer Identification No.
Iowa			42-1208067

131 MAIN STREET, HILLS, Iowa 52235

Telephone number: (319) 679-2291

Securities registered pursuant to Section 12(b) of the Act:


Title of each class	Trading Symbol(s)	Name of each exchange on which registered

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. ☑ Yes ☐ No

Indicate by checkmark whether the Registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). ☑ Yes ☐ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.


Large accelerated filer	☐	Accelerated Filer	☑
Non-accelerated filer	☐	Small Reporting Company	☐
Emerging Growth Company	☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by checkmark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes ☑ No

Index

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		April 30, 2023

Common Stock	No par value	9,187,828

Index

HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION


		Page
		Number

Item 1.	Financial Statements

	Consolidated balance sheets, March 3 1 , 202 3 (unaudited) and December 31, 2022	4
	Consolidated statements of income (unaudited) for three months ended March 3 1 , 202 3 and 2022	5
	Consolidated statements of comprehensive income (loss) (unaudited) for three months ended Marc h 31 , 202 3 and 2022	6
	Consolidated statements of stockholders' equity (unaudited) for three months ended March 31 , 202 3 and 2022	7
	Consolidated statements of cash flows (unaudited) for three months ended March 31 , 202 3 and 2022	8
	Notes to consolidated financial statements (condensed)	10

Item 2.	Management Discussion and Analysis of Financial Condition and Results of Operations	52

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	66

Item 4.	Controls and Procedures	67

	Part II
	OTHER INFORMATION

Item 1.	Legal proceedings	67

Item 1A.	Risk factors	67

Item 2.	Unregistered sales of equity securities and use of proceeds	68

Item 3.	Defaults upon senior securities	69

Item 4.	Mine safety disclosures	69

Item 5.	Other information	69

Item 6.	Exhibits	70

	Signatures	71

Page 3

Index

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


	March 31, 2023		December 31, 2022
ASSETS	(Unaudited)
Cash and cash equivalents	$	146,605	$	36,641
Investment securities available for sale at fair value (amortized cost March 31, 2023 $810,152; December 31, 2022 $830,302)	764,441		776,104
Stock of Federal Home Loan Bank	13,585		6,461
Loans held for sale	2,991		1,663
Loans, net of allowance for credit losses March 31, 2023 $41,070; December 31, 2022 $41,440	3,157,788		3,066,981
Property and equipment, net	33,033		33,518
Tax credit real estate investments	8,633		9,152
Accrued interest receivable	17,381		15,782
Deferred income taxes, net	22,147		24,061
Goodwill	2,500		2,500
Other assets	7,622		7,618
Total Assets	$	4,176,726	$	3,980,481

LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities
Noninterest-bearing deposits	$	627,784	$	647,450
Interest-bearing deposits	2,816,297		2,709,917
Total deposits	$	3,444,081	$	3,357,367
Other short-term borrowings, federal funds purchased	—		82,061
Federal Home Loan Bank borrowings	220,000		40,000
Accrued interest payable	1,875		1,394
Allowance for credit losses on off-balance sheet credit exposures	4,570		4,430
Other liabilities	19,741		15,958
Total Liabilities	$	3,690,267	$	3,501,210

Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	49,804	$	51,011

STOCKHOLDERS' EQUITY
Common stock, no par value; authorized 20,000,000 shares; issued March 31, 2023 10,347,968 shares; December 31, 2022 10,348,123 shares	$	—	$	—
Paid in capital	63,458		63,220
Retained earnings	515,615		512,841
Accumulated other comprehensive loss	(34,658)		(41,060)
Treasury stock at cost (March 31, 2023 1,150,732 shares; December 31, 2022 1,122,639 shares)	(57,956)		(55,730)
Total Stockholders' Equity	$	486,459	$	479,271
Less maximum cash obligation related to ESOP shares	49,804		51,011
Total Stockholders' Equity Less Maximum Cash Obligation Related to ESOP Shares	$	436,655	$	428,260
Total Liabilities & Stockholders' Equity	$	4,176,726	$	3,980,481

See Notes to Consolidated Financial Statements.

