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, 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	At April 30, 2014
Common Stock, no par value	4,718,904

HILLS BANCORPORATION

Index to Form 10-Q

Part I

FINANCIAL INFORMATION

		Page
		Number
Item 1.	Financial Statements
	Consolidated balance sheets, March 31, 2014 (unaudited) and December 31, 2013	3
	Consolidated statements of income (unaudited) for three months ended March 31, 2014 and 2013	4
	Consolidated statements of comprehensive income (unaudited) for three months ended March 31, 2014 and 2013	5
	Consolidated statements of stockholders' equity (unaudited) for three months ended March 31, 2014 and 2013	6
	Consolidated statements of cash flows (unaudited) for three months ended March 31, 2014 and 2013	7
	Notes to consolidated financial statements (condensed)	9
Item 2.	Management Discussion and Analysis of Financial Condition and Results of Operations	36
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	49
Item 4.	Controls and Procedures	49
	Part II
	OTHER INFORMATION
Item 1.	Legal proceedings	50
Item 1A.	Risk factors	50
Item 2.	Unregistered sales of equity securities and use of proceeds	50
Item 3.	Defaults upon senior securities	50
Item 4.	Mine safety disclosures	50
Item 5.	Other information	51
Item 6.	Exhibits	51
Signatures		52
Exhibits Index		53

Page 2

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

ASSETS	March 31, 2014 (Unaudited)			December 31, 2013
Cash and cash equivalents	$	89,077		$	43,702
Investment securities available for sale at fair value (amortized cost March 31, 2014 $237,085; December 31, 2013 $236,702)		238,977			238,510
Stock of Federal Home Loan Bank		7,654			7,579
Loans held for sale		1,870			4,927
Loans, net of allowance for loan losses (March 31, 2014 $25,860; December 31, 2013 $25,550)		1,824,959			1,801,247
Property and equipment, net		29,345			29,836
Tax credit real estate		17,971			18,180
Accrued interest receivable		8,751			7,676
Deferred income taxes, net		9,307			8,605
Other real estate		923			541
Goodwill		2,500			2,500
Other assets		4,038			4,492
Total Assets	$	2,235,372		$	2,167,795
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Noninterest-bearing deposits	$	245,025		$	256,788
Interest-bearing deposits		1,529,178			1,453,089
Total deposits	$	1,774,203		$	1,709,877
Short-term borrowings		40,577			42,016
Federal Home Loan Bank borrowings		125,000			125,000
Accrued interest payable		1,036			1,102
Other liabilities		20,747			16,437
Total Liabilities	$	1,961,563		$	1,894,432
Redeemable Common Stock Held by Employee Stock Ownership Plan (ESOP)	$	29,969		$	29,574
STOCKHOLDERS' EQUITY
Common stock, no par value; authorized 10,000,000 shares; issued March 31, 20145,078,330 shares; December 31, 2013 5,074,894 shares	$	-		$	-
Paid in capital		42,448			42,194
Retained earnings		251,693			250,370
Accumulated other comprehensive income		977			1,591
Unearned ESOP shares		(1,008	)		(1,008	)
Treasury stock at cost (March 31, 2014 354,124 shares; December 31, 2013 347,269 shares)		(20,301	)		(19,784	)
Total Stockholders' Equity	$	273,809		$	273,363
Less maximum cash obligation related to ESOP shares		29,969			29,574
Total Stockholders' Equity Less Maximum Cash Obligations Related to ESOP Shares	$	243,840		$	243,789
Total Liabilities & Stockholders' Equity	$	2,235,372		$	2,167,795

See Notes to Consolidated Financial Statements.

Page 3

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Amounts In Thousands, Except Per Share Amounts)

	Three Months Ended March 31,
	2014		2013
Interest income:
Loans, including fees	$	19,749	$	19,720
Investment securities:
Taxable		270		350
Nontaxable		836		843
Federal funds sold		10		21
Total interest income	$	20,865	$	20,934
Interest expense:
Deposits	$	2,469	$	2,965
Short-term borrowings		3		17
FHLB borrowings		1,378		1,378
Total interest expense	$	3,850	$	4,360
Net interest income	$	17,015	$	16,574
Provision for loan losses		45		(171	)
Net interest income after provision for loan losses	$	16,970	$	16,745
Noninterest income:
Net gain on sale of loans	$	111	$	741
Trust fees		1,460		1,260
Service charges and fees		1,837		2,114
Rental revenue on tax credit real estate		357		319
Net gain on sale of other real estate owned and other repossessed assets		72		40
Other noninterest income		584		614
	$	4,421	$	5,088
Noninterest expenses:
Salaries and employee benefits	$	6,257	$	5,963
Occupancy		1,009		942
Furniture and equipment		1,231		1,281
Office supplies and postage		382		380
Advertising and business development		628		620
Outside services		1,535		1,802
Rental expenses on tax credit real estate		530		344
FDIC insurance assessment		270		261
Other noninterest expense		416		440
	$	12,258	$	12,033
Income before income taxes	$	9,133	$	9,800
Income taxes		2,389		2,990
Net income	$	6,744	$	6,810
Earnings per share:
Basic	$	1.43	$	1.44
Diluted	$	1.43	$	1.44

See Notes to Consolidated Financial Statements.

Page 4

HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited) (Amounts In Thousands)

	Three Months Ended March 31,
	2014			2013
Net income	$	6,744		$	6,810
Other comprehensive loss
Securities:
Net change in unrealized gain on securities available for sale	$	84		$	(783	)
Reclassification adjustment for net gains realized in net income		-			(17	)
Income taxes		(32	)		306
Other comprehensive income (loss) on securities available for sale	$	52		$	(494	)
Derivatives used in cash flow hedging relationships:
Unrealized loss on derivatives	$	(1,079	)	$	-
Income taxes		413			-
Other comprehensive loss on cash flow hedges	$	(666	)	$	-
Other comprehensive loss, net of tax	$	(614	)	$	(494	)
Comprehensive income	$	6,130		$	6,316

See Notes to Consolidated Financial Statements.

Page 5

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

	Paid In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Unearned ESOP Shares			Treasury Stock			Maximum Cash Obligation Related To ESOP Shares			Total
Balance, December 31, 2012	$	42,241		$	229,625		$	3,955		$	(1,513	)	$	(18,397	)	$	(30,715	)	$	225,196
Issuance of 4,946 shares of common stock		177			-			-			-			-			-			177
Issuance of 555 shares of common stock under the employee stock purchase plan		38			-			-			-			-			-			38
Unearned restricted stock compensation		(730	)		-			-			-			-			-			(730	)
Forfeiture of 375 shares of common stock		(24	)		-			-			-			-			-			(24	)
Share-based compensation		7			-			-			-			-			-			7
Income tax benefit related to share-based compensation		70			-			-			-			-			-			70
Change related to ESOP shares		-			-			-			-			-			(443	)		(443	)
Net income		-			6,810			-			-			-			-			6,810
Cash dividends ($1.10 per share)		-			(5,186	)		-			-			-			-			(5,186	)
Purchase of 3,759 shares of common stock		-			-			-			-			(266	)		-			(266	)
Other comprehensive loss		-			-			(494	)		-			-			-			(494	)
Balance, March 31, 2013	$	41,779		$	231,249		$	3,461		$	(1,513	)	$	(18,663	)	$	(31,158	)	$	225,155
Balance, December 31, 2013	$	42,194		$	250,370		$	1,591		$	(1,008	)	$	(19,784	)	$	(29,574	)	$	243,789
Issuance of 3,067 shares of common stock		111			-			-			-			-			-			111
Issuance of 535 shares of common stock under the employee stock purchase plan		39			-			-			-			-			-			39
Unearned restricted stock compensation		59			-			-			-			-			-			59
Forfeiture of 166 shares of common stock		(12	)		-			-			-			-			-			(12	)
Share-based compensation		7			-			-			-			-			-			7
Income tax benefit related to share-based compensation		50			-			-			-			-			-			50
Change related to ESOP shares		-			-			-			-			-			(395	)		(395	)
Net income		-			6,744			-			-			-			-			6,744
Cash dividends ($1.15 per share)		-			(5,421	)		-			-			-			-			(5,421	)
Purchase of 6,855 shares of common stock		-			-			-			-			(517	)		-			(517	)
Other comprehensive loss		-			-			(614	)		-			-			-			(614	)
Balance, March 31, 2014	$	42,448		$	251,693		$	977		$	(1,008	)	$	(20,301	)	$	(29,969	)	$	243,840

