HILLS BANCORPORATION 10-K

Item 7A. 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 of 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. Page 56 Table of Contents The Bank uses derivative financial instruments, when needed, to manage the impact of changes in interest rates on future interest income or interest expense. The Bank is exposed to credit-related losses in the event of nonperformance by the counterparties to these derivative instruments, but believe the risk of the these losses has been minimized by entering into the contracts with large, stable financial institutions. The estimated fair market value of these derivative instruments are presented in Note 17 to the Consolidated Financial Statements. In order to minimize the potential effects of adverse material and prolonged increases or decreases in market interest rates on the Company's operations, management has implemented an asset/liability program designed to mitigate the Company's interest rate sensitivity. The program emphasizes the origination of adjustable rate loans, which are held in the portfolio, the investment of excess cash in short or intermediate term interest-earning assets, and the solicitation of transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly. The table set forth below includes the portion of the balances in interest-bearing checking, savings and money market accounts that management has estimated to mature within one year. The classifications are used because the Bank’s historical data indicates that these have been very stable deposits without much interest rate fluctuation. Historically, these accounts would not need to be adjusted upward as quickly in a period of rate increases so the interest risk exposure would be less than the re-pricing schedule indicates. The FHLB borrowings are classified based on either their due date or if they are callable on their most likely call date based on the interest rate. Repricing Maturities Days More Than Immediately 2-30 31-90 91-180 181-365 One Year Total (Amounts in Thousands) Earning assets: Excess Cash $ 540,364 $ — $ — $ — $ — $ — $ 540,364 Federal funds sold 140 — — — — — 140 Investment securities — 2,909 8,237 31,784 16,375 357,239 416,544 Loans 9,901 239,584 56,722 95,296 190,266 2,163,260 2,755,029 Total earning assets 550,405 242,493 64,959 127,080 206,641 2,520,499 3,712,077 Sources of funds: Interest-bearing checking and savings accounts 145,803 — — — — 1,817,071 1,962,874 Certificates of deposit — 24,683 39,929 115,012 128,338 389,542 697,504 FHLB borrowings — — — — — 105,000 105,000 Federal funds and repurchase agreements — — — — — — — 145,803 24,683 39,929 115,012 128,338 2,311,613 2,765,378 Other sources, primarily noninterest-bearing — — — — — 944,897 944,897 Total sources 145,803 24,683 39,929 115,012 128,338 3,256,510 3,710,275 Interest Rate Gap $ 404,602 $ 217,810 $ 25,030 $ 12,068 $ 78,303 $ (736,011) $ 1,802 Cumulative Interest Rate Gap at December 31, 2020 $ 404,602 $ 622,412 $ 647,442 $ 659,510 $ 737,813 $ 1,802 Gap Ratio 3.77 9.82 1.63 1.10 1.61 0.77 Cumulative Gap Ratio 3.77 4.65 4.08 3.03 2.63 1.00 Page 57 Table of Contents Based on the data following, net interest income should decline with instantaneous increases in interest rates while net interest income should increase with instantaneous declines in interest rates. Generally, during periods of increasing interest rates, the Company's interest rate sensitive liabilities would re-price faster than its interest rate sensitive assets causing a decline in the Company's interest rate spread and margin. This would tend to reduce net interest income because the resulting increase in the Company’s cost of funds would not be immediately offset by an increase in its yield on earning assets. In times of decreasing interest rates, fixed rate assets could increase in value and the lag in re-pricing of interest rate sensitive assets could be expected to have a positive effect on the Company's net interest income. The following table, which presents principal cash flows and related weighted average interest rates by expected maturity dates, provides information about the Company's loans, investment securities and deposits that are sensitive to changes in interest rates. 2021 2022 2023 2024 2025 Thereafter Total Fair Value (Amounts In Thousands) Assets: Loans, fixed: Balance $ 357,894 $ 213,587 $ 122,220 $ 210,923 $ 628,736 $ 166,043 $ 1,699,403 $ 1,520,966 Average interest rate 4.10 % 3.02 % 4.62 % 4.54 % 3.92 % 3.25 % 3.91 % Loans, variable: Balance $ 172,642 $ 132,963 $ 128,135 $ 112,747 $ 328,420 $ 135,834 $ 1,010,741 $ 1,167,185 Average interest rate 3.87 % 4.12 % 4.22 % 4.41 % 3.82 % 4.02 % 4.01 % Investments (1): Balance $ 67,688 $ 54,405 $ 58,711 $ 70,737 $ 55,457 $ 109,546 $ 416,544 $ 416,544 Average interest rate 1.84 % 2.27 % 2.31 % 1.62 % 1.15 % 2.59 % 2.02 % Liabilities: Liquid deposits (2): Balance $ — $ — $ — $ — $ — $ — $ 1,962,874 $ 1,962,867 Average interest rate — % — % — % — % — % — % 0.24 % Deposits, certificates: Balance $ 307,962 $ 190,763 $ 150,275 $ 39,089 $ 9,415 $ — $ 697,504 $ 709,848 Average interest rate 1.49 % 1.71 % 2.87 % 1.47 % 0.91 % — % 1.84 % (1) Includes all available-for-sale investments, federal funds and Federal Home Loan Bank stock. (2) Includes NOW and other demand, savings and money market funds. Item 8. Consolidated Financial Statements and Supplementary Data The consolidated financial statements and supplementary data are included on pages 59 through 119. Page 58 Report of Independent Registered Public Accounting Firm To the Shareholders, Board of Directors and Audit Committee Hills Bancorporation Hills, Iowa Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Hills Bancorporation (the “Company”) as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2020, and the related notes (collectively referred to as the “financial statements”). In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2020, in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) ("PCAOB"), the Company’s internal control over financial reporting as of December 31, 2020, based on Internal Control-Integrated Framework (2013) and our report dated March 5, 2021, expressed an unqualified opinion. Basis for Opinion These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matter communicated below is a matter arising from the current-period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. Page 59 Allowance for Loan Losses As more fully described in Notes 1 and 3 to the Company’s consolidated financial statements, the allowance for loan losses represents losses that are estimated to have occurred. The allowance for loan losses is based on collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. The allowance consists of allocated and general components. The allocated component relates to specific allowances on loans that are classified as impaired. The general component relates to loans that are not classified as impaired and is based on historical charge-off experience and the expected loss, given default, derived from the Company’s internal risk rating process. Other adjustments have been made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected in the historical loss or risk rating data. Management discloses that this evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. We identified the valuation of the allowance for loan losses as a critical audit matter. Auditing the allowance for loan losses involves a high degree of subjectivity in evaluating management’s estimates, such as evaluating management’s assessment of economic conditions and other qualitative or environmental factors, evaluating the adequacy of specific allowances associated with impaired loans, and assessing the appropriateness of loan grades. The primary procedures we performed to address this critical audit matter included: • Testing the design and operating effectiveness of controls, including those related to technology, over the allowance for loan losses, including data completeness and accuracy, classifications of loans by loan segment, historical loss data, the calculation of loss rates, the establishment of qualitative adjustments, grading and risk classification of loans and establishment of specific reserves on impaired loans, and management’s review and disclosure controls over the allowance for loan losses; • Testing of completeness and accuracy of the information utilized in the calculation of the allowance for loan losses; • Testing the allowance model for computational accuracy; • Evaluating the qualitative adjustments to historical loss rates, including assessing the basis for the adjustments and the reasonableness of the significant assumptions; • Testing the internal loan review functions and evaluating the accuracy of loan grades, including utilizing our internal loan review professionals to assist us; • Assessing the reasonableness of specific allowances on certain impaired loans; • Evaluating the overall reasonableness of significant assumptions used by management, considering the past performance of the Company and evaluating trends identified within peer groups; • Evaluating the accuracy and completeness of disclosures in the consolidated financial statements. BKD, LLP We have served as the Company’s auditor since 2012. Springfield, Missouri March 5, 2021 Page 60 Report of Independent Registered Public Accounting Firm To the Shareholders, Board of Directors and Audit Committee Hills Bancorporation Hills, Iowa Opinion on the Internal Control over Financial Reporting We have audited Hills Bancorporation's (the "Company") internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) ("PCAOB"), the consolidated financial statements of the Company and our report dated March 5, 2021, expressed an unqualified opinion. Basis for Opinion The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definitions and Limitations of Internal Control over Financial Reporting A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of reliable financial statements in accordance with accounting principles generally accepted in the United States of America. Because management's assessment and our audit also were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), our audit of Hills Bancorporation's internal control over financial reporting included controls over the preparation of financial statements in accordance with accounting principles generally accepted in the United States of America and with the instructions to the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C). A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention, or timely detection and correction of unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements. Page 61 Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. BKD, LLP Springfield, Missouri March 5, 2021 Page 62 Table of Contents HILLS BANCORPORATION CONSOLIDATED BALANCE SHEETS December 31, 2020 and 2019 (Amounts In Thousands, Except Shares) ASSETS 2020 2019 Cash and cash equivalents $ 574,310 $ 241,965 Investment securities available for sale at fair value (amortized cost 2020 $ 396,670 ; 2019 $ 351,069 ) (Notes 1, 2 and 13) 408,372 355,303 Stock of Federal Home Loan Bank 8,172 11,065 Loans held for sale 43,947 8,400 Loans, net of allowance for loan losses (2020 $ 37,070 ; 2019 $ 33,760 ) (Notes 1, 3, and 12) 2,674,012 2,606,277 Property and equipment, net (Note 4) 35,878 37,146 Tax credit real estate 7,273 8,280 Accrued interest receivable 12,177 12,442 Deferred income taxes, net (Note 10) 6,088 8,018 Goodwill 2,500 2,500 Other assets 7,882 9,491 Total Assets $ 3,780,611 $ 3,300,887 LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Noninterest-bearing deposits $ 532,190 $ 387,612 Interest-bearing deposits (Note 6) 2,660,378 2,273,752 Total deposits 3,192,568 2,661,364 Federal Home Loan Bank borrowings (Note 7) 105,000 185,000 Accrued interest payable 1,733 2,474 Other liabilities 17,905 25,012 Total Liabilities 3,317,206 2,873,850 Commitments and Contingencies (Notes 9 and 15) Redeemable Common Stock Held By Employee Stock Ownership Plan (ESOP) (Note 9) 47,329 51,826 Stockholders' Equity (Note 11) Common stock, no par value; authorized 20,000,000 shares; issued 2020 10,330,242 shares; 2019 10,327,656 shares — — Paid in capital 60,233 55,943 Retained earnings 439,831 409,509 Accumulated other comprehensive gain (Note 8) 8,782 1,415 Treasury stock at cost (2020 999,247 shares; 2019 975,962 shares) ( 45,441 ) ( 39,830 ) Total Stockholders' Equity 463,405 427,037 Less maximum cash obligation related to ESOP shares (Note 9) 47,329 51,826 Total Stockholders' Equity Less Maximum Cash Obligations Related To ESOP Shares 416,076 375,211 Total Liabilities & Stockholders' Equity $ 3,780,611 $ 3,300,887 See Notes to Consolidated Financial Statements. Page 63 Table of Contents HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, 2020, 2019 and 2018 (Amounts In Thousands, Except Per Share Amounts) 2020 2019 2018 Interest income: Loans, including fees $ 120,196 $ 121,269 $ 110,588 Investment securities: Taxable 3,512 3,239 2,759 Nontaxable 3,876 3,844 3,511 Federal funds sold 945 3,980 1,939 Total interest income 128,529 132,332 118,797 Interest expense: Deposits 21,553 28,540 19,531 FHLB borrowings 5,399 6,333 6,792 Total interest expense 26,952 34,873 26,323 Net interest income 101,577 97,459 92,474 Provision for loan losses (Note 3) 4,358 ( 2,880 ) 8,497 Net interest income after provision for loan losses 97,219 100,339 83,977 Noninterest income: Net gain on sale of loans 6,678 3,539 1,517 Trust fees 10,275 9,579 10,007 Service charges and fees 10,186 10,276 9,614 Other noninterest income 1,187 1,426 2,680 Gain (loss) on sale of investment securities 10 ( 28 ) — 28,336 24,792 23,818 Noninterest expenses: Salaries and employee benefits 40,621 36,709 34,981 Occupancy 4,343 4,336 4,374 Furniture and equipment 7,357 6,795 5,741 Office supplies and postage 1,799 1,841 1,778 Advertising and business development 2,082 2,595 2,513 Outside services 11,069 10,360 10,076 FDIC insurance assessment 856 194 856 Other noninterest expenses 7,504 4,434 1,804 75,631 67,264 62,123 Income before income taxes 49,924 57,867 45,672 Income taxes (Note 10) 11,277 12,549 8,905 Net income $ 38,647 $ 45,318 $ 36,767 Earnings per share: Basic $ 4.12 $ 4.85 $ 3.93 Diluted 4.12 4.85 3.92 See Notes to Consolidated Financial Statements. Page 64 Table of Contents HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Years Ended December 31, 2020, 2019 and 2018 (Amounts In Thousands) 2020 2019 2018 Net income $ 38,647 $ 45,318 $ 36,767 Other comprehensive income (loss) Securities: Net change in unrealized gain (loss) on securities available for sale 7,478 6,940 ( 1,593 ) Reclassification adjustment for net (gains) losses realized in net income ( 10 ) 28 — Income taxes ( 1,864 ) ( 1,738 ) 397 Other comprehensive income (loss) on securities available for sale 5,604 5,230 ( 1,196 ) Derivatives used in cash flow hedging relationships: Net change in unrealized (loss) gain on derivatives ( 335 ) ( 753 ) 1,223 Reclassification adjustment for losses realized in net income 2,684 — — Income taxes ( 586 ) 188 ( 305 ) Other comprehensive income (loss) on cash flow hedges 1,763 ( 565 ) 918 Other comprehensive income (loss), net of tax 7,367 4,665 ( 278 ) Comprehensive income $ 46,014 $ 49,983 $ 36,489 See Notes to Consolidated Financial Statements. Page 65 Table of Contents HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Years Ended December 31, 2020, 2019 and 2018 (Amounts In Thousands, Except Share Data) Paid In Capital Retained Earnings Accumulated Other Comprehensive Income (Loss) Treasury Stock Maximum Cash Obligation Related To ESOP Shares Total Balance, December 31, 2017 $ 48,930 $ 341,558 $ ( 2,446 ) $ ( 33,018 ) $ ( 43,308 ) $ 311,716 Issuance of 113,373 shares of common stock 3,386 — — 2,834 — 6,220 Issuance of 8,172 shares of common stock under the employee stock purchase plan 421 — — — — 421 Unearned restricted stock compensation ( 463 ) — — — — ( 463 ) Forfeiture of 3,296 shares of common stock ( 152 ) — — — — ( 152 ) Change related to ESOP shares — — — — ( 5,562 ) ( 5,562 ) Net income — 36,767 — — — 36,767 Cash dividends ($ 0.75 per share) — ( 7,003 ) — — — ( 7,003 ) Reclassification of stranded tax effects due to the Tax Cuts and Jobs Act — 526 ( 526 ) — — — Purchase of 116,962 shares of common stock — — — ( 6,784 ) — ( 6,784 ) Other comprehensive (loss) — — ( 278 ) — — ( 278 ) Balance, December 31, 2018 $ 52,122 $ 371,848 $ ( 3,250 ) $ ( 36,968 ) $ ( 48,870 ) $ 334,882 Issuance of 101,912 shares of common stock 3,549 — — 2,672 — 6,221 Issuance of 7,720 shares of common stock under the employee stock purchase plan 434 — — — — 434 Unearned restricted stock compensation 86 — — — — 86 Forfeiture of 5,255 shares of common stock ( 262 ) — — — — ( 262 ) Share-based compensation 14 — — — — 14 Change related to ESOP shares — — — — ( 2,956 ) ( 2,956 ) Net income — 45,318 — — — 45,318 Cash dividends ($ 0.82 per share) — ( 7,657 ) — — — ( 7,657 ) Purchase of 89,124 shares of common stock — — — ( 5,534 ) — ( 5,534 ) Other comprehensive income — — 4,665 — — 4,665 Balance, December 31, 2019 $ 55,943 $ 409,509 $ 1,415 $ ( 39,830 ) $ ( 51,826 ) $ 375,211 Issuance of 110,337 shares of common stock 4,177 — — 2,939 — 7,116 Issuance of 7,449 shares of common stock under the employee stock purchase plan 413 — — — — 413 Unearned restricted stock compensation ( 68 ) — — — — ( 68 ) Forfeiture of 4,863 shares of