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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

2022-03-04 compared with 2021-03-05 · 587 added, 479 removed, 1565 unchanged (41% of the section changed)

26 unchanged sentences

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 Bank is exposed to credit-related losses in the event of nonperformance by the counterparties to these derivative instruments, but believe the risk of 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.

59 unchanged sentences

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, 2021 and 2020, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2021, 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.

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, 2021, based on Internal Control-Integrated Framework (2013 edition) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 4, 2022, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

Adoption of New Accounting Standard

As discussed in Notes 1 and 3 to the consolidated financial statements, the Company has changed its method of accounting for the allowance for credit losses in 2021 due to the adoption of ASU 2016-13, Financial Instruments – Credit Losses (Topic 326):

Measurement of Credit Losses on Financial Instruments .

As discussed below, auditing the Company’s allowance for credit losses, including adoption of the new accounting guidance related to the estimate of allowance for credit losses, was a critical audit matter.

Basis for Opinion

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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.

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.

Critical Audit Matter

The critical audit matter communicated below is a matter arising from the current-period audit of the financial statements that was communicated or required to be communicated to the audit committee and that:

(1) relates to an account or disclosure that is material to the financial statements and (2) involved especially challenging, subjective or complex judgments.

The communication of the critical audit matter does not alter in any way our opinion on the 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.

Allowance for Credit Losses

As discussed in Notes 1 and 3 , the Company adopted Topic 326 effective January 1, 2021.

The Company uses the discounted cash flow (DCF) method to estimate expected losses for most of the Company’s loan pools that exhibit similar risk characteristics.

For each of these loan pools, the Company generates cash flow projections at the instrument level adjusting payment expectations for estimated prepayment speed, curtailments, time to recovery, probability of default and loss given default.

The Company uses regression analysis of historical internal and peer data to determine suitable loss drivers when modeling lifetime probability of default and loss given default.

The Company’s analysis also determines how expected probability of default and loss given default will react to forecasted levels of the loss drivers.

Additional qualitative adjustments are applied for risk factors that are not considered within the modeling process but are relevant in assessing the expected credit losses within the loan pools.

Loans that do not share risk characteristics are evaluated on an individual basis.

For loans individually evaluated, an allowance is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan.

The Company applies expected funding percentages to the respective model loss rates to estimate the allowance related to unfunded commitments.

Auditing management’s estimate of the allowances for loan credit losses (ACL) and unfunded commitments involved a high degree of subjectivity due to the complexities of the probability of default and loss given default models and the nature of the qualitative factor adjustments.

Management’s qualitative factor adjustments are highly judgmental and had a significant effect on the ACL.

How the Critical Audit Matter was Addressed in the Audit

Our audit procedures related to the ACL and allowance for unfunded commitments included the following procedures, among others:

• Obtained an understanding of the Company’s process for establishing the ACL, including the implementation of models and assumptions and the qualitative factor adjustments of the ACL.

• Obtained an understanding, evaluated the design and tested the operating effectiveness of controls, including information technology, over the reliability and accuracy of data used to calculate and estimate the various components of the ACL including:

◦ Loan data completeness and accuracy

◦ Grouping of loans by segment

◦ Model inputs utilized

◦ Approval of model assumptions selected

◦ Establishment of qualitative factors

• Tested the mathematical accuracy of the calculation of the ACL

• Tested individual loan files to evaluate the reasonableness of loan credit risk ratings

• Tested the completeness and accuracy of inputs utilized in the calculation of the ACL

• Evaluated the reasonableness of selected loss drivers utilized and loss driver forecasts for each loan segment

• Tested the reasonableness of specific reserves on individually evaluated loans

• Tested estimated funding rate of unfunded loan commitments

• Evaluated the qualitative adjustments, including assessing the reasonableness and basis for adjustments

We have served as the Company’s auditor since 2012.

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In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2021, based on criteria established in Internal Control – Integrated Framework:

(2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

(2013) issued by 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 4, 2022, expressed an unqualified opinion.

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Loans held for sale 5,716 43,947

Loans, net of allowance for loan losses (2020 $ 37,070 ;

Loans, net of allowance for credit losses (2021 $ 35,470 ;

2020 $ 37,070 ) (Notes 1, 3, and 12)

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Accrued interest receivable 11,437 12,177

Deferred income taxes, net (Note 10) 6,088 8,018

Deferred income taxes, net (Notes 1 and 10) 9,125 6,088

Goodwill 2,500 2,500

5 unchanged sentences

Total deposits 3,533,994 3,192,568

Other borrowings, federal funds purchased 249 —

Federal Home Loan Bank borrowings (Note 7) — 105,000

Accrued interest payable 1,165 1,733

Allowance for credit losses on off-balance sheet credit exposures 3,850 —

Other liabilities 16,841 19,656

36 unchanged sentences

Net interest income 104,462 101,577 97,459

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

Credit loss (benefit) expense (Note 3) ( 5,507 ) 4,358 ( 2,880 )

Net interest income after credit loss (benefit) expense 109,969 97,219 100,339

Noninterest income:

29 unchanged sentences

Other comprehensive income (loss)

Net change in unrealized gain (loss) on securities available for sale 7,478 6,940 ( 1,593 )

Net change in unrealized (loss) gain on securities available for sale ( 9,734 ) 7,478 6,940

Reclassification adjustment for net (gains) losses realized in net income — ( 10 ) 28

Income taxes 2,429 ( 1,864 ) ( 1,738 )

Other comprehensive income (loss) on securities available for sale 5,604 5,230 ( 1,196 )

Other comprehensive (loss) income on securities available for sale ( 7,305 ) 5,604 5,230

Derivatives used in cash flow hedging relationships:

Net change in unrealized (loss) gain on derivatives ( 335 ) ( 753 ) 1,223

Net change in unrealized loss on derivatives — ( 335 ) ( 753 )

Reclassification adjustment for losses realized in net income — 2,684 —

1 unchanged sentence

Other comprehensive income (loss) on cash flow hedges — 1,763 ( 565 )

Other comprehensive income (loss), net of tax 7,367 4,665 ( 278 )

Other comprehensive (loss) income, net of tax ( 7,305 ) 7,367 4,665

Comprehensive income $ 40,780 $ 46,014 $ 49,983

17 unchanged sentences

( 262 ) — — — — ( 262 )

Share-based compensation 14 — — — — 14

Change related to ESOP shares — — — — ( 2,956 ) ( 2,956 )

2 unchanged sentences

— ( 7,657 ) — — — ( 7,657 )