Page 4

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Amounts In Thousands, Except Per Share Amounts)


	Three Months Ended March 31,
	2023		2022
Interest income:
Loans, including fees	$	34,707	$	25,765
Investment securities:
Taxable	2,697		1,132
Nontaxable	1,187		1,004
Federal funds sold	196		335
Total interest income	$	38,787	$	28,236
Interest expense:
Deposits	$	7,274	$	3,056
Short-term borrowings	2,312		—
Total interest expense	$	9,586	$	3,056
Net interest income	$	29,201	$	25,180
Credit loss expense	368		1,104

Net interest income after credit loss expense	$	28,833	$	24,076
Noninterest income:
Net gain on sale of loans	$	145	$	811
Trust fees	3,270		3,268
Service charges and fees	3,033		2,880
Other noninterest (expense) income	(67)		518

	$	6,381	$	7,477

Noninterest expenses:
Salaries and employee benefits	$	11,503	$	10,396
Occupancy	1,177		1,132
Furniture and equipment	1,692		1,697
Office supplies and postage	448		484
Advertising and business development	874		730
Outside services	2,910		2,950

FDIC insurance assessment	270		281
Other noninterest expense	536		405
	$	19,410	$	18,075
Income before income taxes	$	15,804	$	13,478
Income taxes	3,342		2,826
Net income	$	12,462	$	10,652

Earnings per share:
Basic	$	1.35	$	1.15
Diluted	$	1.35	$	1.15

See Notes to Consolidated Financial Statements.

Page 5

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited) (Amounts In Thousands)


	Three Months Ended March 31,
	2023		2022
Net income	$	12,462	$	10,652

Other comprehensive income (loss)
Securities:
Net change in unrealized gain (loss) on securities available for sale	$	8,487	$	(29,764)

Income taxes	(2,085)		7,426
Other comprehensive income (loss) on securities available for sale	$	6,402	$	(22,338)





Other comprehensive income (loss), net of tax	$	6,402	$	(22,338)

Comprehensive income (loss)	$	18,864	$	(11,686)

See Notes to Consolidated Financial Statements.

Page 6

Index

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

(Unaudited) (Amounts In Thousands, Except Share Amounts)


Three Months Ended March 31, 2023 and 2022
	Paid in Capital		Retained Earnings		Accumulated Other Comprehensive Income (Loss)		Treasury Stock		Maximum Cash Obligation Related to ESOP Shares		Total
Balance, December 31, 2021	$	60,938	$	474,392	$	1,477	$	(48,344)	$	(50,013)	$	438,450
Issuance of 5,339 shares of common stock	189		—		—		48		—		237
Issuance of 1,797 shares of common stock under the employee stock purchase plan	110		—		—		—		—		110
Unearned restricted stock compensation	266		—		—		—		—		266
Forfeiture of 3,219 shares of common stock	(175)		—		—		—		—		(175)
Share-based compensation	6		—		—		—		—		6
Change related to ESOP shares	—		—		—		—		(1,926)		(1,926)
Net income	—		10,652		—		—		—		10,652
Cash dividends (1.00 per share)	—		(9,305)		—		—		—		(9,305)

Purchase of 26,412 shares of common stock	—		—		—		(1,816)		—		(1,816)
Other comprehensive loss	—		—		(22,338)		—		—		(22,338)
Balance, March 31, 2022	$	61,334	$	475,739	$	(20,861)	$	(50,112)	$	(51,939)	$	414,161

Balance, December 31, 2022	$	63,220	$	512,841	$	(41,060)	$	(55,730)	$	(51,011)	$	428,260
Issuance of 4,589 shares of common stock	204		—		—		126		—		330
Issuance of 1,716 shares of common stock under the employee stock purchase plan	111		—		—		—		—		111
Unearned restricted stock compensation	42		—		—		—		—		42
Forfeiture of 1,871 shares of common stock	(125)		—		—		—		—		(125)
Share-based compensation	6		—		—		—		—		6

Change related to ESOP shares	—		—		—		—		1,207		1,207
Net income	—		12,462		—		—		—		12,462
Cash dividends (1.05 per share)	—		(9,688)		—		—		—		(9,688)

Purchase of 32,682 shares of common stock	—		—		—		(2,352)		—		(2,352)
Other comprehensive income	—		—		6,402		—		—		6,402

Balance, March 31, 2023	$	63,458	$	515,615	$	(34,658)	$	(57,956)	$	(49,804)	$	436,655

See Notes to Consolidated Financial Statements.