common stock ( 257 ) — — — — ( 257 ) Share-based compensation 25 — — — — 25 Change related to ESOP shares — — — — 4,497 4,497 Net income — 38,647 — — — 38,647 Cash dividends ($ 0.89 per share) — ( 8,325 ) — — — ( 8,325 ) Purchase of 133,622 shares of common stock — — — ( 8,550 ) — ( 8,550 ) Other comprehensive income — — 7,367 — — 7,367 Balance, December 31, 2020 $ 60,233 $ 439,831 $ 8,782 $ ( 45,441 ) $ ( 47,329 ) $ 416,076 See Notes to Consolidated Financial Statements. Page 66 Table of Contents HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 2020, 2019 and 2018 (Amounts In Thousands) 2020 2019 2018 Cash Flows from Operating Activities Net income $ 38,647 $ 45,318 $ 36,767 Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities: Depreciation 3,128 3,072 3,012 Provision for loan losses 4,358 ( 2,880 ) 8,497 Net (gain) loss on sale of investment securities available for sale ( 10 ) 28 — Share-based compensation 25 14 — Compensation expensed through issuance of common stock 1,272 1,133 1,466 Forfeiture of common stock ( 257 ) ( 262 ) ( 152 ) Provision for deferred income taxes ( 520 ) 1,301 ( 1,971 ) Net gain on sale of other real estate owned and other repossessed assets ( 120 ) ( 94 ) ( 18 ) Decrease (increase) in accrued interest receivable 265 ( 658 ) ( 1,012 ) Amortization of premium on investment securities, net 818 441 480 Decrease (increase) in other assets 1,316 ( 2,681 ) ( 1,086 ) Amortization of operating lease right of use assets 386 354 — (Decrease) increase in accrued interest and other liabilities ( 5,615 ) 650 ( 1,423 ) Loans originated for sale ( 475,187 ) ( 299,223 ) ( 136,746 ) Proceeds on sales of loans 446,318 296,346 141,441 Net gain on sales of loans ( 6,678 ) ( 3,539 ) ( 1,517 ) Net cash and cash equivalents provided by operating activities 8,146 39,320 47,738 Cash Flows from Investing Activities Proceeds from maturities of investment securities available for sale 85,530 63,301 57,284 Proceeds from sale of investment securities available for sale 313 12,467 — Purchases of investment securities available for sale ( 129,359 ) ( 104,539 ) ( 90,295 ) Loans made to customers, net of collections ( 72,138 ) ( 13,024 ) ( 168,567 ) Proceeds on sale of other real estate owned and other repossessed assets 120 818 168 Purchases of property and equipment ( 1,860 ) ( 3,167 ) ( 2,206 ) Net changes from tax credit real estate investment 1,007 913 883 Net cash and cash equivalents used in investing activities ( 116,387 ) ( 43,231 ) ( 202,733 ) (Continued) Page 67 Table of Contents HILLS BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Years Ended December 31, 2020, 2019 and 2018 (Amounts In Thousands) 2020 2019 2018 Cash Flows from Financing Activities Net increase in deposits 531,204 240,240 132,559 Net decrease in short-term borrowings — — — Net decrease in FHLB borrowings ( 80,000 ) ( 30,000 ) ( 80,000 ) Borrowings from FRB 1 1 1 Payments on FRB borrowings ( 1 ) ( 1 ) ( 1 ) Issuance of common stock, net of costs 5,844 5,026 4,713 Stock options exercised — 62 41 Purchase of treasury stock ( 8,550 ) ( 5,534 ) ( 6,784 ) Proceeds from the issuance of common stock through the employee stock purchase plan 413 434 421 Dividends paid ( 8,325 ) ( 7,657 ) ( 7,003 ) Net cash and cash equivalents provided by financing activities 440,586 202,571 43,947 Increase (decrease) in cash and cash equivalents 332,345 198,660 ( 111,048 ) Cash and cash equivalents: Beginning of year 241,965 43,305 154,353 End of year $ 574,310 $ 241,965 $ 43,305 Supplemental Disclosures Cash payments for: Interest paid to depositors $ 22,294 $ 27,878 $ 19,009 Interest paid on other obligations 5,399 6,333 6,792 Income taxes paid 9,874 10,784 9,924 Noncash financing activities: Increase in maximum cash obligation related to ESOP shares $ 4,497 $ 2,956 $ 5,562 Transfers to other real estate owned 45 712 150 Sale and financing of other real estate owned — 97 96 Right of use assets obtained in exchange for operating lease obligations 48 3,581 — See Notes to Consolidated Financial Statements. Page 68 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Nature of Activities and Significant Accounting Policies Nature of activities : Hills Bancorporation (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 is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids, Marion and Washington, Iowa. The Bank competes with other financial institutions and non-financial institutions providing similar financial products. Although the loan activity of the Bank is diversified with commercial and agricultural loans, real estate loans, automobile, installment and other consumer loans, the Bank's credit is concentrated in real estate loans. All of the Company’s operations are considered to be one reportable operating segment. Accounting estimates : The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Certain significant estimates : The allowance for loan losses, fair values of securities and other financial instruments, and share-based compensation expense involve certain significant estimates made by management. These estimates are reviewed by management routinely and it is reasonably possible that circumstances that exist at December 31, 2020 may change in the near-term and the effect could be material to the consolidated financial statements. Principles of consolidation : The consolidated financial statements include the accounts of the Company and its subsidiary. All significant intercompany balances and transactions have been eliminated in consolidation. Revenue recognition : Accounting Standards Codification ("ASC") 606, Revenue from Contracts with Customers ("ASC 606"), establishes principles for reporting information about the nature, amount, timing and uncertainty of revenue and cash flows arising from the Company’s contracts to provide goods or services to customers. The core principle requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it expects to be entitled to receive in exchange for those goods or services recognized as performance obligations are satisfied. The majority of the Company’s revenue-generating transactions are not subject to ASC 606, including revenue generated from financial instruments, such as loans, letters of credit and investment securities as these activities are not subject to the requirements of ASC 606. Interest income on loans and investment securities is recognized on the accrual method in accordance with written contracts. Loan origination fees of mortgage loans originated for sale are recognized when the loans are sold. Descriptions of the Company’s revenue-generating activities that are within the scope of ASC 606 are the following: Service charges and fees on deposit accounts represent general service fees for monthly account maintenance and activity- or transaction-based fees and consist of transaction-based revenue which includes interchange income, time-based revenue (service period), item-based revenue or some other individual attribute-based revenue. Revenue is recognized when the Company’s performance obligation is completed which is generally monthly for account maintenance services or when a transaction has been completed (such as a wire transfer). Payment for such performance obligations are generally received at the time the performance obligations are satisfied. Trust income represents monthly fees due from wealth management customers as consideration for managing the customers' assets. Wealth management and trust services include custody of assets, investment management, fees for trust services and similar fiduciary activities. Revenue is recognized when our performance obligation is completed each month, which is generally the time that payment is received. A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity's obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. As of December 31, 2020 and 2019, the Company did not have any significant contract balances. An entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered. The incremental costs of obtaining a contract are those costs that an Page 69 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission). The Company utilizes the practical expedient which allows entities to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less. The Company did not capitalize any contract acquisition costs for the years ending December 31, 2020 and 2019. Cash and cash equivalents : The Company considers all investments with original maturities of three months or less to be cash equivalents. At December 31, 2020 and 2019, cash equivalents consisted primarily of deposits with other banks. Investment securities : 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 December 31, 2020 or 2019. Stock of the Federal Home Loan Bank is carried at cost. The Company has evaluated the stock and determined there is no impairment. Premiums on debt securities are amortized to the earliest call date and discounts on debt securities are accreted over the period to maturity of those securities. The method of amortization results in a constant effective yield on those securities (the interest method). Realized gains and losses on investment securities are included in income, determined on the basis of the cost of the specific securities sold. Declines in the fair value of investment securities available for sale (with certain exceptions for debt securities noted below) that are deemed to be other-than-temporary are charged to earnings as a realized loss, and a new cost basis for the securities is established. In evaluating other-than-temporary impairment, the Company considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term. Declines in the fair value of debt securities below amortized cost are deemed to be other-than-temporary in circumstances where: (1) the Company has the intent to sell a security; (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis; or (3) the Company does not expect to recover the entire amortized cost basis of the security. If the Company intends to sell a security or if it is more likely than not that the Company will be required to sell the security before recovery, an other-than-temporary impairment write-down is recognized in earnings equal to the difference between the security’s amortized cost basis and its fair value. If the Company does not intend to sell the security or it is not more likely than not that the Company will be required to sell the security before recovery, the other-than-temporary impairment write-down is separated into an amount representing credit loss, which is recognized in earnings, and an amount related to all other factors, which is recognized in other comprehensive income. Realized securities gains or losses on securities sales (using specific identification method) and declines in value judged to be other-than-temporary are included in investment securities gains (losses), net, in the consolidated statements of income. Loans : Loans are stated at the amount of unpaid principal, reduced by the allowance for loan losses. Interest income is accrued on the unpaid balances as earned. Loans held for sale are stated at the lower of aggregate cost or estimated fair value. Loans are sold on a non-recourse basis with servicing released and gains and losses are recognized based on the difference between sales proceeds and the carrying value of the loan. The Company has had very few experiences of repurchasing loans previously sold into the secondary market. A specific reserve was not considered necessary based on the Company’s historical experience with repurchase activity. The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance when management believes the collectability of principal is unlikely. The allowance for loan losses is maintained at a level considered adequate to provide for probable losses that can be reasonably anticipated. The allowance is increased by provisions charged to expense and is reduced by net charge-offs. The Bank makes continuous reviews of the loan portfolio and considers current economic conditions, historical loss experience, review of specific problem loans and other factors in determining the adequacy of the allowance. Management classifies loans within the following categories: excellent, good, satisfactory, monitor, special mention and substandard. Page 70 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The policy for charging off loans is consistent throughout all loan categories. A loan is charged off based on criteria that includes but is not limited to: delinquency status, financial condition of the entire customer credit line and underlying collateral coverage, economic or external conditions that might impact full repayment of the loan, legal issues, overdrafts, and the customer’s willingness to work with the Company. Loans are considered impaired when, based on current information and events, it is probable the Bank will not be able to collect all amounts due. An impaired loan includes any loan that has been placed on nonaccrual status, loans greater than 90 days past due and still accruing and TDR loans. They also include loans, based on current information and events, that it is likely the Bank will be unable to collect all amounts due according to the contractual terms of the original loan agreement. The portion of the allowance for loan losses applicable to impaired loans has been computed based on the present value of the estimated future cash flows of interest and principal discounted at the loans effective interest rate or on the fair value of the collateral for collateral dependent loans. The entire change in present value of expected cash flows of impaired loans or of collateral value is reported as provision expense in the same manner in which impairment initially was recognized or as a reduction in the amount of provision expense that otherwise would be reported. Interest income on nonaccrual loans is recognized once principal has been recovered. The accrual of interest income on loans is discontinued when, in the opinion of management, there is reasonable doubt as to the borrower's ability to meet payments of interest or principal when they become due, which is generally when a loan is 90 days or more past due. When a loan is placed on nonaccrual status, all previously accrued and unpaid interest is reversed. Loans are returned to an accrual status when all of the principal and interest amounts contractually due are brought current and repayment of the remaining contractual principal and interest is expected. A loan may also return to accrual status if additional collateral is received from the borrower and, in the opinion of management, the financial position of the borrower indicates that there is no longer any reasonable doubt as to the collection of the amount contractually due. Payment received on nonaccrual loans are applied first to principal. Once principal is recovered, any remaining payments received are applied to interest income. As of December 31, 2020, none of the Company’s nonaccrual loans were earning interest on a cash basis. Nonrefundable loan fees and origination costs are deferred and recognized as a yield adjustment over the life of the related loan. Troubled debt restructurings (“TDR loans”) : A loan is classified as a troubled debt restructuring when a borrower is experiencing financial difficulties that leads to a restructuring of the loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider. These concessions may include rate reductions, principal forgiveness, extension of maturity date and other actions intended to minimize potential losses to the Company. A loan that is modified at a market rate of interest is no longer classified as troubled debt restructuring in the quarter following the modification if the borrower is no longer experiencing financial difficulties. Performance prior to the restructuring is considered when assessing whether the borrower can meet the new terms. At the time of restructuring, loans included in a troubled debt restructuring may be considered nonaccrual loans. TDR loans are returned to accrual status under the same criteria noted under loans above. Section 4013 of the CARES Act, “Temporary Relief From Troubled Debt Restructurings,” allows financial institutions the option to temporarily suspend certain requirements under GAAP related to TDRs for a limited period of time during the COVID-19 pandemic. In March 2020, various regulatory agencies, including the FRB and the FDIC, issued an interagency statement, effective immediately, on loan modifications and reporting for financial institutions working with customers affected by COVID-19. The agencies confirmed with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not to be considered TDRs. This includes short-term (e.g., six months) modifications, such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. See Note 3 for further discussion. Transfers of financial assets : Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets. Credit related financial instruments : In the ordinary course of business, the Company has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded when they are funded. Page 71 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Tax credit real estate : Tax credit real estate represents two multi-family rental properties, three assisted living rental properties, a multi-tenant rental property for persons with disabilities, and a multi-family senior living rental property, all which are affordable