See Notes to Consolidated Financial Statements.

Page 6

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

	Three Months Ended March 31,
	2014			2013
Cash Flows from Operating Activities
Net income	$	6,744		$	6,810
Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:
Depreciation		681			725
Provision for loan losses		45			(171	)
Net gain on sale of investment securities		-			(17	)
Share-based compensation		7			7
Forfeiture of common stock		(12	)		(24	)
Compensation expensed through issuance of common stock		49			66
Excess tax benefits from share-based compensation		(50	)		(70	)
Provision for deferred income taxes		(321	)		101
Net gain on sale of other real estate owned and other repossessed assets		(72	)		(40	)
Increase in accrued interest receivable		(1,075	)		(1,038	)
Amortization of discount on investment securities, net		216			280
Decrease in prepaid FDIC insurance		-			232
(Increase) decrease in other assets		(265	)		2,392
Increase in accrued interest payable and other liabilities		3,994			1,461
Loans originated for sale		(16,518	)		(59,075	)
Proceeds on sales of loans		19,686			83,727
Net gain on sales of loans		(111	)		(741	)
Net cash and cash equivalents provided by operating activities	$	12,998		$	34,625
Cash Flows from Investing Activities
Proceeds from maturities of investment securities available for sale	$	22,806		$	6,394
Proceeds from sales of investment securities available for sale		-			566
Purchases of investment securities available for sale		(23,480	)		(8,885	)
Loans made to customers, net of collections		(24,557	)		(11,090	)
Proceeds on sale of other real estate owned and other repossessed assets		489			134
Purchases of property and equipment		(190	)		(747	)
Income from (investment in) tax credit real estate, net		209			(94	)
Net cash and cash equivalents used in investing activities	$	(24,723	)	$	(13,722	)
Cash Flows from Financing Activities
Net increase in deposits	$	64,326		$	13,604
Net (decrease) increase in short-term borrowings		(1,439	)		1,140
Stock options exercised		101			149
Excess tax benefits related to share-based compensation		50			70
Purchase of treasury stock		(517	)		(266	)
Dividends paid		(5,421	)		(5,186	)
Net cash and cash equivalents provided by financing activities	$	57,100		$	9,511

(Continued)

Page 7

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

	Three Months Ended March 31,
	2014		2013
Increase in cash and cash equivalents	$	45,375	$	30,414
Cash and cash equivalents:
Beginning of year		43,702		63,582
End of period	$	89,077	$	93,996
Supplemental Disclosures
Cash payments for:
Interest paid to depositors	$	2,535	$	3,049
Interest paid on other obligations		1,381		1,395
Income taxes paid		502		-
Noncash activities:
Increase in maximum cash obligation related to ESOP shares	$	395	$	443
Transfers to other real estate owned		800		124

See Notes to Consolidated Financial Statements.

Page 8

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Summary of Significant Accounting Policies

Basis of Presentation:

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

Operating results for the three month period ended March 31, 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 to amend FASB ASC Topic 323, Investments – Equity Method and Joint Ventures.  The objective of this standard is to provide guidance on accounting for investments by a reporting entity in flow-through limited liability entities that manage or invest in affordable housing projects that qualify for the low-income housing tax credit.  The amendments in the standard permit reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met.  Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit).  The standard will be effective for the Company beginning January 1, 2015; however, early adoption is permitted.  The Company does have significant investments in such qualified affordable housing projects and is currently reviewing the provisions of this standard to determine what, if any, impacts it may have on the Company’s financial position or results of operations.

In January 2014, the FASB issued ASU No. 2014-04, Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure.  ASU 2014-04 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 2014-04 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2014.  The adoption of ASU 2014-04 by the Company is not expected to have a material impact.

Page 9

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 2. Earnings Per Share

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

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

	Three months Ended March 31,
	2014			2013
Common shares outstanding at the beginning of the period		4,711,995			4,712,328
Weighted average number of net shares (redeemed) issued		(1,502	)		2,521
Weighted average shares outstanding (basic)		4,710,493			4,714,849
Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method		2,591			4,290
Weighted average number of shares (diluted)		4,713,084			4,719,139
Net income (In thousands)	$	6,744		$	6,810
Earnings per share:
Basic	$	1.43		$	1.44
Diluted	$	1.43		$	1.44

Page 10

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 3. Other Comprehensive Income

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

	March 31, 2014			December 31, 2013
	(amounts in thousands)
Net unrealized gain on available-for-sale securities	$	1,892		$	1,808
Net unrealized (loss) gain on derivatives used for cash flow hedges		(310	)		769
Tax effect		(605	)		(986	)
Net-of-tax amount	$	977		$	1,591

Amounts reclassified from AOCI and the affected line items in the statement of income during the three months ended March 31, 2014 and 2013, were as follows:

	Amounts reclassifed from AOCI
	2014		2013			Affected Line Item in the Statements of Income
	(amounts in thousands)
Unrealized gains on available-for-sale securities	$	-	$	17		Other noninterest income
Tax effect		-		(7	)	Tax (expense) benefit
Total reclassification out of AOCI	$	-	$	10

Page 11

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Securities

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

	March 31, 2014					December 31, 2013
	Amount		Percent			Amount		Percent
Securities available for sale
U.S. Treasury	$	4,869		2.04	%	$	-		0.00	%
State and political subdivisions		150,541		62.99			151,366		63.46
Other securities (FHLB, FHLMC and FNMA)		83,567		34.97			87,144		36.54
Total securities available for sale	$	238,977		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 March 31, 2014 or December 31, 2013. The carrying amount of available-for-sale securities and their approximate fair values were as follows as of March 31, 2014 and December 31, 2013 (in thousands):

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Estimated Fair Value
March 31, 2014:
U.S. Treasury	$	4,892	$	-	$	(23	)	$	4,869
State and political subdivisions		148,789		2,971		(1,219	)		150,541
Other securities (FHLB, FHLMC and FNMA)		83,404		287		(124	)		83,567
Total	$	237,085	$	3,258	$	(1,366	)	$	238,977
December 31, 2013:
U.S. Treasury	$	-	$	-	$	-		$	-
State and political subdivisions		149,704		3,182		(1,520	)		151,366
Other securities (FHLB, FHLMC and FNMA)		86,998		316		(170	)		87,144
Total	$	236,702	$	3,498	$	(1,690	)	$	238,510

The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at March 31, 2014, were as follows (in thousands):

	Amortized Cost		Fair Value
Due in one year or less	$	42,923	$	43,192
Due after one year through five years		120,894		122,789
Due after five years through ten years		73,168		72,899
Due over ten years		100		97
Total	$	237,085	$	238,977

Page 12

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 4. Securities (continued)

As of March 31, 2014 investment securities with a carrying value of $40.58 million were pledged to collateralize short-term borrowings.