Reclassification of stranded tax effects due to the Tax Cuts and Jobs Act — 526 ( 526 ) — — —

Purchase of 89,124 shares of common stock

18 unchanged sentences

Balance, December 31, 2020 $ 60,233 $ 439,831 $ 8,782 $ ( 45,441 ) $ ( 47,329 ) $ 416,076

Cumulative change in accounting principle (Note 1) — ( 4,751 ) — — — ( 4,751 )

Balance, January 1, 2021 (as adjusted for change in accounting principle) 60,233 435,080 8,782 ( 45,441 ) ( 47,329 ) 411,325

Issuance of 24,513 shares of common stock

24 unchanged sentences

Depreciation 3,052 3,128 3,072

Provision for loan losses 4,358 ( 2,880 ) 8,497

Credit loss (benefit) expense ( 5,507 ) 4,358 ( 2,880 )

Net (gain) loss on sale of investment securities available for sale — ( 10 ) 28

17 unchanged sentences

Purchases of investment securities available for sale ( 245,378 ) ( 129,359 ) ( 104,539 )

Proceeds from sale of stock of FHLB 4,201 — —

Purchases of stock of FHLB ( 575 ) — —

Loans made to customers, net of collections 52,018 ( 72,138 ) ( 13,024 )

1 unchanged sentence

Purchases of property and equipment ( 1,464 ) ( 1,860 ) ( 3,167 )

Investment in tax credit real estate ( 4,183 ) — —

Net changes from tax credit real estate investment 1,641 1,007 913

7 unchanged sentences

Net increase in deposits 341,426 531,204 240,240

Net decrease in short-term borrowings — — —

Net increase in short-term borrowings 249 — —

Net decrease in FHLB borrowings ( 105,000 ) ( 80,000 ) ( 30,000 )

7 unchanged sentences

Net cash and cash equivalents provided by financing activities 224,760 440,586 202,571

Increase (decrease) in cash and cash equivalents 332,345 198,660 ( 111,048 )

Increase in cash and cash equivalents 207,608 332,345 198,660

Cash and cash equivalents:

7 unchanged sentences

Noncash financing activities:

Increase in maximum cash obligation related to ESOP shares $ 4,497 $ 2,956 $ 5,562

Increase (decrease) in maximum cash obligation related to ESOP shares $ 2,684 $ ( 4,497 ) $ 2,956

Transfers to other real estate owned 96 45 712

16 unchanged sentences

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.

The allowance for credit losses, fair values of securities and other financial instruments, and share-based compensation expense involve certain significant estimates made by management.

These estimates are reviewed by management routinely and it is reasonably possible that circumstances that exist at December 31, 2021 may change in the near-term and the effect could be material to the consolidated financial statements.

2 unchanged sentences

All significant intercompany balances and transactions have been eliminated in consolidation.

Reclassification of prior year presentation :

Certain prior year amounts have been reclassified for consistency with the current year presentation.

These reclassifications had no effect on the reported results of operations.

Revenue recognition :

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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

A contract liability balance is an

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).

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, 2021 and 2020, the Company did not have any significant contract balances.

An entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered.

The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission).

The Company utilizes the practical expedient which allows entities to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less.

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Investment securities :

Available-for-sale securities consist of debt securities not classified as trading or held to maturity.

Available-for-sale ("AFS") securities consist of debt securities not classified as trading or held to maturity.

Available-for-sale securities are stated at fair value, and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity.

There were no trading or held to maturity securities as of December 31, 2021 or 2020.

Stock of the Federal Home Loan Bank is carried at cost.

The Company has evaluated the stock and determined there is no impairment.

Fair value measurement is based upon quoted market prices in active markets, if available.

If quoted prices in active markets are not available, fair value is measured using pricing models or other model-based valuation techniques such as present value of future cash flows, which consider prepayment assumptions and other factors such as credit losses and market liquidity.

Unrealized gains and losses are excluded from earnings and reported, net of tax, in other comprehensive income ("OCI").

Premiums on debt securities are amortized to the earliest call date and discounts on debt securities are accreted over the period to maturity of those securities.

The method of amortization results in a constant effective yield on those securities (the interest method).

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 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.

Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

AFS debt securities in unrealized loss positions are evaluated for impairment related to credit losses at least quarterly.

For AFS debt securities, a decline in fair value due to credit loss results in recording an allowance for credit losses to the extent the fair value is less than the amortized cost basis.

Declines in fair value that have not been recorded through an allowance for credit losses, such as declines due to changes in market interest rates, are recorded through other comprehensive income, net of applicable taxes.

Impairment may result from credit deterioration of the issuer or collateral underlying the security.

In performing an assessment of whether any decline in fair value is due to a credit loss, all relevant information is considered at the individual security level.

For asset-backed securities performance indicators considered related to the underlying assets include default rates, delinquency rates, percentage of nonperforming assets, debt-to-collateral ratios, third-party guarantees, current levels of subordination, vintage, geographic concentration, analyst reports and forecasts, credit ratings and other market data.

In assessing whether a credit loss exists, we compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security.

If the present value of cash flows expected to be collected is less than the amortized cost basis for the security, a credit loss exists and an allowance for credit losses is recorded, limited to the amount the fair value is less than amortized cost basis.

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

Accrued interest receivable on AFS debt securities totaled $ 2.05 million at December 31, 2021 and is excluded from the estimate of credit losses.

Stock of the Federal Home Loan Bank is carried at cost.

The Company has evaluated the stock and determined there is no impairment.

Loans held for sale :

Loans held for sale are stated at the lower of aggregate cost or estimated fair value.

Loans are sold on a non-recourse basis with servicing released and gains and losses are recognized based on the difference between sales proceeds and the carrying value of the loan.

The Company has had very few experiences of repurchasing loans previously sold into the secondary market.

A specific reserve was not considered necessary based on the Company’s historical experience with repurchase activity.

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.

The Company has had very few experiences of repurchasing loans previously sold into the

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.

secondary market.

A specific reserve was not considered necessary based on the Company’s historical experience with repurchase activity.

Loans held for investment :

Loans are stated at the amount of unpaid principal, net of deferred loan fees, and reduced by the allowance for credit losses ("ACL").

Accrued interest receivable on loans held for investment totaled $ 9.29 million at December 31, 2021 and is excluded from the estimate of credit losses.

Interest income is accrued on the unpaid principal balance.

Nonrefundable loan fees and origination costs are deferred and recognized as a yield adjustment over the life of the related loan.