housing projects as of December 31, 2020. The Bank has a 99 % or greater limited partnership interest in each limited partnership. The investment in each was completed after the projects had been developed by the general partner. The Company evaluates the recoverability of the carrying value on a regular basis. If the recoverability was determined to be in doubt, a valuation allowance would be established by way of a charge to expense. Depreciation expense is provided on a straight-line basis over the estimated useful life of the assets. Expenditures for normal repairs and maintenance are charged to expense as incurred. In 2016, the Company adopted ASU 2015-02 and the investments in tax credit real estate are recorded for all years presented using the equity method of accounting. The operations of the properties are not expected to contribute significantly to the Company’s income before income taxes. However, the properties do contribute in the form of income tax credits, which lowers the Company’s effective tax rate. Once established, the credits on each property last for ten years and are passed through from the limited partnerships to the Bank and reduces the consolidated federal tax liability of the Company. In February 2019, the Company entered into a Letter of Intent to invest in a limited partnership, as limited partner, which will own and operate an affordable housing property in Iowa City, Iowa. The Company provided construction financing for the project and contributed capital of $ 4.18 million in February 2021. Property and equipment : Property and equipment is stated at cost less accumulated depreciation. Depreciation is computed using primarily declining-balance methods over the estimated useful lives of 7 - 40 years for buildings and improvements and 3 - 10 years for furniture and equipment. Deferred income taxes : Deferred income taxes are provided under the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and net operating loss, and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. The Company recognizes the effect of income tax positions only if those positions are more likely than not of being sustained. Recognized income tax positions are measured at the largest amount that is greater than 50 % likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs. Interest and penalties on unrecognized tax benefits are classified as other noninterest expense. As of December 31, 2020, the Company had no material unrecognized tax benefits. Goodwill : Goodwill represents the excess of cost over the fair value of the net assets acquired, and is not subject to amortization, but requires, at a minimum, annual impairment tests for intangibles that are determined to have an indefinite life. Other real estate : Other real estate represents property acquired through foreclosures and settlements of loans. Property acquired is carried at the lower of the principal amount of the loan outstanding at the time of acquisition, plus any acquisition costs, or the estimated fair value of the property, less disposal costs. The Bank will obtain updated appraisals to determine the estimated fair value of the property based on the type of collateral securing the loan and the date of the latest appraisal. Subsequent write downs estimated on the basis of later valuations are charged to net loss on sale of other real estate owned and other repossessed assets. Net operating expenses incurred in maintaining such properties are charged to other non-interest expense. Net capital expenditures incurred are capitalized to the property. Derivative financial instruments : The Bank uses interest rate swaps as part of its interest rate risk management. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 815 establishes accounting and reporting standards for derivative instruments and hedging activities. The Bank records all interest rate swaps on the balance sheet at fair value. Derivatives used to hedge the exposure to variability in expected future cash flows are considered cash flow hedges. To qualify for hedge accounting, the Bank must comply with the detailed rules and documentation requirements at the inception of the hedge, and hedge effectiveness is assessed at inception and periodically throughout the life of the hedging relationship. As of December 31, 2020, the Bank did not have any outstanding interest rate swaps. Page 72 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For derivatives designated as cash flow hedges, the changes in the fair value of the derivatives is initially reported in other comprehensive income and subsequently reclassified to interest income or expense when the hedged transaction affects earnings. The Bank assesses the effectiveness of each hedging relationship by comparing the cumulative changes in cash flows of the derivative hedging instruments with the cumulative changes in cash flows of the designated hedged item or transaction. No component of the change in the fair value of the hedging instrument is excluded from the assessment of hedge effectiveness. The Bank does not use derivatives for trading or speculative purposes. 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 following table presents calculations of earnings per share: Year Ended December 31, 2020 2019 2018 (Amounts In Thousands, except share and per share data) Computation of weighted average number of basic and diluted shares: Common shares outstanding at the beginning of the year 9,351,694 9,336,441 9,335,154 Weighted average number of net shares issued 17,571 19,304 31,160 Weighted average shares outstanding (basic) 9,369,265 9,355,745 9,366,314 Weighted average of potential dilutive shares attributable to stock options granted, computed under the treasury stock method 3,640 4,035 4,027 Weighted average number of shares (diluted) 9,372,905 9,359,780 9,370,341 Net income $ 38,647 $ 45,318 $ 36,767 Earnings per share: Basic $ 4.12 $ 4.85 $ 3.93 Diluted $ 4.12 $ 4.85 $ 3.92 Stock awards and options : Compensation expense for stock issued through the stock award plan is accounted for using the fair value method prescribed by FASB ASC 718, “Share-Based Payment” (“ASC 718”). Under this method, compensation expense is measured and recognized for all stock-based awards made to employees and directors based on the fair value of each award as of the date of the grant. Common stock held by ESOP : The Company's maximum cash obligation related to these shares is classified outside stockholders' equity because the shares are not readily traded and could be put to the Company for cash. Treasury Stock : Treasury stock is accounted for by the cost method, whereby shares of common stock reacquired are recorded at their purchase price. Trust Department Assets : Property held for customers in fiduciary or agency capacities is not included in the accompanying consolidated balance sheets, as such items are not assets of the Company. Effect of New Financial Accounting Standards : In February 2016, the FASB issued ASU No. 2016-02 (Topic 842), Leases . The ASU provides guidance requiring lessees to recognize right-of-use (ROU) assets and lease liabilities for all leases other than those that meet the definition of short-term leases. For short-term leases, lessees may elect an accounting policy by class of underlying asset under which these assets and liabilities are not recognized and lease payments are generally recognized over the lease term on a straight-line basis. Under this new ASU, lessees will recognize right-of use assets and lease liabilities for most leases currently accounted for as operating leases under generally accepted accounting principles. For public companies, ASU 2016-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company adopted the ASU on January 1, 2019 and used the effective date as the date of initial application. Consequently, financial information will not be updated and Page 73 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS the disclosures required under the new standard will not be provided for dates and periods before January 1, 2019. The new standard provides a number of optional practical expedients in transition. We elected the 'package of practical expedients', which permits us not to reassess under the new standard our prior conclusions about lease identification, lease classification and initial direct costs. We did not elect the use-of-hindsight or the practical expedient pertaining to land easements; the latter not being applicable to us. The most significant impact upon adoption relates to the recognition of new ROU assets and lease liabilities on our balance sheet for our equipment and real estate operating leases. Upon adoption, we recognized additional operating liabilities of $ 3.58 million, with corresponding ROU assets of the same amount based on the present value of the remaining minimum rental payments under current leasing standards for existing operating leases. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments (CECL). The ASU changes the way entities recognize impairment of financial assets by requiring immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the "incurred loss" model required under current GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance. For public companies, ASU 2016-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. With the passage of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) , the option to delay CECL was provided until the earlier of the national health emergency being declared over or December 31, 2020. In December 2020, further legislation was passed titled the Coronavirus Response and Relief Supplemental Appropriations Act 2021 which extends the CECL delay until the earlier of 1) the first day of the fiscal year that begins after the national emergency termination date or 2) January 1, 2022. The Company elected to delay implementing CECL and continued to use the incurred loss method to calculate the allowance for loan losses as of and for the period ending December 31, 2020. The Company anticipates adopting CECL effective January 1, 2021 for the first quarter of 2021 based on the options provided under the December 2020 legislation passed. The Company has implemented a software solution provided by a third party vendor to assist in the determination of the CECL model. Our current planned approach for estimating expected life-time credit losses for loans upon adoption includes the following key components: • An initial forecast period of one year for all portfolio segments and off-balance-sheet credit exposures. This period reflects management’s expectation of losses based on forward-looking economic scenarios over that time. • A historical loss forecast period covering the remaining contractual life, adjusted for prepayments, by portfolio segment based on the change in key historical economic variables. • A reversion period of up to 3 years connecting the initial loss forecast to the historical loss forecast based on economic conditions at the measurement date. • We will primarily utilize discounted cash flow (DCF) methods to estimate credit losses by portfolio segment. The DCF methods obtain estimated life-time credit losses using the conceptual components described above. The adjustment upon adoption at January 1, 2021 will be an overall increase in our Allowance for Credit Losses (ACL) for loans of $ 2.00 million to $ 4.00 million. We will also record an unfunded commitments liability of $ 3.00 million to $ 4.00 million upon adoption. The future effects of CECL on our ACL will depend on the size and composition of our portfolio, the portfolio’s credit quality and economic conditions, as well as any refinements to our model, methodology and other key assumptions. We will recognize a one-time cumulative-effect adjustment to our ACL upon adoption of the new standard. The increase in the ACL will result in a decrease to our regulatory capital amounts and ratios. We estimate the ACL as of December 31, 2020 to be approximately $ 39 million to $ 42 million and the unfunded commitments liability to be approximately $ 2 million to $ 4 million. In January 2017, the FASB issued ASU No. 2017-03, Accounting Changes and Error Corrections (Topic 250) and Investments - Equity Method and Joint Ventures (Topic 323), Amendments to SEC Paragraphs Pursuant to Staff Announcements at the September 22, 2016 and November 17, 2016 EITF Meetings. This ASU adds an SEC paragraph and amends other Topics pursuant to an SEC staff Announcement made at the September 22, 2016 Emerging Issues Task Force (EITF) meeting. The SEC paragraph applies to ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606); ASU No. 2016-02, Leases Page 74 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Topic 842); and ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The ASU provides that a company should evaluate ASUs that have not yet been adopted to determine the appropriate financial statement disclosures about the potential material effects of those ASUs on the financial statements when adopted. If the company does not know or cannot reasonably estimate the impact that adoption of the ASUs referenced in this announcement is expected to have on the financial statements, then in addition to making a statement to that effect, the company should consider additional qualitative financial statement disclosures to assist the reader in assessing the significance of the impact that the standard will have on the financial statements of the company when adopted. Additional qualitative disclosures should include a description of the effect of the accounting policies that the company expects to apply and a comparison to the company's current accounting policies. Also, the company should describe the status of its process to implement the new standards and the significant implementation matters yet to be addressed. In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 250), Simplifying the Test for Goodwill Impairment. The ASU simplifies the goodwill impairment test by requiring a company to perform its annual or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized when the carrying amount exceeds fair value. For public companies, ASU 2017-04 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The adoption of ASU No. 2017-04 by the Company on January 1, 2020 did not have a material impact on the financial statements. In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities. This ASU requires companies to change the recognition and presentation of the effects of hedge accounting by eliminating the requirement to separately measure and report hedge ineffectiveness and requiring companies to present all of the elements of hedge accounting that affect earnings in the same income statement line as the hedged item. Furthermore, the standard eases the requirements for effectiveness testing, hedge documentation and applying the critical terms match method and introduces new alternatives that will permit companies to reduce the risk of material error corrections if they misapply the shortcut method. For public companies, ASU 2017-12 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018. The Company adopted ASU 2017-12 for the period ending March 31, 2019. There was no material impact on the financial statements. In February 2018, the FASB issued ASU No. 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220), Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This ASU allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. ASU 2018-02 is effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. The Company adopted ASU 2018-02 for the period ending March 31, 2018 and elected the specific identification method accounting policy. Upon adoption, there was a $ 0.53 million reclassification recorded in stockholders' equity. In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718), Improvements to Nonemployee Share-Based Payment Accounting . The amendments in this ASU expand the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. ASU 2018-07 is effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within that fiscal year. The Company adopted ASU 2018-07 for the period ending March 31, 2019. There was no material impact on the financial statements. In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820), Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement . The amendments in this ASU modify the disclosure requirements on fair value measurements in Topic 820, Fair Value Measurement, including removal of the requirement to disclose the valuation processes for Level 3 fair value measurements and the additional requirement to disclose the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 is effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The amendments on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements, and the narrative description of measurement uncertainty should be applied prospectively for only the most recent interim or annual period presented in the initial fiscal year of adoption. All other amendments should be applied retrospectively to all periods presented upon their effective date. Early adoption is permitted upon issuance of this ASU. An entity is permitted to early adopt any removed or modified disclosures upon issuance of this ASU and delay adoption of the additional disclosures until their effective date. The adoption of ASU 2018-13 by the Company on January 1, 2020 did not have a material impact on the financial statements. Page 75 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In August 2018, the FASB issued ASU No. 