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

	Less than 12 months										12 months or more										Total
March 31, 2014 Description of Securities		#	Fair Value		Unrealized Loss			%				#	Fair Value		Unrealized Loss			%				#	Fair Value		Unrealized Loss			%
U.S. Treasury		2	$	4,869	$	(23	)		0.47	%		-	$	-	$	-			0.00	%		2	$	4,869	$	(23	)		0.47	%
State and political subdivisions		166		39,132		(941	)		2.40	%		34		6,897		(278	)		4.03	%		200		46,029		(1,219	)		2.65	%
Other securities (FHLB, FHLMC and FNMA)		9		19,693		(83	)		0.42	%		2		6,536		(41	)		0.63	%		11		26,229		(124	)		0.47	%
Total temporarily impaired securities		177	$	63,694	$	(1,047	)		1.64	%		36	$	13,433	$	(319	)		2.37	%		213	$	77,127	$	(1,366	)		1.77	%

	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		-	$	-	$	-			0.00	%		-	$	-	$	-			0.00	%		-	$	-	$	-			0.00	%
State and political subdivisions		164		36,212		(1,259	)		3.48	%		25		5,565		(261	)		4.69	%		189		41,777		(1,520	)		3.64	%
Other securities (FHLB, FHLMC and FNMA)		10		21,810		(149	)		0.68	%		1		2,557		(21	)		0.82	%		11		24,367		(170	)		0.70	%
Total temporarily impaired securities		174	$	58,022	$	(1,408	)		2.43	%		26	$	8,122	$	(282	)		3.47	%		200	$	66,144	$	(1,690	)		2.56	%

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

Page 13

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Loans

Classes of loans are as follows:

	March 31, 2014		December 31, 2013
	(Amounts In Thousands)
Agricultural	$	88,218	$	82,138
Commercial and financial		162,855		166,102
Real estate:
Construction, 1 to 4 family residential		28,474		30,309
Construction, land development and commercial		71,356		69,182
Mortgage, farmland		145,620		142,685
Mortgage, 1 to 4 family first liens		610,462		605,687
Mortgage, 1 to 4 family junior liens		105,226		105,785
Mortgage, multi-family		246,089		244,090
Mortgage, commercial		318,830		315,187
Loans to individuals		19,873		19,824
Obligations of state and political subdivisions		53,181		45,167
	$	1,850,184	$	1,826,156
Net unamortized fees and costs		635		641
	$	1,850,819	$	1,826,797
Less allowance for loan losses		25,860		25,550
	$	1,824,959	$	1,801,247

Page 14

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Loans (continued)

Changes in the allowance for loan losses, the allowance for loan losses applicable to impaired loans and the related loan balance of impaired loans for the three months ended March 31, 2014 were as follows:

	Agricultural			Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	2,852		$	4,733		$	2,918		$	2,557	$	7,064		$	4,787		$	639		$	25,550
Charge-offs		(100	)		(84	)		(2	)		-		(307	)		-			(33	)		(526	)
Recoveries		3			350			186			-		179			41			32			791
Provision		1,307			(480	)		(141	)		225		(315	)		(564	)		13			45
Ending balance	$	4,062		$	4,519		$	2,961		$	2,782	$	6,621		$	4,264		$	651		$	25,860
Ending balance, individually evaluated for impairment	$	3		$	14		$	14		$	-	$	58		$	208		$	-		$	297
Ending balance, collectively evaluated for impairment	$	4,059		$	4,505		$	2,947		$	2,782	$	6,563		$	4,056		$	651		$	25,563
Loans:
Ending balance	$	88,218		$	162,855		$	99,830		$	145,620	$	715,688		$	564,919		$	73,054		$	1,850,184
Ending balance, individually evaluated for impairment	$	274		$	2,669		$	1,285		$	284	$	4,011		$	17,662		$	-		$	26,185
Ending balance, collectively evaluated for impairment	$	87,944		$	160,186		$	98,545		$	145,336	$	711,677		$	547,257		$	73,054		$	1,823,999

Changes in the allowance for loan losses for the three months ended March 31, 2013 were as follows:

	Agricultural		Commercial and Financial			Real Estate: Construction and land development			Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family			Real Estate: Mortgage, multi- family and commercial			Other			Total
	(Amounts In Thousands)
Allowance for loan losses:
Beginning balance	$	1,653	$	4,573		$	3,175		$	1,746	$	8,088		$	5,104		$	821		$	25,160
Charge-offs		-		(115	)		(208	)		-		(249	)		(229	)		(42	)	$	(843	)
Recoveries		15		251			31			-		77			48			52		$	474
Provision		490		(241	)		249			319		(640	)		(212	)		(136	)	$	(171	)
Ending balance	$	2,158	$	4,468		$	3,247		$	2,065	$	7,276		$	4,711		$	695		$	24,620
Ending balance, individually evaluated for impairment	$	-	$	30		$	73		$	-	$	94		$	242		$	1		$	440
Ending balance, collectively evaluated for impairment	$	2,158	$	4,438		$	3,174		$	2,065	$	7,182		$	4,469		$	694		$	24,180
Loans:
Ending balance	$	79,819	$	157,538		$	110,094		$	118,223	$	678,654		$	525,836		$	62,005		$	1,732,169
Ending balance, individually evaluated for impairment	$	-	$	2,108		$	3,375		$	375	$	4,677		$	18,187		$	2		$	28,724
Ending balance, collectively evaluated for impairment	$	79,819	$	155,430		$	106,719		$	117,848	$	673,977		$	507,649		$	62,003		$	1,703,445

Page 15

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Loans (continued)

The following table presents the credit quality indicators by type of loans in each category as of March 31, 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
March 31, 2014
Grade:
Pass	$	62,168	$	129,582	$	23,188	$	57,712
Monitor		15,486		13,594		1,784		4,388
Special Mention		909		13,250		2,210		7,412
Substandard		9,655		6,429		1,292		1,844
Total	$	88,218	$	162,855	$	28,474	$	71,356

	Real Estate: Mortgage, farmland		Real Estate: Mortgage, 1 to 4 family first liens		Real Estate: Mortgage, 1 to 4 family junior liens		Real Estate: Mortgage, multi- family
March 31, 2014
Grade:
Pass	$	128,889	$	535,554	$	97,673	$	196,514
Monitor		12,047		32,744		2,599		30,669
Special Mention		1,608		21,708		2,911		18,054
Substandard		3,076		20,456		2,043		852
Total	$	145,620	$	610,462	$	105,226	$	246,089

	Real Estate: Mortgage, commercial		Loans to individuals		Obligations of state and political subdivisions		Total
March 31, 2014
Grade:
Pass	$	265,192	$	19,337	$	52,131	$	1,567,940
Monitor		32,235		130		1,050		146,726
Special Mention		14,595		292		-		82,949
Substandard		6,808		114		-		52,569
Total	$	318,830	$	19,873	$	53,181	$	1,850,184

Page 16

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Loans (continued)

	Agricultural		Commercial and Financial		Real Estate: Construction, 1 to 4 family residential		Real Estate: Construction, land development and commercial
December 31, 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

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.