The accrual of interest income on loans is discontinued when, in the opinion of management, there is reasonable doubt as to the borrower's ability to meet payments of interest or principal when they become due, which is generally when a loan is 90 days or more past due.

5 unchanged sentences

As of December 31, 2021, 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.

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:

Allowance for credit losses for loans held for investment :

The allowance for credit losses is an estimate of expected losses inherent within the Company's existing loans held for investment portfolio.

The allowance for credit losses for loans held for investment, as reported in our consolidated balance sheet, is adjusted by a credit loss expense, which is reported in earnings, and reduced by the charge-off of loan amounts, net of recoveries.

The loan loss estimation process involves procedures to appropriately consider the unique characteristics of loan portfolio segments which consist of agricultural, 1 to 4 family first and junior liens, commercial, and consumer lending.

These segments are further disaggregated into loan classes, the level at which credit risk is monitored.

For each of these pools, the Company generates cash flow projections at the instrument level wherein payment expectations are adjusted for estimated prepayment speed, curtailments, time to recovery, probability of default, and loss given default.

The modeling of expected prepayment speeds, curtailment rates, and time to recovery are based on historical internal data.

The following provides the credit quality indicators and risk elements that are most relevant and most carefully considered and monitored for each loan portfolio segment.

Agricultural - Agricultural operating loans include loans made to finance agricultural production and other loans to farmers and farming operations.

Agricultural loans also include mortgage loans secured by farmland.

Agricultural operating loans, most of which are secured by crops and machinery, are provided to finance capital improvement and farm operations as well as acquisitions of livestock and machinery.

The ability of the borrower to repay may be affected by many factors outside of the borrower’s control including adverse weather conditions, loss of livestock due to disease or other factors, declines in market prices for agricultural products and the impact of government regulations.

The ultimate repayment of agricultural operating loans is dependent upon the profitable operation or management of the agricultural entity.

Agricultural operating loans generally have a term of one year and may have a fixed or variable rate.

Mortgage loans secured by farmland are made to individuals and businesses within the Company's trade area.

The primary source of repayment is the cash flow generated by the collateral underlying the loan.

The secondary repayment source would be the liquidation of the collateral.

Terms for real estate loans secured by farmland range from one to ten years with an amortization period of 25 years or less.

Generally, interest rates are fixed for mortgage loans secured by farmland.

Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate and the Iowa real gross domestic product (GDP).

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1 to 4 Family First and Junior Liens - The 1 to 4 family first and junior liens portfolio segment is comprised of the single family and home equity loan classes, which are underwritten after evaluating a borrower's capacity to repay, credit, and collateral.

Several factors are considered when assessing a borrower's capacity, including the borrower's employment, income, current debt, assets, and level of equity in the property.

Credit refers to how well a borrower manages their current and prior debts as documented by a credit report that provides credit scores and the borrower's current and past information about their credit history.

Collateral refers to the type and use of property, occupancy, and market value.

Property appraisals are obtained to assist in evaluating collateral.

Loan-to-property value and debt-to-income ratios, loan amount, and lien position are also considered in assessing whether to originate a loan.

These borrowers are particularly susceptible to downturns in economic trends such as conditions that negatively affect housing prices and demand and levels of unemployment.

Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate and the all-transactions house price index for Iowa.

Commercial - The commercial loan portfolio segment is comprised of the commercial real estate mortgage, multifamily residential mortgage, construction/land development and commercial and financial loan classes, whose underwriting standards consider the factors described for single family and home equity loan classes as well as others when assessing the borrower's and associated guarantors or other related party's financial position.

These other factors include assessing liquidity, the level and composition of net worth, leverage, considering all other lender amounts and position, an analysis of cash expected to flow through the obligors including the outflow to other lenders, vacancies and prior experience with the borrower.

This information is used to assess adequate financial capacity, profitability, and experience.

Ultimate repayment of these loans is sensitive to interest rate changes, general economic conditions, liquidity, and availability of long-term financing.

Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate, the all-transactions house price index for Iowa and the Iowa real GDP.

Consumer Lending - The Bank offers consumer loans to individuals including personal loans and automobile loans.

These consumer loans typically have shorter terms, lower balances, higher yields and higher risks of default than real estate-related loans.

Consumer loans collections are dependent on the borrower's continuing financial stability and are more likely to be affected by adverse personal circumstances.

Collateral for these loans generally includes automobiles, boats, recreational vehicles and real estate.

However, depending on the overall financial condition of the borrower, some loans are made on an unsecured basis.

The collateral securing these loans may depreciate over time, may be difficult to recover and may fluctuate in value based on condition.

Key economic forecasts used in estimating expected credit losses for this segment include the Iowa unemployment rate and the Iowa real GDP.

The allowance level is influenced by loan volumes, loan credit quality indicator migration or delinquency status, historic loss experience and other conditions influencing loss expectations, such as reasonable and supportable forecasts of economic conditions.

The methodology for estimating the amount of expected credit losses reported in the allowance for credit losses has two basic components:

first, a pooled component for estimated expected credit losses for pools of loans that share similar risk characteristics;

and second, an asset-specific component involving individual loans that do not share risk characteristics with other loans and the measurement of expected credit losses for such individual loans.

Depending on the nature of the pool of financial assets with similar risk characteristics, the Company uses a discounted cash flow method or remaining life method to estimate expected credit losses.

Discounted cash flow method :

In estimating the component of the allowance for credit losses for loans that share similar risk characteristics with other loans, such loans are segregated into loan classes.

Loans are designated into loan classes based on loans pooled by product types and similar risk characteristics or areas of risk concentration.

In determining the allowance for credit losses, we derive an estimated credit loss assumption from a model that categorizes loan pools based on loan type and purpose.

This model calculates an expected loss percentage for each loan class by considering the probability of default, using life-of-loan analysis periods for all loan segments, and the historical severity of loss, based on the aggregate net lifetime losses incurred per loan class.

The default and severity factors used to calculate the allowance for credit losses for loans that share similar risk characteristics with other loans are adjusted for differences between the historical period used to calculate historical default and loss severity rates and expected conditions over the remaining lives of the loans in the portfolio related to:

(1) lending policies and procedures;

(2) international, national, regional and local economic business conditions and developments that affect the collectability of the portfolio;

(3) the nature and volume of the loan portfolio including the terms of the loans;

(4) the experience, ability, and depth of the lending management and other relevant staff;

(5) the volume and severity of past due and adversely classified or graded loans and the volume of nonaccrual loans;

(6) the quality of our loan review system and (7)

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

the value of underlying collateral for collateralized loans.