Page 7

Index

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


	Three Months Ended March 31,
	2023		2022
Cash Flows from Operating Activities
Net income	$	12,462	$	10,652
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation	616		696
Credit loss expense	368		1,104



Forfeiture of common stock	(125)		(175)
Share-based compensation	6		6
Compensation expensed through issuance of common stock	330		118
Provision for deferred income taxes	(171)		(271)
Net loss on sale of other real estate owned and other repossessed assets	2		—
Increase in accrued interest receivable	(1,599)		(1,509)
(Accretion of discount) amortization of premium on investment securities, net	(103)		302
Decrease in other assets	18		5
Amortization of operating lease right-of-use assets	86		105
Increase in accrued interest payable and other liabilities	4,306		2,693

Loans originated for sale	(19,326)		(47,760)
Proceeds on sales of loans	18,143		49,583
Net gain on sales of loans	(145)		(811)
Net cash and cash equivalents provided by operating activities	$	14,868	$	14,738

Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	20,295	$	18,494
Proceeds from sales of investment securities available for sale	509		—
Purchases of investment securities available for sale	(550)		(184,975)
Net purchases of stock of Federal Home Loan Bank	(7,124)		(316)
Loans made to customers, net of collections	(91,146)		(27,144)

Purchases of property and equipment	(131)		(159)

Net changes from tax credit real estate investment	519		(67)
Net cash and cash equivalents used in investing activities	$	(77,628)	$	(194,167)

Cash Flows from Financing Activities
Net increase in deposits	$	86,714	$	127,590
Net decrease in short-term borrowings	(82,061)		(249)
Net change in short-term FHLB borrowings	180,000		—

Stock options exercised	—		119


Purchase of common stock	(2,352)		(1,816)
Proceeds from the issuance of common stock through the employee stock purchase plan	111		110
Dividends paid	(9,688)		(9,305)
Net cash and cash equivalents provided by financing activities	$	172,724	$	116,449

(Continued)

Page 8

Index

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


	Three Months Ended March 31,
	2023		2022
Increase (decrease) in cash and cash equivalents	$	109,964	$	(62,980)
Cash and cash equivalents:
Beginning of period	36,641		781,918
End of period	$	146,605	$	718,938

Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	6,793	$	3,137
Interest paid on other obligations	2,312		—


Noncash activities:
(Decrease) increase in maximum cash obligation related to ESOP shares	$	(1,207)	$	1,926
Transfers to other real estate owned	111		—

Right-of-use assets obtained in exchange for operating lease obligations	—		47

See Notes to Consolidated Financial Statements.

Page 9

Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1.Summary of Significant Accounting Policies

Basis of Presentation:

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

Operating results for the three month period ended March 31, 2023 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2023. 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, 2022 filed with the Securities Exchange Commission on March 3, 2023. The consolidated balance sheet as of December 31, 2022, 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.

Accounting Estimates:

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Certain Significant Estimates:

The allowance for credit losses, fair values of securities and other financial instruments, and share-based compensation expense involve certain significant estimates made by management. These estimates are reviewed by management routinely and it is reasonably possible that circumstances that exist at March 31, 2023 may change in the near-term and the effect could be material to the consolidated financial statements. Actual amounts and values as of the balance sheet dates may be materially different than the amounts and values reported due to the inherent uncertainty in the estimation process.

Revenue Recognition:

Accounting Standards Codification ("ASC") 606, Revenue from Contracts with Customers ("ASC 606"), establishes principles for reporting information about the nature, amount, timing and uncertainty of revenue and cash flows arising from the Company’s contracts to provide goods or services to customers. The core principle requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it expects to be entitled to receive in exchange for those goods or services recognized as performance obligations are satisfied.

The majority of the Company’s revenue-generating transactions are not subject to ASC 606, including revenue generated from financial instruments, such as loans, letters of credit and investment securities. Interest income on loans and investment securities is recognized on the accrual method in accordance with written contracts.

Descriptions of the Company’s revenue-generating activities that are within the scope of ASC 606 are the following: Service charges and fees on deposit accounts represent general service fees for monthly account maintenance and activity- or transaction-based fees and consist of transaction-based revenue which includes interchange income, time-based revenue (service period), item-based revenue or some other individual attribute-based revenue. Revenue is recognized when the Company’s performance obligation is completed which is generally monthly for account maintenance services or when a transaction has been completed (such as a wire transfer). Payment for such performance obligations are generally received at the time the performance obligations are satisfied. Trust income represents monthly fees due from wealth management

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Index

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

customers as consideration for managing the customers' assets. Wealth management and trust services include custody of assets, investment management, fees for trust services and similar fiduciary activities. Revenue is recognized when our performance obligation is completed each month, which is generally the time that payment is received.

A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity's obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. As of March 31, 2023, the Company did not have any significant contract balances.

An entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered. The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission). The Company utilizes the practical expedient which allows entities to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less. The Company has not incurred or capitalized any contract acquisition costs as of March 31, 2023.

Tax credit real estate: Tax credit real estate represents three multi-family rental properties, three assisted living rental properties, a multi-tenant rental property for persons with disabilities, and a multi-family senior living rental property, all of which are affordable housing projects as of March 31, 2023. The Company has a 99% or greater limited partnership interest in each limited partnership. The investment in each was completed after the projects had been developed by the general partner. On a regular basis, the Company evaluates recoverability of the carrying value of the tax credit real estate investments to determine if an allowance for credit losses is necessary. The allowance for credit losses is measured by a comparison of the carrying amount of the investments to the future undiscounted cash flows expected to be generated by the investment properties, including the low-income housing tax credits and any estimated proceeds from eventual disposition. If there is an indication of impairment, the allowance for credit losses would be established with a charge to credit loss expense. There were no indications of impairment based on management's evaluation and therefore no allowance for credit losses was determined necessary as of March 31, 2023. Depreciation expense is provided on a straight-line basis over the estimated useful life of the assets. Expenditures for normal repairs and maintenance are charged to expense as incurred.

The investments in tax credit real estate are recorded for all years presented using the equity method of accounting, with the exception of the investment in the affordable housing project described below. The operations of the properties are not expected to contribute significantly to the Company’s income before income taxes. However, the properties do contribute in the form of income tax credits, which lowers the Company’s effective tax rate. Once established, the credits on each property last for ten years and are passed through from the limited partnerships to the Company and reduces the consolidated federal tax liability of the Company.

In February 2021, the Company provided construction financing and contributed capital of $4.18 million to Del Ray Ridge LP, as limited partner, which owns and operates an affordable housing property in Iowa City, Iowa. The Company accounts for the investment in this tax credit real estate using the proportional amortization method as provided for under Accounting Standards Codification (ASC) 323-740. The investment qualifies for the proportional amortization method as it meets all of the criteria under ASC 323-740-25-1. Substantially all of the projected benefits are from tax credits and other tax benefits due to the minimum buyout clause included in the partnership agreement.

Available-for-sale debt securities and the allowance for credit losses on available-for-sale debt securities: Available-for-sale ("AFS") securities consist of debt securities not classified as trading or held to maturity. Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity. There were no trading or held to maturity securities as of March 31, 2023 or 2022. Fair value measurement is based upon quoted market prices in active markets, if available. If quoted prices in active markets are not available, fair value is measured using pricing models or other model-based valuation techniques such as present value of future cash flows, which consider prepayment assumptions and other factors such as credit losses and market liquidity. Unrealized gains and losses are excluded from earnings and reported, net of tax, in other comprehensive income ("OCI"). Premiums on debt securities are amortized to the earliest call date and discounts on debt securities are accreted over the period to maturity of those securities. The method of amortization results in a constant effective yield on those securities (the interest method). Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

AFS debt securities in unrealized loss positions are evaluated for impairment related to credit losses at least quarterly. For AFS debt securities, a decline in fair value due to credit loss results in recording an allowance for credit losses to the extent the fair value is less than the amortized cost basis. Declines in fair value that have not been recorded through an allowance for credit losses, such as declines due to changes in market interest rates, are recorded through other comprehensive income, net of applicable taxes.

Impairment may result from credit deterioration of the issuer or collateral underlying the security. In performing an assessment of whether any decline in fair value is due to a credit loss, all relevant information is considered at the individual security level. For asset-backed securities performance indicators considered related to the underlying assets include default rates, delinquency rates, percentage of nonperforming assets, debt-to-collateral ratios, third-party guarantees, current levels of subordination, vintage, geographic concentration, analyst reports and forecasts, credit ratings and other market data. In assessing whether a credit loss exists, we compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis for the security, a credit loss exists and an allowance for credit losses is recorded, limited to the amount the fair value is less than amortized cost basis.

If we intend to sell a debt security or more likely than not we will be required to sell the security before recovery of its amortized cost basis, the debt security is written down to its fair value and the write down is charged against the allowance for credit losses with any incremental impairment reported in earnings.

Accrued interest receivable on AFS debt securities totaled $3.63 million at March 31, 2023 and is excluded from the estimate of credit losses.