Page 17

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Loans (continued)

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.

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

	30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Loans Receivable		Accruing Loans Past Due 90 Days or More
	(Amounts In Thousands)
March 31, 2014:
Agricultural	$	2,124	$	-	$	-	$	2,124	$	86,094	$	88,218	$	-
Commercial and financial		212		58		970		1,240		161,615		162,855		-
Real estate:
Construction, 1 to 4 family residential		-		-		144		144		28,330		28,474		-
Construction, land development and commercial		-		466		731		1,197		70,159		71,356		-
Mortgage, farmland		539		-		-		539		145,081		145,620		-
Mortgage, 1 to 4 family first liens		4,137		406		1,350		5,893		604,569		610,462		419
Mortgage, 1 to 4 family junior liens		106		193		71		370		104,856		105,226		-
Mortgage, multi-family		-		30		-		30		246,059		246,089		-
Mortgage, commercial		183		691		167		1,041		317,789		318,830		-
Loans to individuals		5		-		-		5		19,868		19,873		-
Obligations of state and political subdivisions		-		-		-		-		53,181		53,181		-
	$	7,306	$	1,844	$	3,433	$	12,583	$	1,837,601	$	1,850,184	$	419
December 31, 2013:
Agricultural	$	8	$	10	$	-	$	18	$	82,120	$	82,138	$	-
Commercial and financial		526		177		951		1,654		164,448		166,102		-
Real estate:
Construction, 1 to 4 family residential		-		-		-		-		30,309		30,309		-
Construction, land development and commercial		276		144		731		1,151		68,031		69,182		-
Mortgage, farmland		108		-		-		108		142,577		142,685		-
Mortgage, 1 to 4 family first liens		4,418		1,649		2,223		8,290		597,397		605,687		959
Mortgage, 1 to 4 family junior liens		835		43		29		907		104,878		105,785		-
Mortgage, multi-family		-		150		-		150		243,940		244,090		-
Mortgage, commercial		1,350		-		493		1,843		313,344		315,187		-
Loans to individuals		7		4		-		11		19,813		19,824		-
Obligations of state and political subdivisions		14		-		-		14		45,153		45,167		-
	$	7,542	$	2,177	$	4,427	$	14,146	$	1,812,010	$	1,826,156	$	959

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

Page 18

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Loans (continued)

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

	March 31, 2014						December 31, 2013
	Non-accrual loans (1)		Accruing loans past due 90 days or more (2)		TDR loans		Non- accrual loans (1)		Accruing loans past due 90 days or more (2)		TDR loans
	(Amounts In Thousands)						(Amounts In Thousands)
Agricultural	$	-	$	-	$	274	$	-	$	-	$	120
Commercial and financial		1,077		-		1,592		1,462		-		945
Real estate:
Construction, 1 to 4 family residential		144		-		-		-		-		-
Construction, land development and commercial		1,141		-		-		1,319		-		-
Mortgage, farmland		-		-		284		-		-		284
Mortgage, 1 to 4 family first liens		1,806		419		1,341		2,209		959		1,272
Mortgage, 1 to 4 family junior liens		218		-		227		178		-		-
Mortgage, multi-family		441		-		5,664		456		-		5,608
Mortgage, commercial		1,348		-		10,209		1,568		-		10,146
Loans to individuals		-		-		-		-		-		-
	$	6,175	$	419	$	19,591	$	7,192	$	959	$	18,375

(1) There were $2.26 million and $2.72 million of TDR loans included within nonaccrual loans as of March 31, 2014 and December 31, 2013, respectively.

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

Loans 90 days or more past due that are still accruing interest decreased $0.54 million from December 31, 2013 to March 31, 2014 due to a decrease in the number of loans past due greater than 90 days. The average accruing loans past due 90 days or more balance was $0.10 million as of March 31, 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.

Page 19

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Loans (continued)

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

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

	March 31, 2014						December 31, 2013
	Number						Number
	of		Recorded		Commitments		of		Recorded		Commitments
	contracts		investment		outstanding		contracts		investment		outstanding
			(Amounts In Thousands)						(Amounts In Thousands)
Agricultural		3	$	274	$	35		1	$	120	$	4
Commercial and financial		17		2,441		246		12		2,214		101
Real estate:
Construction, 1 to 4 family residential		-		-		-		-		-		-
Construction, land development and commercial		1		12		-		1		13		-
Mortgage, farmland		1		284		-		1		284		-
Mortgage, 1 to 4 family first liens		13		1,626		-		12		1,697		-
Mortgage, 1 to 4 family junior liens		1		227		72		-		-		177
Mortgage, multi-family		4		6,044		-		3		6,000		-
Mortgage, commercial		11		10,940		-		9		10,766		10
Loans to individuals		-		-		-		-		-		-
		51	$	21,848	$	353		39	$	21,094	$	292

The following is a summary of TDR loans that were modified during the three months ended March 31, 2014:

	Three Months Ended March 31, 2014
	Number		Pre-modification		Post-modification
	of		recorded		recorded
	contracts		investment		investment
			(Amounts In Thousands)
Agricultural		2	$	203	$	156
Commercial and financial		7		748		748
Real estate:
Mortgage, 1 to 4 family first lien		2		81		81
Mortgage, 1 to 4 family junior liens		1		225		225
Mortgage, multi-family		1		89		89
Mortgage, commercial		2		269		269
		15	$	1,615	$	1,568

The Company had commitments to lend $0.35 million in additional borrowings to restructured loan customers as of March 31, 2014.  The Company had commitments to lend $0.29million 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.

Page 20

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Loans (continued)

There were $1.03 million and $0.00 million of TDR loans that were in payment default (defined as past due 90 days or more) as of March 31, 2014 and December 31, 2013, respectively.  As of March 31, 2014, TDR loans in payment default consisted of a $0.09 million 1 to 4 family first lien mortgage loan, a $0.17 million commercial mortgage loan and two commercial and financial loans totaling $0.77 million.

Information regarding impaired loans as of and for the three months ended March 31, 2014 is as follows:

	March 31, 2014						Three Months Ended March 31, 2014
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:	(Amounts In Thousands)
Agricultural	$	156	$	231	$	-	$	194	$	3
Commercial and financial		1,458		2,912		-		1,459		5
Real estate:
Construction, 1 to 4 family residential		139		140		-		140		-
Construction, land development and commercial		1,146		2,775		-		1,235		-
Mortgage, farmland		-		-		-		-		-
Mortgage, 1 to 4 family first liens		2,262		3,135		-		2,278		5
Mortgage, 1 to 4 family junior liens		218		495		-		219		-
Mortgage, multi-family		529		1,151		-		537		1
Mortgage, commercial		2,186		4,804		-		2,240		11
Loans to individuals		-		20		-		-		-
	$	8,094	$	15,663	$	-	$	8,302	$	25
With an allowance recorded:
Agricultural	$	118	$	118	$	3	$	119	$	1
Commercial and financial		1,211		1,210		14		1,256		15
Real estate:
Construction, 1 to 4 family residential		-		-		-		-		-
Construction, land development and commercial		-		-		-		-		-
Mortgage, farmland		284		284		14		284		3
Mortgage, 1 to 4 family first liens		1,304		1,360		56		1,309		16
Mortgage, 1 to 4 family junior liens		227		227		2		226		3
Mortgage, multi-family		5,576		5,576		176		5,592		62
Mortgage, commercial		9,371		9,446		32		9,402		135
Loans to individuals		-		-		-		-		-
	$	18,091	$	18,221	$	297	$	18,188	$	235
Total:
Agricultural	$	274	$	349	$	3	$	313	$	4
Commercial and financial		2,669		4,122		14		2,715		20
Real estate:
Construction, 1 to 4 family residential		139		140		-		140		-
Construction, land development and commercial		1,146		2,775		-		1,235		-
Mortgage, farmland		284		284		14		284		3
Mortgage, 1 to 4 family first liens		3,566		4,495		56		3,587		21
Mortgage, 1 to 4 family junior liens		445		722		2		445		3
Mortgage, multi-family		6,105		6,727		176		6,129		63
Mortgage, commercial		11,557		14,250		32		11,642		146
Loans to individuals		-		20		-		-		-
	$	26,185	$	33,884	$	297	$	26,490	$	260