Additional factors include the existence and effect of any concentrations of credit, and changes in the level of such concentrations and the effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio.

Such factors are used to adjust the historical probabilities of default and severity of loss so that they reflect management expectation of future conditions based on a reasonable and supportable forecast.

The Company uses regression analysis of historical internal and peer data to determine which variables are best suited to be economic variables utilized when modeling lifetime probability of default and loss given default.

This analysis also determines how expected probability of default and loss given default will react to forecasted levels of the economic variables.

For all DCF models, management has determined that four quarters represents a reasonable and supportable forecast period and reverts back to a historical loss rate over twelve quarters on a straight-line basis.

Other internal and external indicators of economic forecasts are also considered by management when developing the forecast metrics.

Remaining life method:

Expected credit losses for credit cards and overdrafts are determined through use of the remaining life method.

The remaining life method utilizes average annual charge-off rates and remaining life to estimate the allowance for credit losses.

This is done by estimating the amount and timing of principal payments expected to be received as payment for the balance outstanding as of the reporting period and applying those principal payments against the balance outstanding as of the reporting period along with the average annual charge-off rate until the expected payments have been fully allocated.

Collateral dependent financial assets :

For a loan that does not share risk characteristics with other loans, expected credit loss is measured based on net realizable value, that is, the difference between the discounted value of the expected future cash flows, based on the original effective interest rate, and the amortized cost basis of the loan.

For these loans, we recognize expected credit loss equal to the amount by which the net realizable value of the loan is less than the amortized cost basis of the loan (which is net of previous charge- offs and deferred loan fees and costs), except when the loan is collateral dependent, that is, when the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the collateral.

In these cases, expected credit loss is measured as the difference between the amortized cost basis of the loan and the fair value of the collateral.

The fair value of the collateral is adjusted for the estimated cost to sell if repayment or satisfaction of a loan is dependent on the sale (rather than only on the operation) of the collateral.

The Company’s estimate of the ACL reflects losses expected over the contractual life of the assets, adjusted for estimated prepayments or curtailments.

The contractual term does not consider extensions, renewals or modifications unless the Company has identified an expected troubled debt restructure (TDR).

A loan that has been modified or renewed is considered a TDR when two conditions are met:

1) the borrower is experiencing financial difficulty and 2) concessions are made for the borrower's benefit that would not otherwise be considered for a borrower or transaction with similar credit risk characteristics.

The Company’s ACL reflects all effects of a TDR when an individual asset is specifically identified as a reasonably expected TDR.

The Company has determined that a TDR is reasonably expected no later than the point when the lender concludes that modification is the best course of action and it is at least reasonably possible that the troubled borrower will accept some form of concession from the lender to avoid a default.

Reasonably expected TDRs and executed non-performing TDRs are evaluated individually to determine the required ACL.

TDRs performing in accordance with their modified contractual terms for a reasonable period of time may be included in the Company’s existing pools based on the underlying risk characteristics of the loan to measure the ACL.

Allowance for credit losses on off-balance sheet credit exposures, including unfunded loan commitments :

The Company maintains a separate allowance for credit losses from off-balance-sheet credit exposures, including unfunded loan commitments, which is disclosed on the balance sheet.

Management estimates the amount of expected losses by calculating a commitment usage factor over the contractual period for exposures that are not unconditionally cancellable by the Company and applying the loss factors used in the ACL methodology to the results of the usage calculation to estimate the liability for credit losses related to unfunded commitments for each loan type.

No credit loss estimate is reported for off-balance-sheet (OBS) credit exposures that are unconditionally cancellable by the Company, such as credit card receivables, or for undrawn amounts under such arrangements that may be drawn prior to the cancellation of the arrangement.

The allowance for credit losses on OBS credit exposures is adjusted as credit loss expense.

Categories of OBS credit exposures correspond to the loan portfolio segments described previously.

Troubled debt restructurings (“TDR loans”) :

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.

A loan is accounted for and reported as a troubled debt restructuring ("TDR") when, for economic or legal reasons, we grant a concession to a borrower experiencing financial difficulty that we would not

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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.

A restructuring that results in only an insignificant delay in payment is not considered a concession.

A delay may be considered insignificant if the payments subject to the delay are insignificant relative to the unpaid principal or collateral value and the contractual amount due, or the delay in timing of the restructured payment period is insignificant relative to the frequency of payments, the debt's original contractual maturity or original expected duration.

TDRs that are performing and on accrual status as of the date of the modification remain on accrual status.

TDRs that are nonperforming as of the date of modification generally remain as nonaccrual until the prospect of future payments in accordance with the modified loan agreement is reasonably assured, generally demonstrated when the borrower maintains compliance with the restructured terms for a predetermined period, normally at least six months.

TDRs with temporary below-market concessions remain designated as a TDR regardless of the accrual or performance status until the loan is paid off.

However, if the TDR loan has been modified in a subsequent restructure with market terms and the borrower is not currently experiencing financial difficulty, then the loan is no longer classified as a TDR in the quarter following the modification.

Management evaluates loans where there is a reasonable expectation at the reporting date that a troubled debt restructuring will be executed with an individual borrower for purposes of estimating the allowance for credit losses.

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.

Under Section 4013 of the CARES Act, loan modifications that qualify for such suspension are those where the borrower was not more than 30 days past due as of December 31, 2019.

In addition, the loan modification being made in response to the COVID-19 pandemic must include a deferral or delay in the payment of principal or interest, or change in the interest rate on the loan.

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.

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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.

Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time a modification program is implemented.

The relief related to TDRs expired on January 1, 2022.

See Note 3 for further discussion.

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Such financial instruments are recorded when they are funded.

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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.

Tax credit real estate represents three multi-family rental properties, three assisted living rental properties, a multi-tenant rental property for persons with disabilities, and a multi-family senior living rental property, all which are affordable housing projects as of December 31, 2021.

The Bank has a 99 % or greater limited partnership interest in each limited partnership.

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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 investments in tax credit real estate are recorded for all years presented using the equity method of accounting, with the exception of the investment in the affordable housing project described below.

The operations of the properties are not expected to contribute significantly to the Company’s income before income taxes.

However, the properties do contribute in the form of income tax credits, which lowers the Company’s effective tax rate.

Once established, the credits on each property last for ten years and are passed through from the limited partnerships to the 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.