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40), Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangements That Is a Service Contract . The amendments in this ASU align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). ASU 2018-15 is effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption of the amendments in this ASU is permitted, including adoption in any interim period, for all entities. The amendments in this ASU should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. The adoption of ASU 2018-15 by the Company on January 1, 2020 did not have a material impact on the financial statements. In October 2018, the FASB issued ASU No. 2018-16, Derivatives and Hedging (Topic 815), Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes . The amendments in this ASU permit use of the OIS rate based on SOFR as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815 in addition to the interest rates on direct Treasury obligations of the U.S. government, the London Interbank Offered Rate (LIBOR) swap rate, the Overnight Index Swap (OIS) Rate based on the Fed Funds Effective Rate and the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate. The amendments in this ASU are required to be adopted concurrently with the amendments in ASU 2017-12. For public companies, this would be for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018. The Company adopted ASU No. 2018-16 for the period ending March 31, 2019 concurrently with ASU 2017-12. There was no material impact on the financial statements. In July 2019, the FASB issued ASU No. 2019-07, Codification Updates to SEC Sections, Amendments to SEC Paragraphs Pursuant to SEC Final Rule Releases No. 33-10532, Disclosure Update and Simplification, and Nos. 33-10231 and 33-10442, Investment Company Reporting Modernization, and Miscellaneous Updates . The amendments in this ASU update the Codification to reflect the amendments of various SEC disclosure requirements that the agency determined were redundant, duplicative, overlapping, outdated or superseded. The SEC amended its disclosure rules in 2018 with the aim of providing investors with useful disclosure information and to simplify compliance without significantly altering the mix of the information being provided. This ASU was effective upon release and there was no material impact on the financial statements. In November 2019, the FASB issued ASU No. 2019-08, Compensation - Stock Compensation (Topic 718) and Revenue from Contracts with Customers (Topic 606), Codification Improvements - Share-Based Consideration Payable to a Customer. The amendments in this ASU require that an entity measure and classify share-based payment awards granted to a customer by applying the guidance in Topic 718. The amount recorded as a reduction of the transaction price is required to be measured on the basis of the grant-date fair value of the share-based payment award in accordance with Topic 718. The grant date is the date at which a grantor (supplier) and a grantee (customer) reach a mutual understanding of the key terms and conditions of a share-based payment award. The classification and subsequent measurement of the award are subject to the guidance in Topic 718 unless the share-based payment award is subsequently modified and the grantee is no longer a customer. The Company adopted ASU 2019-08 for the period ending December 31, 2019. There was no material impact on the financial statements. In November 2019, the FASB issued ASU No. 2019-11, Codification Improvements to Topic 326, Financial Instruments - Credit Losses. The amendments in this ASU clarify or address stakeholders' specific issues about certain aspects of the amendments in ASU 2016-13 in the following areas: expected recoveries for purchased financial assets with credit deterioration, transition relief for troubled debt restructurings, disclosures related to accrued interest receivables and financial assets secured by collateral maintenance provisions. For public companies, ASU 2019-11 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 and will be adopted concurrently with ASU 2016-13. As noted above, we have elected to delay the adoption of ASU 2016-13 as permitted by the CARES Act and related extension. In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740), Simplifying the Accounting for Income Taxes. The amendments in this ASU simplify the accounting for income taxes by removing specific exceptions included in Topic 740, introducing other simplifications and making technical corrections. For public business entities, the amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early Page 76 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS adoption is permitted. The adoption of the ASU by the Company on January 1, 2021 is not expected to have a material impact on the financial statements. In October 2020, the FASB issued ASU 2020-08, Codification Improvements to Subtopic 310-20, Receivables - Nonrefundable Fees and Other Costs . The amendments in this Update clarify that an entity should reevaluate whether a callable debt security is within the scope of paragraph 310-20-35-33 for each reporting period. For each reporting period, to the extent that the amortized cost basis of an individual callable debt security exceeds the amount repayable by the issuer at the next call date, the excess (that is, the premium) shall be amortized to the next call date, unless the guidance in paragraph 310-20-35-26 is applied to consider estimated prepayments. For public business entities, the amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early application is not permitted. The adoption of the ASU by the Company on January 1, 2021 is not expected to have a material impact on the financial statements. In October 2020, the FASB issued ASU 2020-10, Codification Improvements, which consists of two sections. The first applicable section contains amendments that improve the consistency of the Codification by including all disclosure guidance in the appropriate disclosure section and provide the option to give certain information either on the face of the financial statements or in the notes to the financial statements. The second section contains Codification improvements that vary in nature. The amendments in this Update do not change GAAP and, therefore, are not expected to result in a significant change in practice. For public business entities, these amendments are effective for annual periods beginning after December 15, 2020. The adoption of the ASU by the Company on January 1, 2021 is not expected to have a material impact on the financial statements. Note 2. Investment Securities The carrying values of investment securities at December 31, 2020 and December 31, 2019 are summarized in the following table (Amounts in Thousands): December 31, 2020 December 31, 2019 Amount Percent Amount Percent Securities available for sale U.S. Treasury $ 148,646 36.40 % $ 128,585 36.19 % Other securities (FHLB, FHLMC and FNMA) 35,160 8.61 % 15,229 4.29 % State and political subdivisions 224,566 54.99 % 211,489 59.52 % Total securities available for sale $ 408,372 100.00 % $ 355,303 100.00 % Page 77 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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. The Company had no securities designated as trading or held to maturity in its portfolio at December 31, 2020 or 2019. The carrying amount of available-for-sale securities and their approximate fair values were as follows (Amounts in Thousands): Amortized Cost Gross Unrealized Gains Gross Unrealized (Losses) Estimated Fair Value December 31, 2020: U.S. Treasury $ 143,467 $ 5,179 $ — $ 148,646 Other securities (FHLB, FHLMC and FNMA) 35,195 35 ( 70 ) 35,160 State and political subdivisions 218,008 6,674 ( 116 ) 224,566 Total $ 396,670 $ 11,888 $ ( 186 ) $ 408,372 December 31, 2019: U.S. Treasury $ 127,096 $ 1,626 $ ( 137 ) $ 128,585 Other securities (FHLB, FHLMC and FNMA) 15,287 — ( 58 ) 15,229 State and political subdivisions 208,686 2,938 ( 135 ) 211,489 Total $ 351,069 $ 4,564 $ ( 330 ) $ 355,303 The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at December 31, 2020, were as follows (Amounts in Thousands): Amortized Cost Fair Value Due in one year or less $ 59,305 $ 59,517 Due after one year through five years 232,753 239,309 Due after five years through ten years 78,124 82,626 Due over ten years 26,488 26,920 Total $ 396,670 $ 408,372 As of December 31, 2020, investment securities with a carrying value of $ 10.23 million were pledged to collateralize derivative financial instruments and other borrowings. Sales proceeds and gross realized gains and losses on available-for-sale securities were as follows (in thousands): December 31, 2020 December 31, 2019 Sales proceeds $ 313 $ 12,467 Gross realized gains 10 24 Gross realized losses — 52 Page 78 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table shows the Company’s investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2020 and 2019 (Amounts in Thousands): Less than 12 months 12 months or more Total 2020 Description # Fair Value Unrealized Loss % # Fair Value Unrealized Loss % # Fair Value Unrealized Loss % of Securities U.S. Treasury — $ — $ — — % — $ — $ — — % — $ — $ — — % Other securities (FHLB, FHLMC and FNMA) 8 20,019 ( 70 ) 0.35 % — — — — % 8 20,019 ( 70 ) 0.35 % State and political subdivisions 35 14,168 ( 110 ) 0.78 % 4 370 ( 6 ) 1.62 % 39 14,538 ( 116 ) 0.80 % Total temporarily impaired securities 43 $ 34,187 $ ( 180 ) 0.53 % 4 $ 370 $ ( 6 ) 1.62 % 47 $ 34,557 $ ( 186 ) 0.54 % Less than 12 months 12 months or more Total 2019 Description # Fair Value Unrealized Loss % # Fair Value Unrealized Loss % # Fair Value Unrealized Loss % of Securities U.S. Treasury 11 $ 27,932 $ ( 136 ) 0.49 % 1 $ 2,495 $ ( 1 ) 0.04 % 12 $ 30,427 $ ( 137 ) 0.45 % Other securities (FHLB, FHLMC and FNMA) — — — — % 6 15,229 ( 58 ) 0.38 % 6 15,229 ( 58 ) 0.38 % State and political subdivisions 66 17,881 ( 119 ) 0.67 % 20 3,825 ( 16 ) 0.42 % 86 21,706 ( 135 ) 0.62 % Total temporarily impaired securities 77 $ 45,813 $ ( 255 ) 0.56 % 27 $ 21,549 $ ( 75 ) 0.35 % 104 $ 67,362 $ ( 330 ) 0.49 % 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 credit quality 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 79 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 3. Loans Classes of loans are as follows: December 31, 2020 2019 (Amounts In Thousands) Agricultural $ 94,842 $ 91,317 Commercial and financial 286,242 221,323 Real estate: Construction, 1 to 4 family residential 71,117 80,209 Construction, land development and commercial 111,913 108,410 Mortgage, farmland 247,142 242,730 Mortgage, 1 to 4 family first liens 892,089 910,742 Mortgage, 1 to 4 family junior liens 127,833 149,227 Mortgage, multi-family 374,014 350,761 Mortgage, commercial 417,139 402,181 Loans to individuals 31,325 32,308 Obligations of state and political subdivisions 56,488 49,896 2,710,144 2,639,104 Net unamortized fees and costs 938 933 2,711,082 2,640,037 Less allowance for loan losses 37,070 33,760 $ 2,674,012 $ 2,606,277 As of December 31, 2020, the Company has outstanding balances of $ 86.5 million of loans issued under the Paycheck Protection Program (PPP) and $ 2.12 million of deferred PPP loan fees recorded with commercial and financial loans. For the year ended December 31, 2020, the Company has recognized $ 2.88 million of deferred PPP loan fees in interest income and has received forgiveness payments totaling $ 40.4 million from the SBA. Page 80 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Changes in the allowance for loan losses and the allowance for loan loss balance applicable to impaired loans and the related loan balance of impaired loans for the years ended December 31, 2020, 2019 and 2018 are 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) 2020 Allowance for loan losses: Beginning balance $ 2,400 $ 4,988 $ 2,599 $ 3,950 $ 10,638 $ 7,859 $ 1,326 $ 33,760 Charge-offs ( 43 ) ( 1,425 ) ( 43 ) ( 1 ) ( 738 ) ( 291 ) ( 381 ) ( 2,922 ) Recoveries 63 670 118 10 784 49 180 1,874 Provision 88 652 ( 355 ) 214 1,684 1,798 277 4,358 Ending balance $ 2,508 $ 4,885 $ 2,319 $ 4,173 $ 12,368 $ 9,415 $ 1,402 $ 37,070 Ending balance, individually evaluated for impairment $ 86 $ 411 $ 7 $ — $ 93 $ 14 $ 51 $ 662 Ending balance, collectively evaluated for impairment $ 2,422 $ 4,474 $ 2,312 $ 4,173 $ 12,275 $ 9,401 $ 1,351 $ 36,408 Loan balances: Ending balance $ 94,842 $ 286,242 $ 183,030 $ 247,142 $ 1,019,922 $ 791,153 $ 87,813 $ 2,710,144 Ending balance, individually evaluated for impairment $ 1,543 $ 2,191 $ 1,266 $ 2,061 $ 7,417 $ 6,200 $ 51 $ 20,729 Ending balance, collectively evaluated for impairment $ 93,299 $ 284,051 $ 181,764 $ 245,081 $ 1,012,505 $ 784,953 $ 87,762 $ 2,689,415 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) 2019 Allowance for loan losses: Beginning balance $ 2,789 $ 5,826 $ 3,292 $ 3,972 $ 12,516 $ 8,165 $ 1,250 $ 37,810 Charge-offs ( 266 ) ( 981 ) ( 45 ) ( 6 ) ( 896 ) ( 341 ) ( 434 ) ( 2,969 ) Recoveries 95 646 8 5 700 180 165 1,799 Provision ( 218 ) ( 503 ) ( 656 ) ( 21 ) ( 1,682 ) ( 145 ) 345 ( 2,880 ) Ending balance $ 2,400 $ 4,988 $ 2,599 $ 3,950 $ 10,638 $ 7,859 $ 1,326 $ 33,760 Ending balance, individually evaluated for impairment $ 87 $ 792 $ — $ — $ 111 $ 1 $ 93 $ 1,084 Ending balance, collectively evaluated for impairment $ 2,313 $ 4,196 $ 2,599 $ 3,950 $ 10,527 $ 7,858 $ 1,233 $ 32,676 Loan balances: Ending balance $ 91,317 $ 221,323 $ 188,619 $ 242,730 $ 1,059,969 $ 752,942 $ 82,204 $ 2,639,104 Ending balance, individually evaluated for impairment $ 1,730 $ 2,742 $ 421 $ 4,081 $ 8,670 $ 3,188 $ 93 $ 20,925 Ending balance, collectively evaluated for impairment $ 89,587 $ 218,581 $ 188,198 $ 238,649 $ 1,051,299 $ 749,754 $ 82,111 $ 2,618,179 Page 81 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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) 2018 Allowance for loan losses: Beginning balance $ 2,294 $ 4,837 $ 2,989 $ 3,669 $ 8,668 $ 5,700 $ 1,243 $ 29,400 Charge-offs ( 95 ) ( 585 ) — — ( 830 ) ( 251 ) ( 561 ) ( 2,322 ) Recoveries 119 1,057 148 30 612 107 162 2,235 Provision 471 517 155 273 4,066 2,609 406 8,497 Ending balance $ 2,789 $ 5,826 $ 3,292 $ 3,972 $ 12,516 $ 8,165 $ 1,250 $ 37,810 Ending balance, individually evaluated for impairment $ 479 $ 1,189 $ 4 $ — $ 72 $ 306 $ 64 $ 2,114 Ending balance, collectively evaluated for impairment $ 2,310 $ 4,637 $ 3,288 $ 3,972 $ 12,444 $ 7,859 $ 1,186 $ 35,696 Loan balances: Ending balance $ 92,673 $ 229,501 $ 186,086 $ 236,454 $ 1,064,684 $ 735,748 $ 82,797 $ 2,627,943 Ending balance, individually evaluated for impairment $ 2,460 $ 4,162 $ 1,137 $ 3,612 $ 7,012 $ 9,538 $ 64 $ 27,985 Ending balance, collectively evaluated for impairment $ 90,213 $ 225,339 $ 184,949 $ 232,842 $ 1,057,672 $ 726,210 $ 82,733 $ 2,599,958 The Company evaluates the following loans to determine impairment: 1) all nonaccrual and TDR loans, 2) all non consumer and non 1 to 4 family residential loans with prior charge-offs, 3) all non consumer and non 1 to 4 family loan relationships classified as substandard and 4) loans with indications of or suspected deteriorating credit quality. Page 82 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table presents the credit quality indicators by type of loans in each category as of December 31, 2020: Agricultural Commercial and Financial Real Estate: Construction, 1 to 4 family residential Real Estate: Construction, land development and commercial (Amounts In Thousands) 2020 Grade: Excellent $ 3,761 $ 9,024 $ — $ 227 Good 12,369 62,310 13,675 15,187 Satisfactory 42,015 144,999 41,616 64,301 Monitor 29,381 56,439 13,654 23,368 Special Mention 5,143 8,258 1,857 7,137 Substandard 2,173 5,212 315 1,693 Total $ 94,842 $ 286,242 $ 71,117 $ 111,913 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 2020 Grade: Excellent $ 5,706 $ 2,303 $ 204 $ 14,650 Good 41,878 47,233 3,707 57,281 Satisfactory 129,210 701,273 115,731 197,493 Monitor 61,298 114,207 5,153 70,885 Special Mention 6,074 12,890 1,307 15,374 Substandard 2,976 14,183 1,731 18,331 Total $ 247,142 $ 892,089 $ 127,833 $ 374,014 Real Estate: Mortgage, commercial Loans to individuals Obligations of state and political subdivisions Total 2020 Grade: Excellent $ 26,940 $ 1 $ 6,752 $ 69,568 Good 92,699 145 13,094 359,578 Satisfactory 196,310 30,487 26,571 1,690,006 Monitor 77,125 479 9,924 461,913 Special Mention 19,731 127 147 78,045 Substandard 4,334 86 — 51,034 Total $ 417,139 $ 31,325 $ 56,488 $ 2,710,144 Page 83 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table presents the credit quality indicators by type of loans in each category as of December 31, 2019: Agricultural Commercial and Financial Real Estate: Construction, 1 to 4 family residential Real Estate: Construction, land development and commercial (Amounts In Thousands) 2019 Grade: Excellent $ 3,594 $ 3,461 $ 260 $ 190 Good 12,380 47,843 8,868 23,217 Satisfactory 43,308 117,114 51,093 47,987 Monitor 24,857 44,543 17,505 29,009 Special Mention 3,110 5,157 2,483 7,428 Substandard 4,068 3,205 — 579 Total $ 91,317 $ 221,323 $ 80,209 $ 108,410 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 2019 Grade: Excellent $ 3,630 $ 3,209 $ 261 $ 18,955 Good 40,118 32,474 4,233 47,871 Satisfactory 134,738 751,215 136,079 189,391 Monitor 53,147 96,353 5,473 60,965 Special