Page 21

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Loans (continued)

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 22

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 5. Loans (continued)

Impaired loans decreased $0.34million from December 31, 2013 to March 31, 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 1.42% of loans held for investment as of March 31, 2014 and 1.45% as of December 31, 2013.  The decrease in impaired loans is due mainly to a decrease in nonaccrual loans of $1.02 million from December 31, 2013 to March 31, 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.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6. Fair Value Measurements

The carrying value and estimated fair values of the Company's financial instruments as of March 31, 2014 are as follows:

	March 31, 2014
	Carrying Amount		Estimated Fair Value		Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)
	(Amounts In Thousands)
Financial instrument assets:
Cash and cash equivalents	$	89,077	$	89,077	$	89,077	$	-	$	-
Investment securities		246,631		246,631		-		246,631		-
Loans held for sale		1,870		1,870				1,870
Loans
Agricultural		84,156		92,990		-		-		92,990
Commercial and financial		158,336		178,080		-		-		178,080
Real estate:
Construction, 1 to 4 family residential		27,463		26,323		-		-		26,323
Construction, land development and commercial		69,406		67,131		-		-		67,131
Mortgage, farmland		142,838		139,387		-		-		139,387
Mortgage, 1 to 4 family first liens		604,761		596,228		-		-		596,228
Mortgage, 1 to 4 family junior liens		104,306		102,898		-		-		102,898
Mortgage, multi-family		244,391		241,548		-		-		241,548
Mortgage, commercial		316,264		312,217		-		-		312,217
Loans to individuals		19,610		19,766		-		-		19,766
Obligations of state and political subdivisions		52,793		53,064		-		-		53,064
Accrued interest receivable		8,751		8,751		-		8,751		-
Total financial instrument assets	$	2,170,653	$	2,175,961	$	89,077	$	257,252	$	1,829,632
Financial instrument liabilities
Deposits
Noninterest-bearing deposits	$	245,025	$	245,025	$	-	$	245,025	$	-
Interest-bearing deposits		1,529,178		1,533,422		-		1,533,422		-
Short-term borrowings		40,577		40,577		-		40,577		-
Federal Home Loan Bank borrowings		125,000		131,917		-		131,917		-
Accrued interest payable		1,036		1,036		-		1,036		-
Total financial instrument liabilities	$	1,940,816	$	1,951,977	$	-	$	1,951,977	$	-
	Face Amount
Financial instrument with off-balance sheet risk:
Loan commitments	$	355,917	$	-	$	-	$	-	$	-
Letters of credit		12,954		-		-		-		-
Total financial instrument liabilities with off-balance-sheet risk	$	368,871	$	-	$	-	$	-	$	-

(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.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6. Fair Value Measurements (continued)

The carrying value and estimated fair values of the Company's financial instruments as of December 31, 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.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6. Fair Value Measurements (continued)

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.  Recent market conditions have led to diminished, and in some cases, non-existent trading in certain of the financial asset classes.  The Company is required to use observable inputs, to the extent available, in the fair value estimation process unless that data results from forced liquidations or distressed sales.  Despite the Company’s best efforts to maximize the use of relevant observable inputs, the current market environment has diminished the observability of trades and assumptions that have historically been available.

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

ASSETS

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

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

The pricing for investment securities is obtained from an independent source.  There are no level 1 or level 3 investment securities owned by the Company.  The Company obtains an understanding of the independent source’s valuation methodologies used to determine fair value by level of security. The Company validates assigned fair values on a sample basis using an additional third-party provider pricing service to determine if the fair value measurement is reasonable.  Due to the nature of our investment portfolio, we do not expect significant and unusual fluctuations as fair value changes primarily relate to interest rate changes.   No unusual fluctuations were identified during the three months ended March 31, 2014.   If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6. Fair Value Measurements (continued)

ASSETS (continued)

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

Loans:  The Company does not record loans at fair value on a recurring basis.  For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values (Level 3).  The fair values for other loans are determined using estimated future cash flows, discounted at the interest rates currently being offered for loans with similar terms to borrowers with similar credit quality utilizing an entrance price concept (Level 3).  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).

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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6. Fair Value Measurements (continued)

LIABILITIES

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

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

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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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6. Fair Value Measurements (continued)

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

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

	March 31, 2014
	Readily Available Market Prices(1)		Observable Market Prices(2)		Company Determined Market Prices(3)		Total at Fair Value
	(Amounts In Thousands)
U.S. Treasury	$	-	$	4,869	$	-	$	4,869
State and political subdivisions		-		150,541		-		150,541
Other securities (FHLB, FHLMC and FNMA)		-		83,567		-		83,567
Total	$	-	$	238,977	$	-	$	238,977

	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 three months ended March 31, 2014.

Page 29

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6. Fair Value Measurements (continued)

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

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

	March 31, 2014								Three Months Ended March 31, 2014
	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	$	-	$	-	$	271	$	271	$	-
Commercial and financial		-		-		2,655		2,655		-
Real Estate:
Construction, 1 to 4 family residential		-		-		125		125		-
Construction, land development and commercial		-		-		1,146		1,146		-
Mortgage, farmland		-		-		284		284		-
Mortgage, 1 to 4 family first liens		-		-		3,510		3,510		15
Mortgage, 1 to 4 family junior liens		-		-		443		443		24
Mortgage, multi-family		-		-		5,929		5,929		-
Mortgage, commercial		-		-		11,525		11,525		100
Loans to individuals		-		-		-		-		-
Foreclosed assets (5)		-		-		20		20		23
Total	$	-	$	-	$	25,908	$	25,908	$	162

(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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HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 6. Fair Value Measurements (continued)

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

	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.

Page 31

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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 354,124 shares of its common stock in privately negotiated transactions from August 1, 2005 through March 31, 2014.  Of these 354,124 shares, 6,855 shares were purchased during the quarter ended March 31, 2014, at an average price per share of $75.37.

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 $71.09 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.  In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the accompanying consolidated financial statements.

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

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

	March 31, 2014		December 31, 2013
	(Amounts In Thousands)
Firm loan commitments and unused portion of lines of credit:
Home equity loans	$	39,106	$	38,243
Credit cards		44,896		44,326
Commercial, real estate and home construction		91,511		106,241
Commercial lines and real estate purchase loans		180,404		172,135
Outstanding letters of credit		12,954		11,019

Page 32

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 9. Income Taxes

Federal income tax expense for the three months ended March 31, 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 March 31, 2014  and December 31, 2013 and therefore no interest or penalties on unrecognized tax benefits has been recorded.  As of March 31, 2014, the Company does not anticipate any significant increase in unrecognized tax benefits during the twelve-month period ending March 31, 2015.