Loans held for sale: Loans held for sale are stated at the lower of aggregate cost or estimated fair value. Loans are sold on a non-recourse basis with servicing released and gains and losses are recognized based on the difference between sales proceeds and the carrying value of the loan. The Company has had very few experiences of repurchasing loans previously sold into the secondary market. A specific reserve was not considered necessary based on the Company’s historical experience with repurchase activity.

Loans held for investment: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at amortized cost net of the allowance for credit losses ("ACL"). Amortized cost is the principal balance outstanding, net of deferred loan fees and costs. Accrued interest receivable on loans held for investment totaled $13.75 million at March 31, 2023 and is excluded from the estimate of credit losses. Interest income is accrued on the unpaid principal balance. Nonrefundable loan fees and origination costs are deferred and recognized as a yield adjustment over the life of the related loan.

The accrual of interest income on loans is discontinued when, in the opinion of management, there is reasonable doubt as to the

borrower's ability to meet payments of interest or principal when they become due, which is generally when a loan is 90 days or

more past due unless the loan is well secured and in the process of collection. When a loan is placed on nonaccrual status, all previously accrued and unpaid interest is reversed against interest income. Loans are returned to an accrual status when all of the principal and interest amounts contractually due are brought current and repayment of the remaining contractual principal and interest is expected. A loan may also return to accrual status if additional collateral is received from the borrower and, in the opinion of management, the financial position of the borrower indicates that there is no longer any reasonable doubt as to the collection of the amount contractually due. Payment received on nonaccrual loans are applied first to principal. Once principal is recovered, any remaining payments received are applied to interest income.

The policy for charging off loans is consistent throughout all loan categories. A loan is charged off based on criteria that includes but is not limited to: delinquency status, financial condition of the entire customer credit line and underlying collateral coverage, economic or external conditions that might impact full repayment of the loan, legal issues, overdrafts, and the customer’s willingness to work with the Company.

Allowance for credit losses for loans held for investment: The allowance for credit losses is an estimate of the expected losses over the remaining life of the Company's existing loans held for investment portfolio. The allowance for credit losses for loans held for investment, as reported in our consolidated balance sheet, is adjusted by a credit loss expense, which is reported in earnings, and reduced by the charge-off of loan amounts, net of recoveries.

The loan loss estimation process involves procedures to appropriately consider the unique characteristics of loan portfolio

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

segments which consist of agricultural, 1 to 4 family first and junior liens, commercial, and consumer lending. These segments are further disaggregated into loan classes, the level at which credit risk is monitored. For each of these pools, the Company generates cash flow projections at the instrument level wherein payment expectations are adjusted for estimated prepayment speed, curtailments, time to recovery, probability of default, and loss given default. The modeling of expected prepayment speeds, curtailment rates, and time to recovery are based on historical internal data. The following provides the credit quality indicators and risk elements that are most relevant and most carefully considered and monitored for each loan portfolio segment.

Agricultural - Agricultural operating loans include loans made to finance agricultural production and other loans to farmers and farming operations. Agricultural loans also include mortgage loans secured by farmland. Agricultural operating loans, most of which are secured by crops and machinery, are provided to finance capital improvement and farm operations as well as acquisitions of livestock and machinery. The ability of the borrower to repay may be affected by many factors outside of the borrower’s control including adverse weather conditions, loss of livestock due to disease or other factors, declines in market prices for agricultural products and the impact of government regulations. The ultimate repayment of agricultural operating loans is dependent upon the profitable operation or management of the agricultural entity. Agricultural operating loans generally have a term of one year and may have a fixed or variable rate.

Mortgage loans secured by farmland are made to individuals and businesses within the Company's trade area. The primary source of repayment is the cash flow generated by the collateral underlying the loan. The secondary repayment source would be the liquidation of the collateral. Terms for real estate loans secured by farmland range from one to ten years with an amortization period of 25 years or less. Generally, interest rates are fixed for mortgage loans secured by farmland. Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate and the Iowa real gross domestic product (GDP).

1 to 4 Family First and Junior Liens - The 1 to 4 family first and junior liens portfolio segment is comprised of the single family and home equity loan classes, which are underwritten after evaluating a borrower's capacity to repay, credit, and collateral. Several factors are considered when assessing a borrower's capacity, including the borrower's employment, income, current debt, assets, and level of equity in the property. Credit refers to how well a borrower manages their current and prior debts as documented by a credit report that provides credit scores and the borrower's current and past information about their credit history. Collateral refers to the type and use of property, occupancy, and market value. Property appraisals are obtained to assist in evaluating collateral. Loan-to-property value and debt-to-income ratios, loan amount, and lien position are also considered in assessing whether to originate a loan. These borrowers are particularly susceptible to downturns in economic trends such as conditions that negatively affect housing prices and demand and levels of unemployment. Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate and the all-transactions house price index for Iowa.