Mention 3,033 11,167 1,469 27,559 Substandard 8,064 16,324 1,712 6,020 Total $ 242,730 $ 910,742 $ 149,227 $ 350,761 Real Estate: Mortgage, commercial Loans to individuals Obligations of state and political subdivisions Total 2019 Grade: Excellent $ 27,017 $ — $ 7,444 $ 68,021 Good 79,467 221 14,465 311,157 Satisfactory 206,196 31,385 20,274 1,728,780 Monitor 81,381 437 7,323 420,993 Special Mention 4,802 212 390 66,810 Substandard 3,318 53 — 43,343 Total $ 402,181 $ 32,308 $ 49,896 $ 2,639,104 Page 84 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The below are descriptions of the credit quality indicators: Excellent - Excellent rated loans are prime quality loans covered by highly-liquid collateral with generous margins or supported by superior current financial conditions reflecting substantial net worth, relative to total credit extended, and based on assets of a stable and non-speculative nature whose values can be readily verified. Identified repayment source or cash flow is abundant and assured. Good - Good rated loans are adequately secured by readily-marketable collateral or good financial condition characterized by liquidity, flexibility and sound net worth. Loans are supported by sound primary and secondary payment sources and timely and accurate financial information. Satisfactory – Satisfactory rated loans are loans to borrowers of average financial means not especially vulnerable to changes in economic or other circumstances, where the major support for the extension is sufficient collateral of a marketable nature, and the primary source of repayment is seen to be clear and adequate. Monitor – Monitor rated loans are identified by management as warranting special attention for a variety of reasons that may bear on ultimate collectability. This may be due to adverse trends, a particular industry, loan structure, or repayment that is dependent on projections, or a one-time occurrence. Special Mention – Special mention rated loans are supported by a marginal payment capacity and are marginally protected by collateral. There are identified weaknesses that if not monitored and corrected may adversely affect the Company’s credit position. A special mention credit would typically have a weakness in one of the general categories (cash flow, collateral position or payment history) but not in all categories. Substandard – Substandard loans are not adequately supported by the paying capacity of the borrower and may be inadequately collateralized. These loans have a well-defined weakness or weaknesses. For these loans, it is more probable than not that the Company could sustain some loss if the deficiency(ies) is not corrected. Page 85 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Past due loans as of December 31, 2020 and 2019 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) December 31, 2020 Agricultural $ 438 $ — $ 629 $ 1,067 $ 93,775 $ 94,842 $ 111 Commercial and financial 867 195 140 1,202 285,040 286,242 20 Real estate: Construction, 1 to 4 family residential 190 — 536 726 70,391 71,117 536 Construction, land development and commercial — — — — 111,913 111,913 — Mortgage, farmland 279 28 — 307 246,835 247,142 — Mortgage, 1 to 4 family first liens 4,969 1,342 2,486 8,797 883,292 892,089 342 Mortgage, 1 to 4 family junior liens 436 21 155 612 127,221 127,833 47 Mortgage, multi-family — — — — 374,014 374,014 — Mortgage, commercial 783 — 461 1,244 415,895 417,139 — Loans to individuals 218 59 4 281 31,044 31,325 — Obligations of state and political subdivisions — — — — 56,488 56,488 — $ 8,180 $ 1,645 $ 4,411 $ 14,236 $ 2,695,908 $ 2,710,144 $ 1,056 Page 86 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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) December 31, 2019 Agricultural $ 163 $ 275 $ 122 $ 560 $ 90,757 $ 91,317 $ 48 Commercial and financial 1,076 229 101 1,406 219,917 221,323 65 Real estate: Construction, 1 to 4 family residential 635 — — 635 79,574 80,209 — Construction, land development and commercial 215 101 — 316 108,094 108,410 — Mortgage, farmland 736 — 610 1,346 241,384 242,730 — Mortgage, 1 to 4 family first liens 5,026 3,100 4,149 12,275 898,467 910,742 354 Mortgage, 1 to 4 family junior liens 813 126 233 1,172 148,055 149,227 139 Mortgage, multi-family — 97 — 97 350,664 350,761 — Mortgage, commercial 321 489 — 810 401,371 402,181 — Loans to individuals 226 55 15 296 32,012 32,308 — Obligations of state and political subdivisions — — — — 49,896 49,896 — $ 9,211 $ 4,472 $ 5,230 $ 18,913 $ 2,620,191 $ 2,639,104 $ 606 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. Accruing loans past due 90 days or more increased $ 0.45 million from December 31, 2019 to December 31, 2020. As of December 31, 2020 and 2019, accruing loans past due 90 days or more were 0.04 % and 0.02 % of total loans, respectively. The average balance of the accruing loans past due 90 days or more increased in 2020 as compared to 2019. The average 90 days or more past due accruing loan balance per loan was $ 0.09 million as of December 31, 2020 compared to $ 0.08 million as of December 31, 2019. The loans 90 days or more past due and still accruing are believed to be adequately collateralized. Loans are placed on nonaccrual status when management believes the collection of future principal and interest is not reasonably assured. Page 87 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Certain impaired loan information by loan type at December 31, 2020 and 2019 was as follows: December 31, 2020 December 31, 2019 Nonaccrual loans (1) Accruing loans past due 90 days or more TDR loans Nonaccrual loans (1) Accruing loans past due 90 days or more TDR loans (Amounts In Thousands) (Amounts In Thousands) Agricultural $ 1,252 $ 111 $ 85 $ 1,192 $ 48 $ 404 Commercial and financial 479 20 1,263 679 65 1,934 Real estate: Construction, 1 to 4 family residential 315 536 — — — — Construction, land development and commercial 204 — 211 — — 320 Mortgage, farmland 446 — 1,616 1,369 — 2,712 Mortgage, 1 to 4 family first liens 4,331 342 1,751 6,558 354 1,626 Mortgage, 1 to 4 family junior liens 193 47 20 94 139 — Mortgage, multi-family 79 — 1,695 97 — 1,719 Mortgage, commercial 1,550 — 3,610 779 — 593 Loans to individuals — — — — — — $ 8,849 $ 1,056 $ 10,251 $ 10,768 $ 606 $ 9,308 (1) There were $ 2.97 million and $ 4.34 million of TDR loans included within nonaccrual loans as of December 31, 2020 and 2019, respectively. The Company may modify the terms of a loan to maximize the collection of amounts due. In most cases, the modification is 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 financial 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. Section 4013 of the CARES Act, “Temporary Relief From Troubled Debt Restructurings,” allows financial institutions the option to temporarily suspend certain requirements under GAAP related to TDRs for a limited period of time during the COVID-19 pandemic. In March 2020, various regulatory agencies, including the FRB and the FDIC, issued an interagency statement, effective immediately, on loan modifications and reporting for financial institutions working with customers affected by COVID-19. The agencies confirmed with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not to be considered TDRs. This includes short-term (e.g., six months) modifications, such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. As of December 31, 2020, the total amount of the eligible loans in deferral (deferral of principal and/or interest) that met the requirements set forth under the interagency statement and therefore were not considered TDRs was 13 loans, totaling $ 9.4 million. Throughout 2020, COVID-19 related payment deferrals provided for customers totaled approximately 14.82 % of total loans. As of December 31, 2020, COVID-19 related payment deferrals were approximately 1.20 % of total loans. Page 88 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Below is a summary of information for TDR loans as of December 31, 2020 and 2019: December 31, 2020 Number of contracts Recorded investment Commitments outstanding (Dollar Amounts In Thousands) Agricultural 6 $ 1,028 $ — Commercial and financial 17 1,743 35 Real estate: Construction, 1 to 4 family residential — — — Construction, land development and commercial 1 211 4 Mortgage, farmland 6 2,009 — Mortgage, 1 to 4 family first liens 17 1,898 — Mortgage, 1 to 4 family junior liens 1 20 — Mortgage, multi-family 2 1,695 — Mortgage, commercial 13 4,621 — Loans to individuals — — — 63 $ 13,225 $ 39 December 31, 2019 Number of contracts Recorded investment Commitments outstanding (Dollar Amounts In Thousands) Agricultural 9 $ 1,552 $ 3 Commercial and financial 16 2,641 95 Real estate: Construction, 1 to 4 family residential — — — Construction, land development and commercial 2 320 — Mortgage, farmland 8 4,021 — Mortgage, 1 to 4 family first liens 16 2,083 — Mortgage, 1 to 4 family junior liens — — — Mortgage, multi-family 2 1,719 — Mortgage, commercial 7 1,373 — Loans to individuals — — — 60 $ 13,709 $ 98 Page 89 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A summary of TDR loans that were modified during the year ended December 31, 2020 and 2019 was as follows: December 31, 2020 Number of Contracts Pre-modification recorded investment Post-modification recorded investment ( Dollar Amounts In Thousands) Agricultural 2 $ 93 $ 93 Commercial and financial 7 623 623 Real estate: Construction, 1 to 4 family residential — — — Construction, land development and commercial — — — Mortgage, farmland — — — Mortgage, 1 to 4 family first liens 6 283 283 Mortgage, 1 to 4 family junior liens 1 20 20 Mortgage, multi-family — — — Mortgage, commercial 7 3,635 3,635 Loans to individuals — — — 23 $ 4,654 $ 4,654 December 31, 2019 Number of Contracts Pre-modification recorded investment Post-modification recorded investment ( Dollar Amounts In Thousands) Agricultural 4 $ 574 $ 574 Commercial and financial 5 503 503 Real estate: Construction, 1 to 4 family residential — — — Construction, land development and commercial — — — Mortgage, farmland 1 620 620 Mortgage, 1 to 4 family first liens 3 705 705 Mortgage, 1 to 4 family junior liens — — — Mortgage, multi-family 2 1,719 1,719 Mortgage, commercial — — — Loans to individuals — — — 15 $ 4,121 $ 4,121 The Bank has commitments to lend additional borrowings to TDR loan customers. These commitments are in the normal course of business and allow the borrowers to build pre-sold homes and commercial property which increase their overall cash flow. The additional borrowings are not used to facilitate payments on these loans. There were no TDR loans modified during the year that were in payment default (defined as past due 90 days or more) as of December 31, 2020 and one as of December 31, 2019 totaling $ 0.065 million. Page 90 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Information regarding impaired loans as of and for the year ended December 31, 2020 is as follows: Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized (Amounts in Thousands) 2020 With no related allowance recorded: Agricultural $ 1,337 $ 1,928 $ — $ 1,518 $ 24 Commercial and financial 1,520 2,907 — 2,054 85 Real estate: Construction, 1 to 4 family residential 315 337 — 475 — Construction, land development and commercial 415 421 — 420 13 Mortgage, farmland 2,061 2,598 — 3,008 120 Mortgage, 1 to 4 family first liens 6,253 8,013 — 6,578 108 Mortgage, 1 to 4 family junior liens 108 350 — 134 — Mortgage, multi-family 1,773 1,898 — 1,795 80 Mortgage, commercial 4,124 4,960 — 4,315 126 Loans to individuals — 47 — — — $ 17,906 $ 23,459 $ — $ 20,297 $ 556 With an allowance recorded: Agricultural $ 206 $ 206 $ 86 $ 141 $ 14 Commercial and financial 671 724 411 755 27 Real estate: Construction, 1 to 4 family residential 536 536 7 486 24 Construction, land development and commercial — — — — — Mortgage, farmland — — — — — Mortgage, 1 to 4 family first liens 924 975 56 955 25 Mortgage, 1 to 4 family junior liens 132 158 37 149 2 Mortgage, multi-family — — — — — Mortgage, commercial 303 304 14 306 3 Loans to individuals 51 51 51 53 3 $ 2,823 $ 2,954 $ 662 $ 2,845 $ 98 Total: Agricultural $ 1,543 $ 2,134 $ 86 $ 1,659 $ 38 Commercial and financial 2,191 3,631 411 2,809 112 Real estate: Construction, 1 to 4 family residential 851 873 7 961 24 Construction, land development and commercial 415 421 — 420 13 Mortgage, farmland 2,061 2,598 — 3,008 120 Mortgage, 1 to 4 family first liens 7,177 8,988 56 7,533 133 Mortgage, 1 to 4 family junior liens 240 508 37 283 2 Mortgage, multi-family 1,773 1,898 — 1,795 80 Mortgage, commercial 4,427 5,264 14 4,621 129 Loans to individuals 51 98 51 53 3 $ 20,729 $ 26,413 $ 662 $ 23,142 $ 654 Page 91 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Information regarding impaired loans as of and for the year ended December 31, 2019 is as follows: Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized (Amounts in Thousands) 2019 With no related allowance recorded: Agricultural $ 1,596 $ 2,157 $ — $ 1,785 $ 37 Commercial and financial 1,340 2,220 — 1,617 64 Real estate: Construction, 1 to 4 family residential 101 144 — 106 — Construction, land development and commercial 320 336 — 324 18 Mortgage, farmland 4,081 4,613 — 4,144 157 Mortgage, 1 to 4 family first liens 7,157 9,015 — 6,822 51 Mortgage, 1 to 4 family junior liens — 246 — — — Mortgage, multi-family 1,816 1,930 — 1,873 83 Mortgage, commercial 1,302 1,852 — 1,364 26 Loans to individuals — 14 — — — $ 17,713 $ 22,527 $ — $ 18,035 $ 436 With an allowance recorded: Agricultural $ 134 $ 134 $ 87 $ 287 $ 17 Commercial and financial 1,402 1,539 792 1,510 83 Real estate: Construction, 1 to 4 family residential — — — — — Construction, land development and commercial — — — — — Mortgage, farmland — — — — — Mortgage, 1 to 4 family first liens 1,280 1,501 64 1,318 29 Mortgage, 1 to 4 family junior liens 233 233 47 239 6 Mortgage, multi-family — — — — — Mortgage, commercial 70 70 1 73 4 Loans to individuals 93 93 93 62 2 $ 3,212 $ 3,570 $ 1,084 $ 3,489 $ 141 Total: Agricultural $ 1,730 $ 2,291 $ 87 $ 2,072 $ 54 Commercial and financial 2,742 3,759 792 3,127 147 Real estate: Construction, 1 to 4 family residential 101 144 — 106 — Construction, land development and commercial 320 336 — 324 18 Mortgage, farmland 4,081 4,613 — 4,144 157 Mortgage, 1 to 4 family first liens 8,437 10,516 64 8,140 80 Mortgage, 1 to 4 family junior liens 233 479 47 239 6 Mortgage, multi-family 1,816 1,930 — 1,873 83 Mortgage, commercial 1,372 1,922 1 1,437 30 Loans to individuals 93 107 93 62 2 $ 20,925 $ 26,097 $ 1,084 $ 21,524 $ 577 Page 92 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Information regarding impaired loans as of and for the year ended December 31, 2018 is as follows: Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized (Amounts in Thousands) 2018 With no related allowance recorded: Agricultural $ 1,395 $ 1,663 $ — $ 1,071 $ 23 Commercial and financial 1,650 2,503 — 1,977 58 Real estate: Construction, 1 to 4 family residential 111 148 — 113 — Construction, land development and commercial 328 344 — 333 18 Mortgage, farmland 3,612 4,071 — 3,068 89 Mortgage, 1 to 4 family first liens 6,089 7,819 — 6,435 36 Mortgage, 1 to 4 family junior liens — 254 — — — Mortgage, multi-family 145 213 — 153 — Mortgage, commercial 1,871 2,486 — 1,940 42 Loans to individuals — 14 — — — $ 15,201 $ 19,515 $ — $ 15,090 $ 266 With an allowance recorded: Agricultural $ 1,065 $ 1,229 $ 479 $ 980 $ 7 Commercial and financial 2,512 2,512 1,189 2,793 107 Real estate: Construction, 1 to 4 family residential 698 698 4 622 28 Construction, land development and commercial — — — — — Mortgage, farmland — — — — — Mortgage, 1 to 4 family first liens 899 974 70 888 25 Mortgage, 1 to 4 family junior liens 24 24 2 25 1 Mortgage, multi-family 7,447 7,447 305 7,543 346 Mortgage, commercial 75 75 1 77 4 Loans to individuals 64 64 64 77 9 $ 12,784 $ 13,023 $ 2,114 $ 13,005 $ 527 Total: Agricultural $ 2,460 $ 2,892 $ 479 $ 2,051 $ 30 Commercial and financial 4,162 5,015 1,189 4,770 165 Real estate: Construction, 1 to 4 family residential 809 846 4 735 28 Construction, land development and commercial 328 344 — 333 18 Mortgage, farmland 3,612 4,071 — 3,068 89 Mortgage, 1 to 4 family first liens 6,988 8,793 70 7,323 61 Mortgage, 1 to 4 family junior liens 24 278 2 25 1 Mortgage, multi-family 7,592 7,660 305 7,696 346 Mortgage, commercial 1,946 2,561 1 2,017 46 Loans to individuals 64 78 64 77 9 $ 27,985 $ 32,538 $ 2,114 $ 28,095 $ 793 Page 93 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Impaired loans decreased by $ 0.20 million from December 31, 2019 to December 31, 2020. Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more, TDR loans and specific reserve loans. Impaired loans also include loans that, based on management’s evaluation of current information and events, the Bank expects to be unable to collect in full according to the contractual terms of the original loan agreement. Impaired loans were 0.76 % and 0.79 % of loans held for investment as of December 31, 2020 and 2019, respectively. The decrease in impaired loans is due mainly to a decrease in nonaccrual loans of $ 1.92 million and offset by an increase of accruing loans past due 90 days or more of $ 0.45 million, an increase of $ 0.43 million in specific reserve loans and an increase in TDR loans of $ 0.94 million from December 31, 2019 to December 31, 2020. 