Income taxes as a percentage of income before taxes were 26.16% for the three months ended March 31, 2014 and 30.51% for the same period in 2013.  The decrease in the effective tax rate is due to tax-exempt interest income and the relationship to total income before income taxes.

Page 33

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 outline collateral pledging requirements for each counterparty.  Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty.  The Bank was not required to pledge any collateral as of March 31, 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 March 31, 2014 and December 31, 2013:

	Notional Amount		Fair Value			Balance Sheet Category	Maturity
	(Amounts in Thousands)
March 31, 2014
Interest rate swap	$	25,000	$	2		Other Liabilities	11/9/2020
Interest rate swap		25,000		(312	)	Other Liabilities	11/7/2023
December 31, 2013
Interest rate swap	$	25,000	$	357		Other Assets	11/9/2020
Interest rate swap		25,000		412		Other Assets	11/7/2023

Page 34

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Note 10.   Derivative Financial Instruments (continued)

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

	Effective Portion						Ineffective Portion
	Recognized in OCI			Reclassifed from AOCI into Income			Recognized in Income on Derivatives
	Amount of Gain (Loss)			Category	Amount of Gain (Loss)		Category	Amount of Gain (Loss)
	(Amounts in Thousands)
March 31, 2014
Interest rate swap	$	(219	)	Interest Expense	$	-	Other Income	$	-
Interest rate swap		(447	)	Interest Expense		-	Other Income		-
December 31, 2013
Interest rate swap	$	220		Interest Expense	$	-	Other Income	$	-
Interest rate swap		255		Interest Expense		-	Other Income		-

Page 35

HILLS BANCORPORATION

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

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

Special Note Regarding Forward Looking Statements

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

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

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

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

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

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

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

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

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

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

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

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

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HILLS BANCORPORATION

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

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

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

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

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

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

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

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

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

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

Critical Accounting Policies

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. The financial information contained within these financial statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Based on its consideration of accounting policies that involve the most complex and subjective decisions and assessments, management has identified its most critical accounting policies to be those which are related to the allowance for loan losses. The Company's allowance for loan losses methodology incorporates a variety of risk considerations, both quantitative and qualitative in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include the general economic environment in the Company's markets, including economic conditions throughout the Midwest and the state of certain industries.  Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management.  Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position.  Size and complexity of individual credits in relation to loan structure, existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the methodology. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. This discussion of the Company’s critical accounting policies should be read in conjunction with the Company’s consolidated financial statements and the accompanying notes presented elsewhere herein, as well as other relevant portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations.  Although management believes the levels of the allowance as of March 31, 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.

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HILLS BANCORPORATION

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

Overview

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

The Company is a holding company engaged in the business of commercial banking.  The Company’s subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned.  The Bank was formed in Hills, Iowa in 1904.  The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa.  At March 31, 2014, the Bank has seventeen full-service locations.

Net income for the three month period ended March 31, 2014 was $6.74 million compared to $6.81 million for the same three months of 2013, a decrease of 1.03%.  The $0.07 million decrease in net income was caused by a number of factors.  The principal factors in the decrease in net income for the first three months of 2014 are a decrease in noninterest income of $0.67 million, an increase in the provision for loan losses of $0.22 million and an increase in noninterest expenses of $0.22 million.  These changes were offset by an increase in net interest income of $0.44 million and a decrease in income tax expense of $0.60 million.

The Company achieved a return on average assets of 1.22% and a return on average equity of 11.30% for the twelve months ended March 31, 2014, compared to the twelve months ended March 31, 2013, which were 1.25% and 11.81%, respectively.Dividends of $1.15 per share were paid in January 2014 to 2,204 shareholders.  The 2012 dividend was $1.10 per share.

The Bank’s net interest income is the largest component of revenue and it is primarily a function of the average earning assets and the net interest margin percentage.The Bank achieved a net interest margin on a tax-equivalent basis of 3.47% for the three months ended March 31, 2014 compared to 3.59% for the same three months of 2013.  Average earning assets were $2.066 billion in 2013 and $1.967 billion in 2013.

Highlights noted on the balance sheet as of March 31, 2014 for the Company included the following:

Ÿ Total assets were $2.235 billion, an increase of $67.58 million since December 31, 2013.

Ÿ Cash and cash equivalents were $89.08 million, an increase of $45.38 million since December 31, 2013.

Ÿ Net loans were $1.827 billion, an increase of $20.66 million since December 31, 2013.  Loans held for sale decreased $3.06 million since December 31, 2013.

Ÿ Deposit growth of $64.33 million since December 31, 2013.  Deposit growth included $68.35 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.

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HILLS BANCORPORATION

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

Financial Condition

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

	March 31, 2014					December 31, 2013
	Amount		Percent			Amount		Percent
	(Amounts In Thousands)					(Amounts In Thousands)
Agricultural	$	88,218		4.77	%	$	82,138		4.50	%
Commercial and financial		162,855		8.80			166,102		9.10
Real estate:
Construction, 1 to 4 family residential		28,474		1.54			30,309		1.66
Construction, land development and commercial		71,356		3.86			69,182		3.79
Mortgage, farmland		145,620		7.87			142,685		7.81
Mortgage, 1 to 4 family first liens		610,462		33.00			605,687		33.16
Mortgage, 1 to 4 family junior liens		105,226		5.69			105,785		5.79
Mortgage, multi-family		246,089		13.30			244,090		13.37
Mortgage, commercial		318,830		17.23			315,187		17.26
Loans to individuals		19,873		1.07			19,824		1.09
Obligations of state and political subdivisions		53,181		2.87			45,167		2.47
	$	1,850,184		100.00	%	$	1,826,156		100.00	%
Net unamortized fees and costs		635					641
	$	1,850,819				$	1,826,797
Less allowance for loan losses		25,860					25,550
	$	1,824,959				$	1,801,247

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

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

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

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HILLS BANCORPORATION

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

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.

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 March 31, 2014 and December 31, 2013:

	March 31, 2014								December 31, 2013
	Amount		% of Total Allowance			% of Loans to Total Loans			Amount		% of Total Allowance			% of Loans to Total Loans
	(In Thousands)								(In Thousands)
Agricultural	$	4,062		15.71	%		4.77	%	$	2,852		11.17	%		4.50	%
Commercial and financial		4,519		17.47			8.80			4,733		18.52			9.10
Real estate:
Construction, 1 to 4 family residential		1,011		3.91			1.54			1,011		3.96			1.66
Construction, land development and commercial		1,950		7.54			3.86			1,907		7.46			3.79
Mortgage, farmland		2,782		10.76			7.87			2,557		10.01			7.81
Mortgage, 1 to 4 family first liens		5,701		22.04			33.00			6,101		23.87			33.16
Mortgage, 1 to 4 family junior liens		920		3.56			5.69			963		3.77			5.79
Mortgage, multi-family		1,698		6.57			13.30			2,064		8.08			13.37
Mortgage, commercial		2,566		9.92			17.23			2,723		10.66			17.26
Loans to individuals		263		1.02			1.07			369		1.44			1.09
Obligations of state and political subdivisions		388		1.50			2.87			270		1.06			2.47
	$	25,860		100.00	%		100.00	%	$	25,550		100.00	%		100.00	%

The allowance for loan losses totaled $25.86 million at March 31, 2014 compared to $25.55 million at December 31, 2013.  The percentage of the allowance to outstanding loans was 1.40% and 1.40% at March 31, 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 increase in the allowance in 2014 is the result of an increase in the size of the Company’s loan portfolio as well as a change in the composition and allocation of loans within credit quality ratings.