Once established, the credits on each property last for ten

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

years and are passed through from the limited partnerships to the Bank and reduces the consolidated federal tax liability of the Company.

In February 2021, the Company provided construction financing and contributed capital of $ 4.18 million to Del Ray Ridge LP, as limited partner, which owns and operates an affordable housing property in Iowa City, Iowa.

The Company accounts for the investment in this tax credit real estate using the proportional amortization method as provided for under Accounting Standards Codification (ASC) 323-740.

The investment qualifies for the proportional amortization method as it meets all of the criteria under ASC 323-740-25-1.

Substantially all of the projected benefits are from tax credits and other tax benefits due to the minimum buyout clause included in the partnership agreement.

On a regular basis, the Company evaluates recoverability of the carrying value of the tax credit real estate investments to determine if an allowance for credit losses is necessary.

The allowance for credit losses is measured by a comparison of the carrying amount of the investments to the future undiscounted cash flows expected to be generated by the investment properties, including the low-income housing tax credits and any estimated proceeds from eventual disposition.

If there is an indication of impairment, the allowance for credit losses would be established with a charge to credit loss expense.

There were no indications of impairment based on management's evaluation and therefore no allowance for credit losses was determined necessary as of December 31, 2021.

Property and equipment :

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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.

As of December 31, 2021 and 2020, the Bank did not have any outstanding interest rate swaps.

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

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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.

11 unchanged sentences

Common shares outstanding at the beginning of the year 9,330,995 9,351,694 9,336,441

Weighted average number of net shares issued 17,571 19,304 31,160

Weighted average number of net shares (redeemed) issued ( 23,793 ) 17,571 19,304

Weighted average shares outstanding (basic) 9,307,202 9,369,265 9,355,745

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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

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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);

2016-02, Leases

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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.

Accounting guidance adopted in 2021

On January 1, 2021, the Company adopted Accounting Standards Update (ASU) 2016-13 Financial Instruments - Credit Losses (Topic 326):

Measurement of Credit Losses on Financial Instruments , which requires the recognition of the allowance for credit losses be estimated using the current expected credit loss (CECL) methodology.

The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables and held-to-maturity debt securities.

It also applies to off-balance sheet (OBS) credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments) and net investments in leases recognized by a lessor in accordance with Topic 842 on leases.

In addition, ASC 326 made changes to the accounting for available-for-sale debt securities.

One such change is to require credit losses to be presented as an allowance rather than as a

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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.

write-down on available-for-sale debt securities management does not intend to sell or believes that it is more likely than not they will be required to sell.

The Company adopted ASC 326 using the modified retrospective method for all financial assets measured at amortized cost and OBS credit exposures.

Results for reporting periods beginning January 1, 2021 are presented under ASC 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP.

The Company recorded a net decrease to retained earnings of $ 4.75 million as of January 1, 2021 for the cumulative effect of adopting ASC 326, which includes deferred taxes of $ 1.58 million.

The transition adjustment includes a $ 2.75 million increase to the Allowance for Credit Losses and the recording of a $ 3.58 million Allowance for Credit Losses on OBS Credit Exposures.

The following table illustrates the impact of ASC 326 (amounts in thousands).

January 1, 2021

As Reported Under ASC 326 Pre-ASC 326 Adoption Impact of ASC 326 Adoption

Allowance for credit losses on loans $ 39,816 $ 37,070 $ 2,746

Allowance for credit losses on off-balance sheet credit exposures $ 3,584 $ — $ 3,584

In December 2019, the FASB issued ASU No.

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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.

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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.

Early adoption is permitted.

The adoption of ASU 2019-12 by the Company on January 1, 2021 did not 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 .

3 unchanged sentences

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.

The adoption of the ASU by the Company on January 1, 2021 did not have a material impact on the financial statements.

In October 2020, the FASB issued ASU 2020-10, Codification Improvements, which consists of two sections.

3 unchanged sentences

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 did not have a material impact on the financial statements.

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Accounting guidance pending adoption as of December 31, 2021

In May 2021, the FASB issued ASU 2021-04, Earnings Per Share (Topic 260), Debt-Modifications and Extinguishments (Subtopic 470-50), Compensation-Stock Compensation (Topic 718), and Derivatives and Hedging-Contracts in Entity's Own Equity (Subtopic 815-40), Issuer's Accounting for Certain Modifications or Exchanges of Freestanding Equity-Classified Written Call Options .

The amendments in this ASU affect entities that issue freestanding written call options that are classified in equity.

Specifically, the amendments affect those entities when a freestanding equity-classified written call option is modified or exchanged and remains equity classified after the modification or exchange.

An entity should recognize the effect of a modification or an exchange of a freestanding equity-classified written call option to compensate for goods or services in accordance with the guidance in Topic 718, Compensation-Stock Compensation.

The amendments in this ASU are effective for all entities for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years.

An entity should apply the amendments prospectively to modifications or exchanges occurring on or after the effective date of the amendments.

The adoption of the ASU by the Company on January 1, 2022 is not expected to have a material impact on the financial statements.

In October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 815) Accounting for Contract Assets and Contract Liabilities from Contracts with Customers .

The amendments in this Update require that an entity (acquirer) recognize and measure contract assets and contract liabilities acquired in a business combination in accordance with Topic 606.

At the acquisition date, an acquirer should account for the related revenue contracts in accordance with Topic 606 as if it had originated the contracts.

To achieve this, an acquirer may assess how the acquiree applied Topic 606 to determine what to record for the acquired revenue contracts.

The amendments in this ASU are effective for all entities for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.

An entity should apply the amendments prospectively to business combinations occurring on or after the effective date of the amendments.

The Company is in the process of evaluating the impact of this ASU on the financial statements.

Investment Securities

6 unchanged sentences

State and political subdivisions 263,516 47.80 % 224,566 54.99 %

Mortgage-backed securities and collateralized mortgage obligations 9,446 1.71 % — — %

Total securities available for sale $ 551,354 100.00 % $ 408,372 100.00 %

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Investment securities have been classified in the consolidated balance sheets according to management’s intent.

1 unchanged sentence

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.

Municipal bonds are comprised of general obligation bonds and revenue bonds issued by various municipal corporations.

As of December 31, 2021 and 2020, all securities held were rated investment grade based upon external ratings where available and, where not available, based upon management knowledge of the local issuers and their financial situations.

The Company had no securities designated as trading or held to maturity in its portfolio at December 31, 2021 or 2020.