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 that can be identified as uncollectible. In general, this is the amount that the carrying value of the loan exceeds the related appraised value. 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 additional charge-off or loss allocations based on the applicable facts and circumstances. In instances where there is an estimated decline in value, either a loss allocation is 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 loss allocation 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. 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 helping to determine 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. The Company separates its portfolio loans and leases into segments for determining the allowance for loan losses. The Company's portfolio segments includes agricultural, commercial and financial, real estate, loans to individuals and obligations of state and political subdivisions. The Company further separates its portfolio into classes for purposes of monitoring and assessing credit quality based on certain risk characteristics. Classes with the real estate portfolio segment includes 1 to 4 family residential constructions, land development and commercial construction, farmland, 1 to 4 family first liens, 1 to 4 family junior liens, multi-family and commercial. Loans that exhibit probable or observed credit weaknesses, as well as loans that have been modified in a TDR, are subject to individual review for impairment. When individual loans are reviewed for impairment, the Company determines allowances based on management's estimate of the borrower's ability to repay the loan given the availability of the collateral, other sources of cash flow, as well as evaluation of legal options available. Allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the underlying collateral. Historical loss rates are applied to loans that are not individually reviewed for impairment. The 20 quarter migration analysis performed by management uses loan level attributes to track the movement of loans through the various credit risk rating categories in order to estimate the percentage of historical loss to apply to each specific credit risk rating in each loan category. The credit risk rating system currently utilized for allowance analysis purposes encompasses six categories. Page 94 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Company's allowance for loan loss 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 changes in lending policies and procedures; changes in national and local economic and business conditions; changes in the nature and volume of the loan portfolio; changes in the experience, ability and depth of lending management and staff; changes in the quality of the Bank's loan review system; the existence and effect of concentrations of credit; and the effect of any other identified external factors. 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. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. Although management believes the levels of the allowance for loan losses as of December 31, 2020 and 2019 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. Note 4. Property and Equipment The major classes of property and equipment and the total accumulated depreciation are as follows: December 31, 2020 2019 (Amounts In Thousands) Land $ 11,266 $ 11,261 Buildings and improvements 37,512 37,261 Furniture and equipment 40,053 38,449 88,831 86,971 Less accumulated depreciation 52,953 49,825 Net $ 35,878 $ 37,146 Note 5. Leases The Bank leases branch offices, parking facilities and certain equipment under operating leases. The leases have remaining lease terms of 1 year to 15 years, some of which include options to extend the leases for up to 10 years, and some of which include options to terminate the leases within 1 year. As the options are reasonably certain to be exercised, they are recognized as part of the right-of-use assets and lease liabilities. For the years ended December 31, 2020 and 2019, total operating lease expense was $ 0.56 million and $ 0.62 million, respectively, and is included in occupancy expenses in the consolidated statement of income. Included in this were $ 0.47 million and $ 0.53 million of operating lease costs, respectively, $ 0.03 million and $ 0.03 million of short term lease costs, respectively, and $ 0.06 million and $ 0.06 million of variable lease costs, respectively. For the years ended December 31, 2020 and 2019, cash paid for amounts included in the measurement of operating lease liabilities was $ 0.47 million and $ 0.53 million, respectively, and right-of-use assets obtained in exchange for lease obligations was $ 0.05 million and $ 3.58 million, respectively. As of December 31, 2020 and 2019, operating lease right-of-use assets included in other assets was $ 2.86 million and $ 3.20 million, respectively. Operating lease liabilities was $ 2.91 million and $ 3.23 million, respectively. The weighted average remaining lease term for operating leases was 10.27 years and 10.86 years, respectively, and the weighted average discount rate for operating leases was 3.45 % and 3.46 %, respectively. Discount rates used were determined from FHLB borrowing rates for comparable terms. Page 95 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS As of December 31, 2020, maturities of lease liabilities were as follows: Year ending December 31: (Amounts In Thousands) 2021 472 2022 464 2023 317 2024 250 2025 253 Thereafter 1,756 Total lease payments 3,512 Less imputed interest ( 601 ) Total operating lease liabilities $ 2,911 Note 6. Interest - Bearing Deposits A summary of these deposits is as follows: December 31, 2020 2019 (Amounts In Thousands) NOW and other demand $ 801,550 $ 610,271 Savings 1,161,324 981,827 Time, $100,000 and over 327,861 292,982 Other time 369,643 388,672 $ 2,660,378 $ 2,273,752 Brokered deposits totaled $ 74.08 million and $ 109.29 million as of December 31, 2020 and 2019, respectively, with an average interest rate of 0.34 % and 1.65 % as of December 31, 2020 and 2019, respectively. As of December 31, 2020, brokered deposits of $ 74.08 million are included in savings deposits. At December 31, 2019, brokered deposits of $ 109.29 million were included in savings deposits. Time deposits have a maturity as follows: December 31, 2020 2019 (Amounts In Thousands) Due in one year or less $ 307,962 $ 324,554 Due after one year through two years 190,763 124,527 Due after two years through three years 150,275 90,009 Due after three years through four years 39,089 130,252 Due over four years 9,415 12,312 $ 697,504 $ 681,654 Page 96 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 7. Federal Home Loan Bank Borrowings As of December 31, 2020 and 2019, the borrowings were as follows: 2020 2019 (Effective interest rates as of December 31, 2020) (Amounts In Thousands) Due 2020, 3.05 % $ — $ 25,000 Due 2023, 3.77 % — 25,000 Due 2024, 2.38 % — 15,000 Due 2025, 2.81 % to 2.94 % 45,000 60,000 Due 2026, 2.52 % to 2.86 % 30,000 30,000 Due 2027, 2.76 % to 2.95 % 30,000 30,000 $ 105,000 $ 185,000 On November 9, 2020 the Company paid $ 25.00 million in FHLB Borrowings due in 2020. On December 30, 2020 the Company paid $ 25.00 million in FHLB Borrowings that were due in 2023, $ 15.00 million in FHLB Borrowings due in 2024 and $ 15.00 million in FHLB Borrowings due in 2025. Fees incurred with the 2020 prepayments were $ 2.53 million and recorded in other noninterest expenses. On December 13, 2019 the Company paid $ 30.00 million in FHLB Borrowings due in 2025 and incurred prepayment fees of $ 2.09 million which were recorded in other noninterest expenses. The remaining borrowings with the FHLB may have prepayment fees based on the current FHLB borrowing rate. To participate in the FHLB advance program, the Company is required to have an investment in FHLB stock. The Company’s investment in FHLB stock was $ 8.17 million and $ 11.06 million at December 31, 2020 and 2019, respectively. Collateral is provided by the Company’s 1 to 4 family mortgage loans totaling $ 141.75 million at December 31, 2020 and $ 249.75 million at December 31, 2019. The Company also has the ability to borrow against agricultural real estate, commercial real estate and multi-family loans totaling $ 315.86 million as of December 31, 2020 and $ 306.86 million as of December 31, 2019 and there was $ 0 borrowed against this collateral as of December 31, 2020 or 2019. Note 8. Accumulated Other Comprehensive Income The components of accumulated other comprehensive income (AOCI), included in stockholders’ equity, are as follows: December 31, 2020 2019 (amounts in thousands) Net unrealized gain on available-for-sale securities $ 11,702 $ 4,234 Net unrealized loss on derivatives used for cash flow hedges — ( 2,349 ) Tax effect ( 2,920 ) ( 470 ) Net-of-tax amount $ 8,782 $ 1,415 Note 9. Employee Benefit Plans The Company has an Employee Stock Purchase Plan (the “ESPP”). For each quarterly offering period, eligible employees can elect to contribute from 1 % to 15 % of his or her compensation. The purchase price is the lesser of 90% of the fair market value on the first day of the offering period or the last day of the offering period. The maximum dollar amount any one employee can elect to contribute in a year is $ 9,000 . During the year ended December 31, 2020, 7,449 shares of stock were purchased by employees of the Bank through the ESPP. 7,720 shares of stock were purchased by employees of the Bank through the ESPP for the year ended December 31, 2019. Page 97 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Company has an Employee Stock Ownership Plan (the "ESOP") to which it makes discretionary cash contributions. The Company's contribution to the ESOP totaled $ 1.27 million, $ 1.08 million and $ 1.05 million for the years ended December 31, 2020, 2019 and 2018, respectively. The 2020, 2019 and 2018 discretionary contribution rate was 4.5 % of qualified salaries. In the event a terminated plan participant desires to sell his or her shares of the Company stock, or for certain employees who elect to diversify their account balances, the Company may be required to purchase the shares from the participant at their fair value. To the extent that shares of common stock held by the ESOP are not readily traded, a sponsor must reflect the maximum cash obligation related to those securities outside of stockholders' equity. The Company obtains a quarterly independent appraisal of the shares of stock. As of December 31, 2020 and 2019, the shares held by the ESOP, fair value and maximum cash obligation were as follows: 2020 2019 Shares held by the ESOP 757,262 797,317 Fair value per share $ 62.50 $ 65.00 Maximum cash obligation $ 47,329,000 $ 51,826,000 The Company has a profit-sharing plan with a 401(k) feature, which provides for discretionary annual contributions in amounts to be determined by the Board of Directors. The Company made a 4.50 % or $ 1.27 million contribution to the profit sharing plan for the year ended December 31, 2020. The Company made a 4.50 % or $ 1.08 million contribution to the profit sharing plan for the year ended December 31, 2019. The Company made a 4.50 % or $ 1.05 million contribution to the profit sharing plan for the year ended December 31, 2018. The Company made matching contributions under its 401(k) plan of $ 0.26 million in 2020, $ 0.22 million in 2019, and $ 0.21 million in 2018 and each such amount is included in salaries and employee benefits expense. The Company provides a deferred compensation program for executive officers. This program allows executive officers to elect to defer a portion of their salaried compensation for payment by the Company at a subsequent date. The executive officers can defer up to 30 % of their base compensation and up to 100 % of any bonus into the deferral plan. Any amount so deferred is credited to the executive officer’s deferred compensation account and converted to units equivalent in value to the fair market value of a share of stock in Hills Bancorporation. The “stock units” are book entry only and do not represent an actual purchase of stock. The executive officer’s account is adjusted each year for dividends paid and the change in the market value of Hills Bancorporation stock. The deferrals and earnings grow tax deferred until withdrawn from the plan. Earnings credited to the individual’s accounts are recorded as compensation expense when earned. The deferred compensation liability is recorded in other liabilities and totals $ 3.31 million and $ 4.89 million at December 31, 2020 and 2019, respectively. Expense related to the deferred compensation plan was $( 0.02 ) million for 2020, $ 0.42 million for 2019 and $ 0.85 million for 2018 and is included in salaries and employee benefits expense. The Company also provides a deferred compensation program for its Board of Directors. Under the plan, each director may elect to defer up to 50 % of such director’s cash compensation from retainers and meeting fees for payment by the Company at a subsequent date. Any amount so deferred is credited to the director’s deferred compensation account and converted to units equivalent in value to the fair market value of a share of stock in Hills Bancorporation. The “stock units” are book entry only and do not represent an actual purchase of stock. The director’s account is adjusted each year for dividends paid and the change in the market value of Hills Bancorporation stock. The deferred compensation liability for the directors’ plan is recorded in other liabilities and totaled $ 3.78 million and $ 3.94 million at December 31, 2020 and 2019, respectively. Expense related to the directors’ deferred compensation plan was $( 0.09 ) million for 2020, $ 0.28 million for 2019 and $ 0.43 million for 2018 and is included in other noninterest expense. The Company has a Stock Option and Incentive Plan for certain key employees and directors whereby shares of common stock have been reserved for awards in the form of stock options or restricted stock awards. Under the plan, the aggregate number of options and shares granted cannot exceed 250,000 shares. A Stock Option Committee may grant options at prices equal to the fair value of the stock at the date of the grant. Options expire 10 years from the date of the grant. Director options and officers' rights under the plan vest over a five-year period from the date of the grant. The fair value of each option is estimated as of the date of grant using a Black Scholes option pricing model. The expected lives of options granted incorporate historical employee exercise behavior. The risk-free rate for periods that coincide with the expected life of the options is based on the ten year interest rate swap rate as published by the Federal Reserve Bank on the date Page 98 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS of issuance. Expected volatility is based on volatility levels of the Company’s peers’ common stock as the Company’s stock has limited trading activity. Expected dividend yield was based on historical dividend rates. Significant assumptions at the date of grant on May 14, 2019 include the risk-free interest rate of 2.39 %, expected option life of 7.5 years, expected volatility of 33 % and expected dividends of 1.23 %. There were no stock options granted in 2020, 5,805 in 2019 and no ne in 2018. The weighted-average fair value of options granted in 2019 was $ 21.31 per share. The intrinsic value of options exercised was $ 0.00 million, $ 0.06 million and $ 0.03 million for 2020, 2019 and 2018, respectively. A summary of the stock options is as follows: Number of Shares Weighted- Average Exercise Price Weighted-Average Remaining Contractual Term (Years) Aggregate Intrinsic Value (In Thousands) Balance, December 31, 2017 10,220 $ 33.44 4.45 $ 342 Granted — Exercised ( 1,200 ) Balance, December 31, 2018 9,020 $ 33.30 3.41 250 Granted 5,805 Exercised ( 1,800 ) Balance, December 31, 2019 13,025 $ 45.92 5.47 248 Granted — Exercised — Balance, December 31, 2020 13,025 $ 45.92 4.47 $ 216 Other pertinent information related to the options outstanding at December 31, 2020 is as follows: Exercise Price Number Outstanding Remaining Contractual Life Number Exercisable 33.00 7,220 16 months 7,220 62.00 5,805 101 months — 13,025 7,220 As of December 31, 2020, the outstanding options have a weighted-average exercise price of $ 45.92 per share and a weighted average remaining contractual term of 4.47 years. There was $ 0.09 million in unrecognized compensation cost for stock options granted under the plan as of December 31, 2020. The cost is expected to be recognized over a weighted-average period of 3.40 years. As of December 31, 2020, the vested options totaled 7,220 shares with a weighted-average exercise price of $ 33.00 per share. As of December 31, 2020, 231,425 shares were available for stock options and awards under the 2020 Stock Option and Incentive Plan (2020 Plan). The 2010 Stock Option and Incentive Plan (2010 Plan) was discontinued upon the approval of the 2020 Plan in April 2020. No stock options or stock awards will be issued from the 2010 Plan after April 2020. The Compensation and Incentive Stock Committee is also authorized to grant awards of restricted common stock. A summary of the restricted stock option activity for the year ended December 31, 2020 is as follows: Page 99 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2020 Stock Option and Incentive Plan 2010 Stock Option and Incentive Plan Number of Shares Weighted Average Grant Date Fair Value Number of Shares Weighted Average Grant Date Fair Value Balance, December 31, 2019 — 19,853 Authorization of shares 250,000 — Granted 19,063 $ 62.26 1,364 $ 62.26 Forfeited 488 $ 52.93 4,375 $ 52.93 Balance, December 31, 2020 231,425 22,864 The Company authorized the issuance of 20,427 shares in 2020, 23,527 shares in 2019, and 24,899 shares in 2018 to certain employees. The vesting period for these awards is five years and the Bank amortizes the expense on a straight line basis during the vesting period. The expense relating to these awards for the years ended December 31, 2020, 2019 and 2018 was $ 0.95 million, $ 0.96 million and $ 0.85 million, respectively. 