Page 40

HILLS BANCORPORATION

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

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

Management has determined that the allowance for loan losses was appropriate at March 31, 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.

Investment securities available for sale held by the Company increased by $0.47 million from December 31, 2013 to March 31, 2014.  The fair value of securities available for sale was $1.89 million more than the amortized cost of such securities as of March 31, 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 $64.33 million in the first three months of 2014.  Deposit growth included $68.35 million of temporary public funds.  These temporary public funds are also included in the increase in cash and cash equivalents for the first three months of 2014.  Repurchase agreements decreased $1.44 million in the same period.  In the opinion of the Company’s management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth.

Brokered deposits are included in total deposits and totaled $55.82 million as of March 31, 2014 with an average rate of 0.43%.  Brokered deposits were $57.77 million as of December 31, 2013 with an average interest rate of 0.44%.  As of March 31, 2014 and December 31, 2013, brokered deposits were 3.15% and 3.38% of total deposits, respectively.

Page 41

HILLS BANCORPORATION

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

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 March 31, 2014 totaled $243.84 million.  Under risk-based capital rules, the total amount of Tier 1 risk-based capital was 16.23% and 16.19% as of March 31, 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 17.48% and 17.44% as of March 31, 2014 and December 31, 2013, respectively. As of March 31, 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.

Page 42

HILLS BANCORPORATION

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

Net Income Overview

Net income decreased $0.07 million for the three months ended March 31, 2014 compared to the first three months of 2013.  Total net income was $6.74 million in 2014 and $6.81 million in the comparable period in 2013, a decrease of 1.03%.  The changes in net income in 2014 from the first three months of 2013 were primarily the result of the following:

Ÿ Net interest income increased by $0.44 million, before provision expense, primarily as a result of total interest expense reductions significantly outpacing reductions in total interest income.

Ÿ The provision for loan losses increased by $0.22 million.

Ÿ Noninterest income decreased by $0.67 million.

Ÿ Noninterest expenses increased by $0.22 million.

Ÿ Income tax expense decreased by $0.60 million.

For the three-month periods ended March 31, 2014 and 2013, basic earnings per share were $1.43 and $1.44, respectively. Diluted earnings per share were $1.43 for the three months ended March 31, 2014 compared to $1.44 for the same period in 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 earnings assets.Net interest income of $17.02 million for the first three months of 2014 was derived from the Company’s$2.066 billion of average earning assets during that period and its tax-equivalent net interest margin of 3.47%.  Average earning assets in the three months ended March 31, 2013 were $1.967 billion and the tax-equivalent net interest margin was 3.59%.The importance of net interest margin is illustrated by the fact that an increase or decrease in the net interest margin of 10 basis points would have resulted approximately in a $0.52 million change in income before income taxes in the three month period ended March 31, 2014.  Net interest income for the Company decreased due to the decrease in the interest rates on average earning assets.  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 $1.827 billion at March 31, 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 an expense of $0.05 million in 2014 compared to a reduction of expense of $0.17 million in 2013.  The Company believes that the provision for loan losses will continue to increase for the foreseeable future resulting from projected increases in the size of the Company’s loan portfolio as well as stabilization of credit quality.

The third significant factor affecting the Company’s net income is income tax expense.  Federal and state income tax expenses were $2.39 million and $2.99 million for the three months ended March 31, 2014 and 2013, respectively.  Income taxes as a percentage of income before taxes were 26.16% in 2014 and 30.51% in 2013.

Page 43

HILLS BANCORPORATION

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

Discussion of operations for the three months ended March 31, 2014 and 2013

Net Interest Income

Net interest income increased for the three months ended March 31, 2014 compared to the comparable period in 2013.  The increase was primarily the result of a decrease in net interest expense due to the mix of interest bearing liabilities of the bank as well as a reduction in dollar amount and rate on time deposits.  Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities.  The factors that have the greatest impact on net interest income are the volume of average earning assets and the net interest margin.  The net interest margin for the first three months of 2014 was 3.47% compared to 3.59% in 2013 for the same period.  The measure is shown on a tax-equivalent basis using a tax rate of 35% to make the interest earned on taxable and non-taxable assets more comparable.  The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2014 compared to the comparable period in 2013 are shown in the following table:

							Increase (Decrease) in Net Interest Income
	Change in Average Balance			Change in Average Rate			Volume Changes			Rate Changes			Net Change
	(Amounts in Thousands)
Interest income:
Loans, net	$	101,393			(0.30	)%	$	1,180		$	(1,347	)	$	(167	)
Taxable securities		(4,775	)		(0.27	)		(18	)		(62	)		(80	)
Nontaxable securities		18,880			(0.54	)		191			(201	)		(10	)
Federal funds sold		(16,564	)		0.01			(11	)		-			(11	)
	$	98,934					$	1,342		$	(1,610	)	$	(268	)
Interest expense:
Interest-bearing demand deposits	$	35,726			(0.04	)%	$	(19	)	$	43		$	24
Savings deposits		87,582			(0.01	)		(50	)		8			(42	)
Time deposits		(56,283	)		(0.21	)		244			270			514
Short-term borrowings		1,465			(0.04	)		(2	)		4			2
FHLB borrowings		-			-			-			-			-
Interest-bearing other liabilities		(55	)		(1.73	)		-			12			12
	$	68,435					$	173		$	337		$	510
Change in net interest income							$	1,515		$	(1,273	)	$	242

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

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

(Tax Equivalent Basis)	2014			2013
Yield on average interest-earning assets		4.22	%		4.49	%
Rate on average interest-bearing liabilities		0.95			1.13
Net interest spread		3.27	%		3.36	%
Effect of noninterest-bearing funds		0.20			0.23
Net interest margin (tax equivalent interest income divided by average interest-earning assets)		3.47	%		3.59	%

Page 44

HILLS BANCORPORATION

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

Discussion of operations for the three months ended March 31, 2014 and 2013

Net Interest Income (continued)

In pricing loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining interest rates.  The Federal Open Market Committee met three times during the first three 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 March 31, 2014, the rate indexes for the one, three and five year indexes were 0.14%, 0.85% and 1.67%, respectively.  The one year index decreased 6.67% from 0.15% at March 31, 2013, the three year index increased 223.68% and the five year index increased 208.75%.  The three year index was 0.38% and the five year index was 0.80% at March 31, 2013.  The targeted federal funds rate was 0.25% at March 31, 2014 and 2013.  The Company anticipates gradual increases in the indexes for 2014.

Provision for Loan Losses

The provision for loan losses was an expense of $0.05 million in 2014 compared to a reduction of expense of $0.17 million in 2013, an increase of $0.22 million.  The loan loss provision is the amount necessary to adjust the allowance to the level considered appropriate by management.  The provision is computed on a quarterly basis and is a result of management’s determination of the quality of the loan portfolio.  The provision reflects a number of factors, including the size of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact on the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more.  In addition, management considers the credit quality of the loans based on management’s review of problem and watch loans, including loans with historical higher credit risks.  The increase in expense in 2014 is the result of an increase in loan volume as well as a change in the composition and allocation of balances within the credit quality ratings.