Commercial - The commercial loan portfolio segment is comprised of the commercial real estate mortgage including obligations of states and political subdivisions, multifamily residential mortgage, construction/land development and commercial and financial loan classes, whose underwriting standards consider the factors described for single family and home equity loan classes as well as others when assessing the borrower's and associated guarantors or other related party's financial position. These other factors include assessing liquidity, the level and composition of net worth, leverage, considering all other lender amounts and position, an analysis of cash expected to flow through the obligors including the outflow to other lenders, vacancies and prior experience with the borrower. This information is used to assess adequate financial capacity, profitability, and experience. Ultimate repayment of these loans is sensitive to interest rate changes, general economic conditions, liquidity, and availability of long-term financing. Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate, the all-transactions house price index for Iowa and the Iowa real GDP.

Consumer Lending - The Company offers consumer loans to individuals including personal loans and automobile loans. These consumer loans typically have shorter terms, lower balances, higher yields and higher risks of default than real estate-related loans. Consumer collections are dependent on the borrower's continuing financial stability and are more likely to be affected by adverse personal circumstances. Collateral for these loans generally includes automobiles, boats, recreational vehicles and real estate. However, depending on the overall financial condition of the borrower, some loans are made on an unsecured basis. The collateral securing these loans may depreciate over time,

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may be difficult to recover and may fluctuate in value based on condition. Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate and the Iowa real GDP.

The allowance level is influenced by loan volumes, loan credit quality indicator migration or delinquency status, historic loss experience and other conditions influencing loss expectations, such as reasonable and supportable forecasts of economic conditions. The methodology for estimating the amount of expected credit losses reported in the allowance for credit losses has two basic components: first, a pooled component for estimated expected credit losses for pools of loans that share similar risk characteristics; and second, an asset-specific component involving individual loans that do not share risk characteristics with other loans and the measurement of expected credit losses for such individual loans. Depending on the nature of the pool of financial assets with similar risk characteristics, the Company uses a discounted cash flow method or remaining life method to estimate expected credit losses.

Discounted cash flow method: In estimating the component of the allowance for credit losses for loans that share similar risk characteristics with other loans, such loans are segregated into loan classes. Loans are designated into loan classes based on loans pooled by product types and similar risk characteristics or areas of risk concentration. In determining the allowance for credit losses, we derive an estimated credit loss assumption from a model that categorizes loan pools based on loan type and purpose. This model calculates an expected loss percentage for each loan class by considering the probability of default, using life-of-loan analysis periods for all loan segments, and the historical severity of loss, based on the aggregate net lifetime losses incurred per loan class. The default and severity factors used to calculate the allowance for credit losses for loans that share similar risk characteristics with other loans are adjusted for differences between the historical period used to calculate historical default and loss severity rates and expected conditions over the remaining lives of the loans in the portfolio related to: (1) lending policies and procedures; (2) international, national, regional and local economic business conditions and developments that affect the collectability of the portfolio; (3) the nature and volume of the loan portfolio including the terms of the loans; (4) the experience, ability, and depth of the lending management and other relevant staff; (5) the volume and severity of past due and adversely classified or graded loans and the volume of nonaccrual loans; (6) the quality of our loan review system and (7) the value of underlying collateral for collateralized loans. Additional factors include the existence and effect of any concentrations of credit, and changes in the level of such concentrations and the effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio. Such factors are used to adjust the historical probabilities of default and severity of loss so that they reflect management expectation of future conditions based on a reasonable and supportable forecast. The Company uses regression analysis of historical internal and peer data to determine which variables are best suited to be economic variables utilized when modeling lifetime probability of default and loss given default. This analysis also determines how expected probability of default and loss given default will react to forecasted levels of the economic variables.

For all DCF models, management has determined that four quarters represents a reasonable and supportable forecast period and reverts back to a historical loss rate over twelve quarters on a straight-line basis. Other internal and external indicators of economic forecasts are also considered by management when developing the forecast metrics.

Remaining life method: Expected credit losses for credit cards and overdrafts are determined through use of the remaining life method. The remaining life method utilizes average annual charge-off rates and remaining life to estimate the allowance for credit losses. This is done by estimating the amount and timing of principal payments expected to be received as payment for the balance outstanding as of the reporting period and applying those principal payments against the balance outstanding as of the reporting period along with the average annual charge-off rate until the expected payments have been fully allocated.