10,800 , 7,200 and 15,200 shares of the restricted common stock shares awarded in December 31, 2020, 2019 and 2018, are subject to forfeiture upon termination of the employee's employment with the Company within eight years of the award. Note 10. Income Taxes Income taxes for the years ended December 31, 2020, 2019 and 2018 are summarized as follows: 2020 2019 2018 (Amounts In Thousands) Current: Federal $ 9,124 $ 8,857 $ 7,783 State 2,673 2,391 3,093 Deferred: Federal ( 417 ) 1,068 ( 1,560 ) State ( 103 ) 233 ( 411 ) $ 11,277 $ 12,549 $ 8,905 Page 100 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Temporary differences between the amounts reported in the consolidated financial statements and the tax basis of assets and liabilities result in deferred taxes. Deferred tax assets and liabilities at December 31, 2020 and 2019 were as follows: December 31, 2020 2019 (Amounts In Thousands) Deferred income tax assets: Allowance for loan losses $ 9,249 $ 8,423 Deferred compensation 1,619 2,047 Unrealized losses on interest rate swaps — 586 Accrued expenses 589 716 State net operating loss 1,011 929 Gross deferred tax assets $ 12,468 $ 12,701 Valuation allowance ( 1,011 ) ( 929 ) Deferred tax asset, net of valuation allowance $ 11,457 $ 11,772 Deferred income tax liabilities: Property and equipment 1,941 1,955 Unrealized gains on investment securities 2,920 1,056 Goodwill 407 407 Other 101 336 Gross deferred tax liabilities $ 5,369 $ 3,754 Net deferred tax assets $ 6,088 $ 8,018 The Company has recorded a deferred tax asset for the future tax benefits of Iowa net operating loss carry-forwards. The net operating loss carry-forwards are generated by the Company largely from its investment in tax credit real estate properties. The Company is required to file a separate Iowa tax return and cannot be consolidated with the Bank. The net operating loss carry-forwards will expire, if not utilized, between 2021 and 2039. The Company has recorded a valuation allowance to reduce the deferred tax asset attributable to the net operating loss carry-forwards. At December 31, 2020 and 2019, the Company believes it is more likely than not that the Iowa net operating loss carry-forwards will not be realized. A valuation allowance related to the remaining deferred tax assets has not been provided because management believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets. The valuation allowance increased by $ 82,000 and $ 134,000 for the years ended December 31, 2020 and 2019, respectively. The net change in the deferred income taxes for the years ended December 31, 2020, 2019 and 2018 is reflected in the consolidated financial statements as follows: Year Ended December 31, 2020 2019 2018 (Amounts In Thousands) Consolidated statements of income $ ( 520 ) $ 1,301 $ 1,971 Consolidated statements of stockholders' equity 2,450 1,550 92 $ 1,930 $ 2,851 $ 2,063 Page 101 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Income tax expense for the years ended December 31, 2020, 2019 and 2018 are less than the amounts computed by applying the maximum effective federal income tax rate to the income before income taxes because of the following items: 2020 2019 2018 Amount % Of Pretax Income Amount % Of Pretax Income Amount % Of Pretax Income (Amounts In Thousands) Expected tax expense $ 10,484 21.0 % $ 12,152 20.9 % $ 9,591 21.0 % Tax-exempt interest ( 1,219 ) ( 2.4 ) ( 1,201 ) ( 2.1 ) ( 1,122 ) ( 2.5 ) Interest expense limitation 79 0.1 109 0.2 87 0.2 State income taxes, net of federal income tax benefit 2,030 4.1 2,073 3.5 2,119 4.6 Income tax credits ( 51 ) ( 0.1 ) ( 531 ) ( 0.9 ) ( 1,292 ) ( 2.8 ) Other ( 46 ) ( 0.1 ) ( 53 ) 0.1 ( 478 ) ( 1.0 ) $ 11,277 22.6 % $ 12,549 21.7 % $ 8,905 19.5 % Federal income tax expense for the years ended December 31, 2020, 2019 and 2018 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 the State of Iowa purposes. The tax years ended December 31, 2020, 2019, 2018 and 2017 , remain subject to examination by the Internal Revenue Service. For state tax purposes, the tax years ended December 31, 2020, 2019, 2018 and 2017 , remain open for examination. There were no material unrecognized tax benefits at December 31, 2020 and December 31, 2019. No interest or penalties on these unrecognized tax benefits has been recorded. As of December 31, 2020, the Company does no t anticipate any significant increase or decrease in unrecognized tax benefits during the twelve month period ending December 31, 2021. Note 11. Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and Cash Restrictions The Company and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial results. Under capital adequacy guidelines and the regulatory frameworks for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classifications of the Company and the Bank are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.Quantitative measures established by the regulations to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of capital. Under the BASEL III rules, the minimum capital ratios are 4% for Tier 1 Leverage Capital Ratio, 4.5% for the Common Equity Tier 1 Capital Ratio, 6% for the Tier 1 Risk-Based Capital Ratio and 8% for the Total Risk-Based Capital Ratio. A capital conservation buffer of 2.5% of risk-weighted assets was completely phased in beginning January 1, 2019. As of March 31, 2020, the Bank elected to use the Community Bank Leverage Ratio (CBLR) framework as provided for in the Economic Growth, Regulatory Relief and Consumer Protection Act. Under the CBLR framework, the Bank is required to maintain a CBLR of greater than 9%. The Coronavirus Aid, Relief and Economic Security ("CARES") Act reduced the minimum ratio to 8% beginning in the 2nd quarter of 2020 through December 31, 2020, increasing to 8.5% for 2021 and returning to 9% beginning January 1, 2022. Management believes that, as of December 31, 2020 and 2019, the Company and the Bank met all capital adequacy requirements to which they are subject. As of December 31, 2020 and 2019, the most recent notifications from the Federal Reserve System categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, Tier 1 common equity and Tier 1 leverage ratios as set forth in the table that follows. There are no conditions or events since that notification that management believes have changed the Bank's category. Page 102 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The actual amounts and capital ratios as of December 31, 2020 and 2019, with the minimum regulatory requirements for the Company and Bank are presented below (amounts in thousands): Actual For Capital Adequacy Purposes Amount Ratio Ratio As of December 31, 2020: Company: Community Bank Leverage Ratio $ 452,123 11.91 % 8.00 % Bank: Community Bank Leverage Ratio 453,073 11.94 8.00 Actual For Capital Adequacy Purposes To Be Well-Capitalized Under Prompt Corrective Action Provisions Amount Ratio Ratio Ratio As of December 31, 2019: Company: Total risk-based capital $ 454,452 18.15 % 8.00 % 10.00 % Tier 1 risk-based capital 423,122 16.90 6.00 8.00 Tier 1 common equity 423,122 16.90 4.50 6.50 Leverage ratio 423,122 12.77 4.00 5.00 Bank: Total risk-based capital 455,440 18.20 8.00 10.00 Tier 1 risk-based capital 424,127 16.95 6.00 8.00 Tier 1 common equity 424,127 16.95 4.50 6.50 Leverage ratio 424,127 12.81 4.00 5.00 The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by the Bank. The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends. To maintain acceptable capital ratios in the Bank, certain of its retained earnings are not available for the payment of dividends. To maintain a ratio of capital to assets of 8.00%, retained earnings of $ 243.57 million as of December 31, 2020 are available for the payment of dividends to the Company. The Bank is required to maintain reserve balances in cash or with the Federal Reserve Bank. Reserve balances totaled $ 541.05 million and $ 221.18 million as of December 31, 2020 and 2019, respectively. Note 12. Related Party Transactions Certain directors of the Company and the Bank, companies with which the directors are affiliated, and certain principal officers are customers of, and have banking transactions with, the Bank in the ordinary course of business. Such indebtedness has been incurred on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons. Page 103 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following is an analysis of the changes in the loans to related parties during the years ended December 31, 2020 and 2019: Year Ended December 31, 2020 2019 (Amounts In Thousands) Balance, beginning $ 55,717 $ 51,216 Net increase (decrease) due to change in related parties — 2,481 Advances 14,406 17,243 Collections ( 16,070 ) ( 15,223 ) Balance, ending $ 54,053 $ 55,717 Deposits from these related parties totaled $ 13.18 million and $ 11.16 million as of December 31, 2020 and 2019, respectively. Deposits from related parties are accepted subject to the same interest rates and terms as those from nonrelated parties. Page 104 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 13. Fair Value Measurements The carrying value and estimated fair values of the Company’s financial instruments as of December 31, 2020 are as follows: December 31, 2020 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 $ 574,310 $ 574,310 $ 574,310 $ — $ — Investment securities 416,544 416,544 148,646 267,898 — Loans held for sale 43,947 43,947 — 43,947 — Loans Agricultural 92,334 92,922 — — 92,922 Commercial and financial 281,357 282,015 — — 282,015 Real estate: Construction, 1 to 4 family residential 70,210 70,432 — — 70,432 Construction, land development and commercial 110,501 110,039 — — 110,039 Mortgage, farmland 242,969 242,978 — — 242,978 Mortgage, 1 to 4 family first liens 882,156 890,409 — — 890,409 Mortgage, 1 to 4 family junior liens 126,336 124,945 — — 124,945 Mortgage, multi-family 369,552 370,538 — — 370,538 Mortgage, commercial 412,186 413,409 — — 413,409 Loans to individuals 30,573 31,164 — — 31,164 Obligations of state and political subdivisions 55,838 59,300 — — 59,300 Accrued interest receivable 12,177 12,177 — 12,177 — Total financial instrument assets $ 3,720,990 $ 3,735,129 $ 722,956 $ 324,022 $ 2,688,151 Financial instrument liabilities: Deposits Noninterest-bearing deposits $ 532,190 $ 532,190 $ — $ 532,190 $ — Interest-bearing deposits 2,660,378 2,673,815 — 2,673,815 — Federal Home Loan Bank borrowings 105,000 115,259 — 115,259 — Interest rate swaps — — — — — Accrued interest payable 1,733 1,733 — 1,733 — Total financial instrument liabilities $ 3,299,301 $ 3,322,997 $ — $ 3,322,997 $ — Face Amount Financial instrument with off-balance sheet risk: Loan commitments $ 483,602 $ — $ — $ — $ — Letters of credit 8,056 — — — — Total financial instrument liabilities with off-balance-sheet risk $ 491,658 $ — $ — $ — $ — (1) Considered Level 1 under Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”). (2) Considered Level 2 under ASC 820. (3) Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market. Page 105 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The carrying value and estimated fair values of the Company’s financial instruments as of December 31, 2019 are as follows: December 31, 2019 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 $ 241,965 $ 241,965 $ 241,965 $ — $ — Investment securities 366,368 366,368 128,585 237,783 — Loans held for sale 8,400 8,400 — 8,400 — Loans Agricultural 88,917 90,118 — — 90,118 Commercial and financial 216,335 217,640 — — 217,640 Real estate: Construction, 1 to 4 family residential 79,096 79,954 — — 79,954 Construction, land development and commercial 106,924 107,276 — — 107,276 Mortgage, farmland 238,780 239,521 — — 239,521 Mortgage, 1 to 4 family first liens 902,630 896,676 — — 896,676 Mortgage, 1 to 4 family junior liens 147,634 143,261 — — 143,261 Mortgage, multi-family 346,938 349,663 — — 349,663 Mortgage, commercial 398,145 395,838 — — 395,838 Loans to individuals 31,455 32,722 — — 32,722 Obligations of state and political subdivisions 49,423 50,564 — — 50,564 Accrued interest receivable 12,442 12,442 — 12,442 — Total financial instrument assets $ 3,235,452 $ 3,232,408 $ 370,550 $ 258,625 $ 2,603,233 Financial instrument liabilities: Deposits Noninterest-bearing deposits $ 387,612 $ 387,612 $ — $ 387,612 $ — Interest-bearing deposits 2,273,752 2,292,332 — 2,292,332 — Federal Home Loan Bank Borrowings 185,000 186,091 — 186,091 — Interest rate swaps 2,349 2,349 — 2,349 — Accrued interest payable 2,474 2,474 — 2,474 — Total financial instrument liabilities $ 2,851,187 $ 2,870,858 $ — $ 2,870,858 $ — Face Amount Financial instrument with off-balance sheet risk: Loan commitments $ 424,165 $ — $ — $ — $ — Letters of credit 8,569 — — — — Total financial instrument liabilities with off-balance-sheet risk $ 432,734 $ — $ — $ — $ — (1) Considered Level 1 under Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”). (2) Considered Level 2 under ASC 820. (3) Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market Page 106 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Fair value of financial instruments : FASB ASC 820, Fair Value Measurements and Disclosures (“ASC 820”) provides a single definition for fair value, a framework for measuring fair value and expanded disclosures concerning fair value. Fair value is defined under ASC 820 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company determines the fair market value of its financial instruments based on the fair value hierarchy established in ASC 820. There are three levels of inputs that may be used to measure fair value as follows: Level 1 Quoted prices in active markets for identical assets or liabilities. Level 2 Observable inputs other than quoted prices included within Level 1. Observable inputs include the quoted prices for similar assets or liabilities in markets that are not active and inputs other than quoted prices that are observable for the asset or liability. Level 3 Unobservable inputs supported by little or no market activity for financial instruments. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. The Company is required to use observable inputs, to the extent available, in the fair value estimation process unless that data results from forced liquidations or distressed sales. The following is a description of valuation methodologies used for assets and liabilities recorded at fair value. ASSETS 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. U.S. Treasury securities are considered Level 1 with the remaining securities considered Level 2. The pricing for investment securities is obtained from an independent source. There are no 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 year ended December 31, 2020. If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information. Loans held for sale and Loans : ASU 2016-1, Financial Instruments -Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. Methodologies utilized for this financial statement period are as follows: •Income Approach: Fair value is determined based on a discounted cash flow analysis. The discounted cash flow analysis was based on the contractual maturity of the loan and market indications of rates, prepayment speeds, defaults and credit risk. •Asset Approach: Fair value is determined based on the estimated values of the underlying collateral or individual analysis of receipts. This provides a better indication of value than the contractual income streams as these loans are not performing or exhibit strong signs indicative of non-performance. Fair value has been estimated in accordance with ASC 820, Fair Value Measurements and Disclosures, and is intended to represent the price that would be received in an orderly transaction between market participants as of the measurement date. In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, at least one significant assumption not observable in the market was utilized. These unobservable assumptions reflect estimates that market participants would use in pricing the asset or liability. Inputs to these valuation techniques are subjective in nature, Page 107 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS involve uncertainties and require significant judgment and therefore cannot be determined with precision. Accordingly, the fair value estimates presented are not necessarily indicative of the amounts to be realized in a current market exchange. Loans are classified as Level 3. 