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The carrying amount of available-for-sale securities and their approximate fair values were as follows (Amounts in Thousands):

(Losses) Estimated

(Losses) Allowance for Credit Losses Estimated

December 31, 2021:

2 unchanged sentences

State and political subdivisions 260,266 4,420 ( 1,170 ) — 263,516

Mortgage-backed securities and collateralized mortgage obligations 9,575 — ( 129 ) — 9,446

Total $ 549,386 $ 6,431 $ ( 4,463 ) $ — $ 551,354

9 unchanged sentences

Due over ten years 48,518 48,167

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.

$ 539,811 $ 541,908

Mortgage-backed securities and collateralized mortgage obligations 9,575 9,446

$ 549,386 $ 551,354

Expected maturities of MBS may differ from contractual maturities because the mortgages underlying the securities may be called or prepaid without any penalties.

Therefore, these securities are not included in the maturity categories in the above summary.

As of December 31, 2021, investment securities with a carrying value of $ 10.03 million were pledged to collateralize other borrowings.

As of December 31, 2021, there were no holdings of securities of any one issuer, other than the U.S.

government and its agencies, in an amount greater than 10% of stockholders' equity.

Sales proceeds and gross realized gains and losses on available-for-sale securities were as follows (in thousands):

12 unchanged sentences

State and political subdivisions 231 70,542 ( 1,055 ) 1.50 % 14 9,248 ( 115 ) 1.24 % 245 79,790 ( 1,170 ) 1.47 %

Total temporarily impaired securities 43 $ 34,187 $ ( 180 ) 0.53 % 4 $ 370 $ ( 6 ) 1.62 % 47 $ 34,557 $ ( 186 ) 0.54 %

Mortgage-backed securities and collateralized mortgage obligations 4 9,446 ( 129 ) 1.37 % — — — — % 4 9,446 ( 129 ) 1.37 %

295 $ 229,339 ( 3,690 ) 1.61 % 24 $ 33,648 $ ( 773 ) 2.30 % 319 $ 262,987 $ ( 4,463 ) 1.70 %

Less than 12 months 12 months or more Total

4 unchanged sentences

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 77 $ 45,813 $ ( 255 ) 0.56 % 27 $ 21,549 $ ( 75 ) 0.35 % 104 $ 67,362 $ ( 330 ) 0.49 %

43 $ 34,187 $ ( 180 ) 0.53 % 4 $ 370 $ ( 6 ) 1.62 % 47 $ 34,557 $ ( 186 ) 0.54 %

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.

None of the unrealized losses in the above table was due to the deterioration in the credit quality of any of the issues that might result in the non-collection of contractual principal and interest.

The unrealized losses are due to changes in interest rates.

The Company has not recognized any unrealized loss in income because management does not have the intent to sell the securities included in the previous table.

Management has concluded that it is more likely than not that the Company will not be required to sell these securities prior to recovery of the amortized cost basis.

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

The securities are of high credit quality (investment grade credit ratings) and principal and interest payments are made timely with no payments past due as of December 31, 2021.

The fair value is expected to recover as the securities approach maturity.

Treasury and other securities are issued and guaranteed by U.S.

government-sponsored entities and agencies.

The mortgage-backed securities and collateralized mortgage obligations have implied U.S.

government guarantees of the agency securities.

The Company evaluates if a credit loss exists by monitoring to ensure it has adequate credit support considering the nature of the investment, number and significance of investments in an unrealized loss position, collectability or delinquency issues, the underlying financial statements of the issuers, credit ratings and subsequent changes thereto, and other available relevant information.

Considering the above factors, management has determined that no allowance for credit losses is necessary for the securities portfolio as of December 31, 2021.

HILLS BANCORPORATION

16 unchanged sentences

2,660,532 2,711,082

Less allowance for loan losses 37,070 33,760

Less allowance for credit losses (2021) and loan losses (2020) 35,470 37,070

$ 2,625,062 $ 2,674,012

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.

As of December 31, 2021 and 2020, the Company has outstanding balances of $ 5.34 million and $ 86.5 million of loans issued under the Paycheck Protection Program (PPP).

For the year ended December 31, 2021, the Company recognized $ 5.81 million of deferred PPP loan fees in interest income and received forgiveness payments totaling $ 140.1 million from the SBA.

For the year ended December 31, 2020, the Company recognized $ 2.88 million of PPP loan fees in interest income and has received forgiveness payments totaling $ 40.4 million from the SBA.

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:

Changes in the allowance for credit losses, the allowance for credit losses applicable to individually evaluated loans and the related loan balances for the years ended December 31, 2021, 2020 and 2019 are as follows:

Agricultural Commercial and Financial Real Estate:

5 unchanged sentences

(Amounts In Thousands)

Allowance for loan losses:

Beginning balance $ 2,400 $ 4,988 $ 2,599 $ 3,950 $ 10,638 $ 7,859 $ 1,326 $ 33,760

Allowance for credit losses:

Beginning balance, prior to adoption of ASC 326 $ 2,508 $ 4,885 $ 2,319 $ 4,173 $ 12,368 $ 9,415 $ 1,402 $ 37,070

Impact of adopting ASC 326 ( 328 ) 298 327 763 522 1,396 ( 232 ) 2,746

Charge-offs ( 106 ) ( 136 ) ( 3 ) ( 1 ) ( 482 ) ( 265 ) ( 323 ) ( 1,316 )

Recoveries 142 1,103 94 25 964 263 152 2,743

Provision 88 652 ( 355 ) 214 1,684 1,798 277 4,358

Credit loss (benefit) expense 45 ( 1,881 ) ( 437 ) ( 1,527 ) ( 1,874 ) ( 311 ) 212 ( 5,773 )

Ending balance $ 2,261 $ 4,269 $ 2,300 $ 3,433 $ 11,498 $ 10,498 $ 1,211 $ 35,470

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

Ending balance, individually evaluated for credit losses $ 1 $ 189 $ 124 $ — $ 49 $ 1 $ 20 $ 384

Ending balance, collectively evaluated for credit losses $ 2,260 $ 4,080 $ 2,176 $ 3,433 $ 11,449 $ 10,497 $ 1,191 $ 35,086

Loan balances:

Ending balance $ 106,933 $ 222,002 $ 207,507 $ 232,744 $ 1,023,906 $ 784,169 $ 82,972 $ 2,660,233

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

Ending balance, individually evaluated for credit losses $ 788 $ 2,062 $ 603 $ 1,277 $ 6,187 $ 5,696 $ 20 $ 16,633

Ending balance, collectively evaluated for credit losses $ 106,145 $ 219,940 $ 206,904 $ 231,467 $ 1,017,719 $ 778,473 $ 82,952 $ 2,643,600

Agricultural Commercial and Financial Real Estate:

38 unchanged sentences

Ending balance, collectively evaluated for impairment $ 89,587 $ 218,581 $ 188,198 $ 238,649 $ 1,051,299 $ 749,754 $ 82,111 $ 2,618,179

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.