The allowance for loan losses increased $0.31 million during the first three months of 2014.  In the first three months of 2014, there was a decrease of $0.33 million due to the volume and composition of loans outstanding and a $0.64 million increase in the amount allocated to the allowance due to a combination of deterioration in credit quality and charge-offs.

The allowance for loan losses balance is affected by charge-offs, net of recoveries, for the periods presented.  For the three months ended March 31, 2014 and 2013, recoveries were $0.79 million and $0.48 million, respectively; and charge-offs were $0.53 million in 2014 and $0.84 million in 2013.  The allowance for loan losses totaled $25.86 million at March 31, 2014 compared to $25.55 million at December 31, 2013.  The allowance represented 1.40% and 1.40% of loans held for investment at March 31, 2014 and December 31, 2013, respectively.

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HILLS BANCORPORATION

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

Discussion of operations for the three months ended March 31, 2014 and 2013

Noninterest Income

The following table sets forth the various categories of noninterest income for the three months ended March 31, 2014 and 2013.

	Three Months Ended March 31,
	2014		2013		$ Change			% Change
	(Amounts in thousands)
Net gain on sale of loans	$	111	$	741	$	(630	)		(85.02	)%
Trust fees		1,460		1,260		200			15.87
Service charges and fees		1,837		2,114		(277	)		(13.10	)
Rental revenue on tax credit real estate		357		319		38			11.91
Net gain on sale of other real estate owned and other reposessed assets		72		40		32			80.00
Other noninterest income		584		614		(30	)		(4.89	)
	$	4,421	$	5,088	$	(667	)		(13.11	)

Loans originated for sale in the first three months of 2014 totaled $16.52 million compared to $59.08 million in the same period in 2013, a decrease of 72.04%.  In the three months ended March 31, 2014 and 2013, the net gain on sale of loans was $0.11 million and $0.74 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 $0.20 million in the first three months of 2014 as a result of assets under management increasing to $1.219 billion as of March 31, 2014 from $1.168 billion as of March 31, 2013 due to market conditions and new trust relationships.

Service charges and fees decreased $0.28 million in the first three 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 $0.33 million due to a change to an agent program utilized by the Bank.  This decrease was offset by an increase of $0.05 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 $0.03 million to a net gain of $0.07 million for the three months ended March 31, 2014.  The total net gain on sale of other real estate owned for the three months ended March 31, 2014 consisted of a $0.09 million net gain on the sale of 3 properties offset by a $0.02 million fair market value adjustment on one property.  During the same period in 2013, the gain consisted of a $0.04 net gain on sale of one property within other real estate owned.

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HILLS BANCORPORATION

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

Discussion of operations for the three months ended March 31, 2014 and 2013

Noninterest Expenses

The following table sets forth the various categories of noninterest expenses for the three months ended March 31, 2014 and 2013.

	Three Months Ended March 31,
	2014		2013		$ Change			% Change
	(Amounts in thousands)
Salaries and employee benefits	$	6,257	$	5,963	$	294			4.93	%
Occupancy		1,009		942		67			7.11
Furniture and equipment		1,231		1,281		(50	)		(3.90	)
Office supplies and postage		382		382		-			-
Advertising and business development		628		620		8			1.29
Outside services		1,535		1,800		(265	)		(14.72	)
Rental expenses on tax credit real estate		530		344		186			54.07
FDIC insurance assessment		270		261		9			3.45
Other noninterest expense		416		440		(24	)		(5.45	)
	$	12,258	$	12,033	$	225			1.87

Outside services expenses decreased $0.27 million in the first three 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 $0.31 million due to a change to an agent program utilized by the Bank.  Most other noninterest expense categories experienced marginal period-to-period increases for the three months ended March 31, 2014.

Income Taxes

Federal and state income tax expenses were $2.39 million and $2.99 million for the three months ended March 31, 2014 and 2013, respectively.  Income taxes as a percentage of income before taxes were 26.16% in 2014 and 30.51% in 2013.

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HILLS BANCORPORATION

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

Liquidity

The Company actively monitors and manages its liquidity position with the objective of maintaining sufficient cash flows to fund operations, meet client commitments, take advantage of market opportunities and provide a margin against unforeseeable liquidity needs.  Federal funds sold and investment securities available for sale are readily marketable assets.  Maturities of all investment securities are managed to meet the Company’s normal liquidity needs, to respond to market changes or to adjust the Company’s interest rate risk position.  Investment securities available for sale comprised 10.69% of the Company’s total assets at March 31, 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 March 31, 2014, the Company had borrowed $125 million from the Federal Home Loan Bank (“FHLB”) of Des Moines.Advances are used as a means of providing both long and short-term, fixed-rate funding for certain assets and for managing interest rate risk.  The Company had additional borrowing capacity available from the FHLB of approximately $428.06 million at March 31, 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 $205.49 million.The borrowings under these credit lines would be secured by the Bank’s investment securities.  The combination of high levels of potentially liquid assets, low dependence on volatile liabilities and additional borrowing capacity provided sources of liquidity for the Company which management considered sufficient at March 31, 2014.

As of March 31, 2014, investment securities with a carrying value of $40.58 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.

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.

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HILLS BANCORPORATION

Item 3. Quantitative and Qualitative Disclosures about Market Risk

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

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

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

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

Item 4. Controls and Procedures

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

Item 1A. Risk Factors

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

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

The following table sets forth information about the Company’s stock purchases, all of which were made pursuant to the 2005 Stock Repurchase Program, for the three months ended March 31, 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)
January 1 to January 31		2,295	$	75.00		349,564		400,436
February 1 to February 28		2,216		75.17		351,780		398,220
March 1 to March 31		2,344		75.92		354,124		395,876
Total		6,855	$	75.37		354,124		395,876

(1)  On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to 750,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”).  The Company’s Board of Directors authorized the 2005 Stock Repurchase Program through December 31, 2015. The Company expects the purchases pursuant to the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price equal to the most recent quarterly independent appraisal of the shares of the Company’s common stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a quarterly basis.  All purchases made pursuant to the 2005 Stock Repurchase Program since its inception have been made on that basis.  The amount and timing of stock repurchases will be based on various factors, such as the Board’s assessment of the Company’s capital structure and liquidity, the amount of interest shown by shareholders in selling shares of stock to the Company at their appraised value, and applicable regulatory, legal and accounting factors.

During the first three months of 2014, the Company issued 127 shares of restricted stock under the 2010 Stock Option and Incentive Plan.  The restricted shares were issued to officers of the company for no cash consideration and will vest over a five-year period from the date of grant.  The issuance of these shares was exempt from the registration requirements of the SEC pursuant to Section 4(2) of the Securities Act of 1933.

Item 3. Defaults upon Senior Securities

Hills Bancorporation has no senior securities.

Item 4. Mine Safety Disclosure

Not applicable.

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HILLS BANCORPORATION

PART II - OTHER INFORMATION (Continued)

Item 5. Other Information

None

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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SIGNATURES

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

	HILLS BANCORPORATION
Date:  May 9, 2014	By:  /s/ Dwight O. Seegmiller
	Dwight O. Seegmiller, Director, President and Chief Executive Officer
Date:  May 9, 2014	By:  /s/ Shari DeMaris
	Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer

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HILLS BANCORPORATION

QUARTERLY REPORT OF FORM 10-Q FOR THE

QUARTER ENDED MARCH 31, 2014

Exhibit Number	Description	Page Number In The Sequential Numbering System March 31, 2014 Form 10-Q
31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002	54-55
32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002	56

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