Collateral dependent financial assets: For a loan that does not share risk characteristics with other loans, expected credit loss is measured based on net realizable value, that is, the difference between the discounted value of the expected future cash flows, based on the original effective interest rate, and the amortized cost basis of the loan. For these loans, we recognize expected credit loss equal to the amount by which the net realizable value of the loan is less than the amortized cost basis of the loan (which is net of previous charge- offs and deferred loan fees and costs), except when the loan is collateral dependent, that is, when the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the collateral. In these cases, expected credit loss is measured as the difference between the amortized cost basis of the loan and the fair value of the collateral. The fair value of the collateral is adjusted for the estimated cost to sell if repayment or satisfaction of a loan is dependent on the sale (rather than only on the operation) of the collateral.

The Company’s estimate of the ACL reflects losses expected over the contractual life of the assets, adjusted for estimated prepayments or curtailments. The contractual term does not consider extensions, renewals or modifications unless the Company

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has identified a modification including a concession to a borrower experiencing financial difficulties. A modification of a loan to a borrower experiencing financial difficulties occurs when two conditions are met: 1) the borrower is experiencing financial difficulty and 2) concessions are made for the borrower's benefit that would not otherwise be considered for a borrower or transaction with similar credit risk characteristics.

Allowance for credit losses on off-balance sheet credit exposures, including unfunded loan commitments: The Company maintains a separate allowance for credit losses from off-balance-sheet credit exposures, including unfunded loan commitments, which is disclosed on the balance sheet. Management estimates the amount of expected losses by calculating a commitment usage factor over the contractual period for exposures that are not unconditionally cancellable by the Company and applying the loss factors used in the ACL methodology to the results of the usage calculation to estimate the liability for credit losses related to unfunded commitments for each loan type. No credit loss estimate is reported for off-balance-sheet (OBS) credit exposures that are unconditionally cancellable by the Company, such as credit card receivables, or for undrawn amounts under such arrangements that may be drawn prior to the cancellation of the arrangement. The allowance for credit losses on OBS credit exposures is adjusted as credit loss expense. Categories of OBS credit exposures correspond to the loan portfolio segments described previously.

Troubled debt restructurings (“TDR loans”): Prior to January 1, 2023, a loan was accounted for and reported as a troubled debt restructuring ("TDR") when, for economic or legal reasons, the Company granted a concession to a borrower experiencing financial difficulty that the Company would not otherwise consider. These concessions may include rate reductions, principal forgiveness, extension of maturity date and other actions intended to minimize potential losses to the Company. A restructuring that results in only an insignificant delay in payment is not considered a concession. A delay may be considered insignificant if the payments subject to the delay are insignificant relative to the unpaid principal or collateral value and the contractual amount due, or the delay in timing of the restructured payment period is insignificant relative to the frequency of payments, the debt's original contractual maturity or original expected duration. TDRs performing in accordance with their modified contractual terms for a reasonable period of time may be included in the Company’s existing pools based on the underlying risk characteristics of the loan to measure the ACL.

TDRs that are performing and on accrual status as of the date of the modification remain on accrual status. TDRs that are nonperforming as of the date of modification generally remain as nonaccrual until the prospect of future payments in accordance with the modified loan agreement is reasonably assured, generally demonstrated when the borrower maintains compliance with the restructured terms for a predetermined period, normally at least six months. TDRs with temporary below-market concessions remain designated as a TDR regardless of the accrual or performance status until the loan is paid off. However, if the TDR loan has been modified in a subsequent restructure with market terms and the borrower is not currently experiencing financial difficulty, then the loan is no longer classified as a TDR in the quarter following the modification.

Effect of New Financial Accounting Standards:

In May 2021, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2021-04, Earnings Per Share (Topic 260), Debt-Modifications and Extinguishments (Subtopic 470-50), Compensation-Stock Compensation (Topic 718), and Derivatives and Hedging-Contracts in Entity's Own Equity (Subtopic 815-40), Issuer's Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options. The amendments in this ASU affect entities that issue freestanding written call options that are classified in equity. Specifically, the amendments affect those entities when a freestanding equity-classified written call option is modified or exchanged and remains equity classified after the modification or exchange. An entity should recognize the effect of a modification or an exchange of a freestanding equity-classified written call option to compensate for goods or services in accordance with the guidance in Topic 718, Compensation-Stock Compensation. The amendments in this ASU are effective for all entities for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. An entity should apply the amendments prospectively to modifications or exchanges occurring on or after the effective date of the amendments. The adoption of the ASU by the Company on January 1, 2022 did not have a material impact on the financial statements.