Changes in the allowance for credit losses for off-balance sheet credit exposures for the year ended December 31, 2021 were as follows:

Year Ended December 31, 2021

Agricultural Commercial and

Financial Real Estate:

Construction and

land development Real Estate:

farmland Real Estate:

Mortgage, 1 to 4

family Real Estate:

Mortgage, multi-

commercial Other Total

(Amounts In Thousands)

Allowance for credit losses for off-balance sheet credit exposures:

Beginning balance, prior to adoption of ASC 326 $ — $ — $ — $ — $ — $ — $ — $ —

Impact of adopting ASC 326 385 1,585 736 180 471 212 15 3,584

Credit loss (benefit) expense ( 2 ) ( 467 ) 113 ( 67 ) 323 347 19 266

(Charge-offs), net recoveries — — — — — — — —

Ending balance $ 383 $ 1,118 $ 849 $ 113 $ 794 $ 559 $ 34 $ 3,850

Credit loss (benefit) expense for off-balance sheet credit exposures is included in credit loss (benefit) expense on the consolidated statement of income for the year ended December 31, 2021.

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)

Management regularly reviews loans in the portfolio to assess credit quality indicators and to determine appropriate loan classification and grading in accordance with applicable bank regulations.

The Company's risk rating methodology assigns risk ratings ranging from 1 to 6, where a higher rating represents higher risk.

The Company differentiates its lending portfolios into loans sharing common risk characteristics for which expected credit loss is measured on a pool basis and loans not sharing common risk characteristics for which credit loss is measured individually.

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.

Loans are secured with cash, cash equivalents, or collateral with very low loan to values.

The borrower would qualify for unsecured debt and guarantors provide excellent secondary support to the relationship.

The borrower has a long-term relationship with Hills Bank, maintains high deposit balances and has an established payment history with Hills Bank and an established business in an established industry.

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.

The relationship is not quite as strong as a borrower that is assigned an excellent rating but still has a very strong liquidity position, low leverage, and track record of strong performance.

These loans have a strong collateral position with limited risk to bank capital.

The collateral will not materially lose value in a distressed liquidation.

Guarantors provide additional secondary support to mitigate possible bank losses.

The borrower has a long-term relationship with Hills Bank with an established track record of payments;

loans with shorter remaining loan amortization;

deposit balances are consistent;

loan payments could be made from cash reserves in the interim period;

and source of income is coming from a stable industry.

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.

The borrower's financial performance is consistent, ratios and trends are positive and the primary repayment source can clearly be identified and supported with acceptable financial information.

The loan relationship could be vulnerable to changes in economic or industry conditions but have the ability to absorb unexpected issues.

The loan collateral coverage is considered acceptable and guarantors can provide financial support but net worth might not be as liquid as a 1 or 2 rated relationship.

The borrower has an established relationship with Hills Bank.

The relationship is making timely loan payments, any operating line is revolving and deposit balances are positive with limited to no overdrafts.

Management and industry is considered stable.

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 .

The relationship l iquidity levels are minimal and the borrower’s leverage position is brought into question.

The primary repayment source is showing signs of being stressed or is not proven.

If the borrower performs as planned, the loan will be repaid.

The collateral coverage is still considered acceptable but there might be some concern with the type of real estate securing the debt or highly dependent on chattel assets.

Some loans may be better secured than others.

Guarantors still provide some support but there is not an abundance of financial strength supporting the guaranty.

A monitor credit may be appropriate when the borrower is experiencing rapid growth which is impacting liquidity levels and increasing debt levels.

Other attributes to consider would include if the business is a start-up or newly acquired, if the relationship has significant financing relationships with other financial institutions, the quality of financial information being received, management depth of the company, and changes to the business model.

The track history with Hills Bank has some deficiencies such as slow payments or some overdrafts.

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.

Potential indicators of a special mention would include past due payments, overdrafts, management issues, poor financial performance, industry issues, or the need for additional short-term borrowing.

The ability to continue to make payments is in question;

there are “red flags” such as past due payments, non-

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

revolving credit lines, overdrafts, and the inability to sell assets.

The borrower is experiencing delinquent taxes, legal issues, etc., obtaining financial information has become a challenge, collateral coverage is marginal at best, and the value and condition could be brought into question.

Collateral document deficiencies have been noted and if not addressed, could become material.

Guarantors provide minimal support for this relationship.

The credit may include an action plan or follow up established in the asset quality process.

There is a change in the borrower’s communication pattern.

Industry issues may be impacting the relationship.

Adverse credit scores or history of payment deficiencies could be noted.

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.

Full repayment of the loan(s) according to the original terms and conditions is in question or not expected.

For these loans, it is more probable than not that the Company could sustain some loss if the deficiency(ies) is not corrected.

There are identified shortfalls in the primary repayment source such as carry over debt, past due payments, and overdrafts.

Obtaining quality and timely financial information is a weakness.

The loan is under secured with exposure that could impact bank capital.

It appears the liquidation of collateral has become the repayment source.

The collateral may be difficult to foreclose or have little to no value.

Collateral documentation deficiencies have been noted during the review process.

Guarantor(s) provide minimal to no support of the relationship.

The borrower’s communication with the Bank continues to decrease and the borrower is not addressing the situation.

There is some concern about the borrower’s ability and willingness to repay the loans.

Problems may be the result of external issues such as economic or industry related issues.