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. The Company does record nonrecurring fair value adjustments to impaired 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). A loan is considered to be impaired when it is probable that all of the principal and interest due may not be collected according to its contractual terms. Generally, when a loan is considered impaired, the amount of reserve required under ASC 310, Receivables, is measured based on the fair value of the underlying collateral. The Company makes such measurements on all material loans deemed impaired using the fair value of the collateral for collateral dependent loans or based on the present value of the estimated future cash flows of interest and principal discounted at the loans effective interest rate or the fair value of the loan if determinable. The fair value of collateral used by the Company is determined by obtaining an observable market price or by obtaining an appraised value from an independent, licensed or certified appraiser, using observable market data. This data includes information such as selling price of similar properties and capitalization rates of similar properties sold within the market, expected future cash flows or earnings of the subject property based on current market expectations, and other relevant factors. All appraised values are adjusted for market-related trends based on the Company's experience in sales and other appraisals of similar property types as well as estimated selling costs. Each quarter management reviews all collateral dependent impaired loans on a loan-by-loan basis to determine whether updated appraisals are necessary based on loan performance, collateral type and guarantor support. At times, the Company measures the fair value of collateral dependent impaired loans using appraisals with dates prior to one year from the date of review. These appraisals are discounted by applying current, observable market data about similar property types such as sales contracts, estimations of value by individuals familiar with the market, other appraisals, sales or collateral assessments based on current market activity until updated appraisals are obtained. Depending on the length of time since an appraisal was performed, the data provided through reviews and estimated selling costs, collateral values are typically discounted by 0-35%. 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 costs 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). Page 108 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS LIABILITIES Interest Rate Swap Agreements : The fair value is estimated using forward-looking interest rate curves and is calculated using discounted cash flows that are observable or that can be corroborated by observable market data (Level 2). 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: December 31, 2020 Readily Available Market Prices(1) Observable Market Prices(2) Company Determined Market Prices(3) Total at Fair Value Securities available for sale (Amounts in Thousands) U.S. Treasury $ 148,646 $ — $ — $ 148,646 State and political subdivisions — 224,566 — 224,566 Other securities (FHLB, FHLMC and FNMA) — 35,160 — 35,160 Derivative Financial Instruments Interest rate swaps — — — — Total $ 148,646 $ 259,726 $ — $ 408,372 December 31, 2019 Readily Available Market Prices(1) Observable Market Prices(2) Company Determined Market Prices(3) Total at Fair Value Securities available for sale (Amounts in Thousands) U.S. Treasury $ 128,585 $ — $ — $ 128,585 State and political subdivisions — 211,489 — 211,489 Other securities (FHLB, FHLMC and FNMA) — 15,229 — 15,229 Derivative Financial Instruments Interest rate swaps — ( 2,349 ) — ( 2,349 ) Total $ 128,585 $ 224,369 $ — $ 352,954 (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 years ended December 31, 2020 and 2019. Page 109 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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. For assets measured at fair value on a nonrecurring basis that were still held on the balance sheet at December 31, 2020 and 2019, the following tables provide the level of valuation assumptions used to determine the adjustment and the carrying value of the related individual assets at year end. December 31, 2020 Year Ended December 31, 2020 Readily Available Market Prices(1) Observable Market Prices(2) Company Determined Market Prices(3) Total at Fair Value Total Losses (Amounts in Thousands) Loans (4) Agricultural $ — $ — $ 1,081 $ 1,081 $ — Commercial and financial — — 1,692 1,692 385 Real Estate: Construction, 1 to 4 family residential — — 414 414 — Construction, land development and commercial — — 315 315 — Mortgage, farmland — — 1,718 1,718 — Mortgage, 1 to 4 family first liens — — 5,906 5,906 252 Mortgage, 1 to 4 family junior liens — — 176 176 19 Mortgage, multi-family — — 1,773 1,773 — Mortgage, commercial — — 5,082 5,082 250 Loans to individuals — — — — — Foreclosed assets (5) — — — — — Total $ — $ — $ 18,157 $ 18,157 $ 906 (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 110 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2019 Year Ended December 31, 2019 Readily Available Market Prices(1) Observable Market Prices(2) Company Determined Market Prices(3) Total at Fair Value Total Losses (Amounts in Thousands) Loans (4) Agricultural $ — $ — $ 1,272 $ 1,272 $ 36 Commercial and financial — — 1,803 1,803 499 Real Estate: Construction, 1 to 4 family residential — — — — — Construction, land development and commercial — — 215 215 8 Mortgage, farmland — — 3,576 3,576 — Mortgage, 1 to 4 family first liens — — 7,986 7,986 370 Mortgage, 1 to 4 family junior liens — — 49 49 — Mortgage, multi-family — — 1,816 1,816 — Mortgage, commercial — — 1,237 1,237 125 Loans to individuals — — — — — Foreclosed assets (5) — — — — — Total $ — $ — $ 17,954 $ 17,954 $ 1,038 (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 111 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 14. Parent Company Only Financial Information Following is condensed financial information of the Company (parent company only): CONDENSED BALANCE SHEETS December 31, 2020 and 2019 (Amounts In Thousands) ASSETS 2020 2019 Cash and cash equivalents at subsidiary bank $ 1,100 $ 5,114 Investment in subsidiary bank 464,355 428,042 Other assets 1,846 1,331 Total assets $ 467,301 $ 434,487 LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities $ 3,896 $ 7,450 Redeemable common stock held by ESOP 47,329 51,826 Stockholders' equity: Capital stock 60,233 55,943 Retained earnings 439,831 409,509 Accumulated other comprehensive gain 8,782 1,415 Treasury stock at cost ( 45,441 ) ( 39,830 ) 463,405 427,037 Less maximum cash obligation related to ESOP shares 47,329 51,826 Total stockholders' equity 416,076 375,211 Total liabilities and stockholders' equity $ 467,301 $ 434,487 CONDENSED STATEMENTS OF INCOME Years Ended December 31, 2020, 2019 and 2018 (Amounts In Thousands) 2020 2019 2018 Dividends received from subsidiary $ 14,822 $ 7,657 $ 11,502 Other expenses ( 362 ) ( 708 ) ( 786 ) Income before income tax benefit and equity in undistributed income of subsidiary 14,460 6,949 10,716 Income tax benefit 173 271 273 14,633 7,220 10,989 Equity in undistributed income of subsidiary 24,014 38,098 25,778 Net income $ 38,647 $ 45,318 $ 36,767 Page 112 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONDENSED STATEMENTS OF CASH FLOWS Years Ended December 31, 2020, 2019 and 2018 (Amounts In Thousands) 2020 2019 2018 Cash flows from operating activities: Net income $ 38,647 $ 45,318 $ 36,767 Adjustments to reconcile net income to cash and cash equivalents provided by operating activities: Equity in undistributed income of subsidiary ( 24,014 ) ( 38,098 ) ( 25,778 ) Share-based compensation 25 14 — Compensation expensed through issuance of common stock 1,272 1,133 1,466 Forfeiture of common stock ( 257 ) ( 262 ) ( 152 ) (Increase) decrease in other assets ( 515 ) ( 100 ) 162 (Decrease) increase in other liabilities ( 3,554 ) 1,036 574 Net cash and cash equivalents provided by operating activities 11,604 9,041 13,039 Cash flows from financing activities: Issuance of common stock, net of costs 5,844 5,026 4,713 Stock options exercised — 62 41 Purchase of treasury stock ( 8,550 ) ( 5,534 ) ( 6,784 ) Proceeds from the issuance of common stock through the employee stock purchase plan 413 434 421 Capital contribution to subsidiary ( 5,000 ) — ( 4,700 ) Dividends paid ( 8,325 ) ( 7,657 ) ( 7,003 ) Net cash and cash equivalents used by financing activities ( 15,618 ) ( 7,669 ) ( 13,312 ) (Decrease) increase in cash and cash equivalents ( 4,014 ) 1,372 ( 273 ) Cash and cash equivalents: Beginning of year 5,114 3,742 4,015 Ending of year $ 1,100 $ 5,114 $ 3,742 Note 15. Commitments and Contingencies Concentrations of credit risk : The Bank’s loans, commitments to extend credit, unused lines of credit and outstanding letters of credit have been granted to customers within the Bank's market area. Investments in securities issued by state and political subdivisions within the state of Iowa totaled approximately $ 91.33 million. The concentrations of credit by type of loan are set forth in Note 3 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 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 conditions, or results of operations. The outbreak of Coronavirus Disease 2019 (“COVID-19”) has and will continue to adversely impact a broad range of industries in which the Company’s customers operate and impair their ability to fulfill their financial obligations to the Company. The World Health Organization has declared COVID-19 to be a global pandemic indicating that almost all public commerce and related business activities must be, to varying degrees, curtailed with the goal of decreasing the rate of new infections. The spread of the outbreak has caused significant disruptions in the U.S. economy and is highly likely to disrupt banking and other financial activity in the areas in which the Company operates and could also potentially create widespread business continuity issues for the Company. The Company’s business is dependent upon the willingness and ability of its employees and Page 113 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS customers to conduct banking and other financial transactions. If the global response to contain COVID-19 escalates or is unsuccessful, the Company could experience a material adverse effect on its business, financial condition, results of operations and cash flows. See Note 3 for further discussion regarding the financial impact of COVID-19. 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 December 31, 2020 and 2019 is as follows: 2020 2019 (Amounts In Thousands) Firm loan commitments and unused portion of lines of credit: Home equity loans $ 69,974 $ 65,203 Credit cards 60,535 57,421 Commercial, real estate and home construction 118,186 94,490 Commercial lines and real estate purchase loans 234,907 207,051 Outstanding letters of credit 8,056 8,569 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the party. Collateral held varies, but may include accounts receivable, crops, livestock, inventory, property and equipment, residential real estate and income-producing commercial properties. Credit card commitments are the unused portion of the holders' credit limits. Such amounts represent the maximum amount of additional unsecured borrowings. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements and, generally, have terms of one year or less. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Bank holds collateral, which may include accounts receivable, inventory, property, equipment, and income-producing properties, supporting those commitments if deemed necessary. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Bank would be required to fund the commitment. The maximum potential amount of future payments the Bank could be required to make is represented by the contractual amount shown in the summary above. If the commitment is funded the Bank would be entitled to seek recovery from the customer. At December 31, 2020 and 2019, no amounts have been recorded as liabilities for the Bank’s potential obligations under these guarantees. Page 114 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Lease commitments: The Company leases certain facilities under operating leases. The minimum future rental commitments as of December 31, 2020 for all non-cancelable leases relating to Bank premises were as follows: Year ending December 31: (Amounts In Thousands) 2021 $ 375 2022 319 2023 316 2024 82 2025 1 Thereafter 4 $ 1,097 Rent expense was $ 0.38 million, $ 0.40 million and $ 0.36 million for the years ended December 31, 2020, 2019 and 2018, respectively. Note 16. Quarterly Results of Operations (unaudited, amounts in thousands, except per share amounts) Quarter Ended March June September December Year 2020 Interest income $ 32,452 $ 32,246 $ 31,675 $ 32,156 $ 128,529 Interest expense 7,862 6,645 6,465 5,980 26,952 Net interest income $ 24,590 $ 25,601 $ 25,210 $ 26,176 $ 101,577 Provision for loan losses 4,649 8 ( 157 ) ( 142 ) 4,358 Other income 6,167 6,531 7,510 8,128 28,336 Other expense 17,227 16,872 18,055 23,477 75,631 Income before income taxes $ 8,881 $ 15,252 $ 14,822 $ 10,969 $ 49,924 Income taxes 1,806 3,541 3,392 2,538 11,277 Net income $ 7,075 $ 11,711 $ 11,430 $ 8,431 $ 38,647 Basic earnings per share $ 0.75 $ 1.25 $ 1.22 $ 0.90 $ 4.12 Diluted earnings per share 0.75 1.25 1.22 0.90 4.12 2019 Interest income $ 31,847 $ 33,236 $ 33,969 $ 33,280 $ 132,332 Interest expense 8,074 8,848 9,274 8,677 34,873 Net interest income $ 23,773 $ 24,388 $ 24,695 $ 24,603 $ 97,459 Provision for loan losses ( 1,246 ) ( 540 ) 144 ( 1,238 ) ( 2,880 ) Other income 5,250 5,851 6,638 7,053 24,792 Other expense 16,049 16,360 16,604 18,251 67,264 Income before income taxes $ 14,220 $ 14,419 $ 14,585 $ 14,643 $ 57,867 Income taxes 3,017 3,199 3,303 3,030 12,549 Net income $ 11,203 $ 11,220 $ 11,282 $ 11,613 $ 45,318 Basic earnings per share $ 1.20 $ 1.20 $ 1.21 $ 1.24 $ 4.85 Diluted earnings per share 1.20 1.20 1.21 1.24 4.85 Note 17. 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 consolidated financial statements and are measured at fair value. The Bank’s Page 115 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates. The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amount to be exchanged between the counterparties. The Bank is exposed to credit risk in the event of nonperformance by counterparties to financial instruments. The Bank minimizes this risk by entering into derivative contracts with large, stable financial institutions. The Bank has not experienced any losses from nonperformance by counterparties. The Bank monitors counterparty risk in accordance with the provisions of ASC 815. In addition, the Bank’s interest rate-related derivative instruments contain language outlining collateral pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty. The Bank determined to terminate one interest rate swap in December 2020 and the other matured in November 2020, therefore the Bank was required to pledge no collateral as of December 31, 2020. Cash Flow Hedges: The Bank executed two forward-starting interest rate swap transactions on November 7, 2013. One of the interest rate swap transactions had an effective date of November 9, 2015, and an expiration date of November 9, 2020 , effectively converting $ 25.00 million of variable rate debt to fixed rate debt. The other interest rate swap transaction had an effective date of November 7, 2016 and an expiration date of November 7, 2023 , effectively converting $ 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 Bank determined to terminate the remaining interest rate swap in December 2020 and in connection with the termination paid $ 2.684 million to the counterparty. The losses realized on the interest rate swap were reclassified into the income statement from other comprehensive income. In connection with the termination of the swap, the related FHLB borrowing was paid off as described in Note 7. The table below identifies the balance sheet category and fair values of the Bank’s derivative instruments designated as cash flow hedges as of December 31, 2020 and 2019: Notional Amount Fair Value Balance Sheet Category Maturity (Amounts in Thousands) December 31, 2020 Interest rate swap $ — $ — Other Liabilities Interest rate swap — — Other Liabilities December 31, 2019 Interest rate swap $ 25,000 $ ( 279 ) Other Liabilities 11/9/2020 Interest rate swap 25,000 ( 2,070 ) Other Liabilities 11/7/2023 Page 116 Table of Contents HILLS BANCORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The table below identifies the gains and losses recognized on the Bank’s derivative instruments designated as cash flow hedges for the years ended December 31, 2020 and 2019: Recognized in OCI Reclassified 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) December 31, 2020 Interest rate swap $ 209 Interest Expense $ — Other Income $ — Interest rate swap ( 438 ) Interest Expense ( 1,992 ) Other Income — December 31, 2019 Interest rate swap $ ( 119 ) Interest Expense $ — Other Income $ — Interest rate swap ( 446 ) Interest Expense — Other Income — Note 18. Subsequent Events The Company is currently finalizing the CECL model and upon adoption of ASU 2016-13 (CECL) in the first quarter of 2021 anticipates an increase to the allowance for credit losses for loans of approximately $ 2 to $ 4 million and an unfunded commitment liability of approximately $ 3 to $ 4 million. See Note 1 for further discussion. Subsequent events have been evaluated through March 5, 2021. Page 117 Table of Contents Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure None.