In October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 815) Accounting for Contract Assets and Contract Liabilities from Contracts with Customers. The amendments in this Update require that an entity (acquirer) recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606. At the acquisition date, an acquirer should account for the related revenue contracts in accordance with Topic 606 as if it had originated the contracts. To achieve this, an acquirer may assess how the acquiree applied Topic 606 to determine what to record for the acquired revenue contracts. The amendments in this ASU are effective for all entities for fiscal years beginning

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after December 15, 2022, including interim periods within those fiscal years. An entity should apply the amendments prospectively to business combinations occurring on or after the effective date of the amendments. The adoption of the ASU by the Company on January 1, 2023 did not have a material impact on the financial statements.

In March 2022, the FASB issued ASU 2022-02, Financial Instruments - Credit Losses (Topic 326) Troubled Debt Restructurings and Vintage Disclosures. The FASB issued these amendments to eliminate accounting guidance for TDRs by creditors in Subtopic 310-40, Receivables-Troubled Debt Restructurings by Creditors, while enhancing disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty, and to require that an entity disclose current-period gross writeoffs by year of origination for financing receivables and net investments in leases within the scope of Subtopic 326-20, Financial Instruments-Credit Losses-Measured at Amortized Cost. The amendments in this Update are effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years, and should be applied prospectively, except as provided in the next sentence. For the transition method related to the recognition and measurement of TDRs, an entity has the option to apply a modified retrospective transition method, resulting in a cumulative-effect adjustment to retained earnings in the period of adoption. Early adoption is permitted if an entity has adopted the amendments in Update 2016-03, including adoption in an interim period. The adoption of the ASU on a prospective basis by the Company on January 1, 2023 did not have a material impact on the financial statements

In March 2023, the FASB issued ASU 2023-02, Investments - Equity Method and Joint Ventures (Topic 323) Accounting for Investments in Tax Credit Structures Using Proportional Amortization Method. The FASB is issuing this ASU to allow reporting entities to consistently account for equity investments made primarily for the purposes of receiving income tax credits and other income tax benefits. The ASU permits reporting entities to elect to account for tax equity investments, regardless of the tax credit program from which the income tax credits are received, using the proportional amortization method if certain conditions are met. For public business entities, the amendments are effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted for all entities in any interim period. If an entity adopts the amendments in an interim period, it shall adopt them as of the beginning of the fiscal year that includes that interim period. The Company is in the process of evaluating the impact of this ASU on the financial statements.

Note 2.Earnings Per Share

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

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


	Three Months Ended March 31,
	2023		2022
Common shares outstanding at the beginning of the period	9,225,484		9,299,640
Weighted average number of net shares redeemed	(6,484)		(9,053)
Weighted average shares outstanding (basic)	9,219,000		9,290,587
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method	765		3,194
Weighted average number of shares (diluted)	9,219,765		9,293,781
Net income (In thousands)	$	12,462	$	10,652
Earnings per share:
Basic	$	1.35	$	1.15
Diluted	$	1.35	$	1.15

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Note 3.Accumulated Other Comprehensive Income (Loss)

The following table summarizes the balances of each component of accumulated other comprehensive (loss) income (AOCI), included in stockholders’ equity, at March 31, 2023 and December 31, 2022:


	March 31, 2023		December 31, 2022
	(amounts in thousands)
Net unrealized loss on available-for-sale securities	$	(45,711)	$	(54,198)

Tax effect	11,053		13,138
Net-of-tax amount	$	(34,658)	$	(41,060)

Note 4.Securities

The carrying values of investment securities at March 31, 2023 and December 31, 2022 are summarized in the following table (dollars in thousands):


	March 31, 2023				December 31, 2022
	Amount		Percent		Amount		Percent
Securities available for sale
U.S. Treasury	$	435,202	56.93	%	$	445,392	57.39	%
Other securities (FHLB, FHLMC and FNMA)	32,365		4.23		31,934		4.11
State and political subdivisions	247,277		32.35		248,582		32.03
Mortgage-backed securities and collateralized mortgage obligations	49,597		6.49		50,196		6.47
Total securities available for sale	$	764,441	100.00	%	$	776,104