The following tables present the credit quality indicators and origination years by type of loan in each category as of December 31, 2021 (amounts in thousands):

December 31, 2021 2021 2020 2019 2018 2017 Prior Revolving Loans Amortized Cost Basis Total

Excellent $ 762 $ 213 $ 30 $ 10 $ — $ — $ 2,312 $ 3,327

5 unchanged sentences

Total $ 23,275 $ 13,481 $ 3,395 $ 2,591 $ 626 $ 345 $ 63,220 $ 106,933

farmland Real Estate:

Mortgage, 1 to 4

family first liens Real Estate:

Mortgage, 1 to 4

family junior liens Real Estate:

Mortgage, multi-

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Commercial and Financial

December 31, 2021 2021 2020 2019 2018 2017 Prior Revolving Loans Amortized Cost Basis Total

Excellent $ 965 $ 924 $ 4 $ 235 $ 31 $ — $ 3,391 $ 5,550

5 unchanged sentences

Total $ 79,683 $ 36,555 $ 13,003 $ 6,150 $ 2,904 $ 2,245 $ 81,462 $ 222,002

commercial Loans to

individuals Obligations of state

and political

subdivisions Total

Construction, 1 to 4 Family Residential

December 31, 2021 2021 2020 2019 2018 2017 Prior Revolving Loans Amortized Cost Basis Total

Excellent $ — $ — $ — $ — $ — $ — $ — $ —

5 unchanged sentences

Total $ 9,087 $ 94 $ — $ — $ — $ — $ 71,305 $ 80,486

Construction, Land Development and Commercial

December 31, 2021 2021 2020 2019 2018 2017 Prior Revolving Loans Amortized Cost Basis Total

Excellent $ 5,079 $ — $ — $ — $ 143 $ 4 $ — $ 5,226

Good 3,294 1,200 — — 153 242 12,678 17,567

Satisfactory 22,907 4,354 2,356 263 1,081 21 40,048 71,030

Monitor 5,694 547 7 38 74 — 18,832 25,192

Special Mention — — — — — — — —

Substandard 7,515 298 193 — — — — 8,006

Total $ 44,489 $ 6,399 $ 2,556 $ 301 $ 1,451 $ 267 $ 71,558 $ 127,021

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Mortgage, Farmland

December 31, 2021 2021 2020 2019 2018 2017 Prior Revolving Loans Amortized Cost Basis Total

Excellent $ — $ 3,568 $ 124 $ 60 $ 80 $ 41 $ 134 $ 4,007

Good 17,827 14,308 2,144 2,460 5,932 3,929 3,844 50,444

Satisfactory 51,639 35,616 4,689 8,358 6,745 8,339 8,242 123,628

Monitor 8,532 16,925 5,518 3,901 2,154 4,866 5,695 47,591

Special Mention 4,031 288 — — 298 190 — 4,807

Substandard 1,283 447 291 47 — 199 — 2,267

Total $ 83,312 $ 71,152 $ 12,766 $ 14,826 $ 15,209 $ 17,564 $ 17,915 $ 232,744

Mortgage, 1 to 4 Family First Liens

December 31, 2021 2021 2020 2019 2018 2017 Prior Revolving Loans Amortized Cost Basis Total

Excellent $ 462 $ 914 $ 427 $ 19 $ 149 $ 404 $ 1 $ 2,376

Good 9,598 12,300 3,124 3,443 3,091 10,943 2,496 44,995

Satisfactory 233,412 189,247 69,037 65,201 60,906 118,608 8,443 744,854

Monitor 24,908 33,863 5,038 6,527 7,273 12,203 4,066 93,878

Special Mention 1,682 3,422 887 962 1,051 3,168 — 11,172

Substandard 1,571 1,261 1,129 1,609 576 6,142 1 12,289

Total $ 271,633 $ 241,007 $ 79,642 $ 77,761 $ 73,046 $ 151,468 $ 15,007 $ 909,564

Mortgage, 1 to 4 Family Junior Liens

December 31, 2021 2021 2020 2019 2018 2017 Prior Revolving Loans Amortized Cost Basis Total

Excellent $ — $ 13 $ — $ — $ — $ — $ 6 $ 19

Good 193 611 96 — 108 482 1,374 2,864

Satisfactory 13,684 10,116 5,854 7,309 5,230 6,053 55,496 103,742

Monitor 326 1,233 70 365 140 281 2,801 5,216

Special Mention 103 489 35 56 42 110 142 977

Substandard 77 209 79 441 74 99 545 1,524

Total $ 14,383 $ 12,671 $ 6,134 $ 8,171 $ 5,594 $ 7,025 $ 60,364 $ 114,342

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Mortgage, Multi-Family

December 31, 2021 2021 2020 2019 2018 2017 Prior Revolving Loans Amortized Cost Basis Total

Excellent $ 2,539 $ 4,513 $ — $ — $ — $ 701 $ — $ 7,753

Good 16,931 35,396 1,555 — — 9,289 — 63,171

Satisfactory 107,192 69,287 13,635 2,030 1,561 14,660 14,764 223,129

Monitor 26,088 35,886 176 — 131 1,584 5,669 69,534

Special Mention 640 — 820 — — — — 1,460

Substandard 12,186 — — — — 5,559 — 17,745

Total $ 165,576 $ 145,082 $ 16,186 $ 2,030 $ 1,692 $ 31,793 $ 20,433 $ 382,792

Mortgage, Commercial

December 31, 2021 2021 2020 2019 2018 2017 Prior Revolving Loans Amortized Cost Basis Total

Excellent $ 597 $ 16,781 $ — $ — $ 3,313 $ 350 $ 1 $ 21,042

Good 20,143 36,773 2,619 1,356 3,811 7,085 9,812 81,599

Satisfactory 75,040 52,653 14,727 12,091 9,707 17,398 16,333 197,949

Monitor 18,664 49,774 3,923 2,202 3,037 8,461 3,387 89,448

Special Mention 5,791 795 303 — 554 337 — 7,780

Substandard 1,528 1,721 — 208 — 102 — 3,559

Total $ 121,763 $ 158,497 $ 21,572 $ 15,857 $ 20,422 $ 33,733 $ 29,533 $ 401,377

Loans to Individuals

December 31, 2021 2021 2020 2019 2018 2017 Prior Revolving Loans Amortized Cost Basis Total

Excellent $ — $ — $ — $ — $ — $ — $ — $ —

Good — — 67 21 5 — 1 94

Satisfactory 12,162 5,606 2,212 967 141 10,867 57 32,012

Monitor 200 160 15 46 3 — 1 425

Special Mention 37 32 29 4 — — 1 103

Substandard 12 24 12 — 1 3 1 53

Total $ 12,411 $ 5,822 $ 2,335 $ 1,038 $ 150 $ 10,870 $ 61 $ 32,687

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Obligations of State and Political Subdivisions

December 31, 2021 2021 2020 2019 2018 2017 Prior Revolving Loans Amortized Cost Basis Total

Excellent $ — $ — $ — $ — $ — $ 6,076 $ — $ 6,076

Good — 1,984 — — — 9,051 — 11,035

Satisfactory 1,009 2,034 1,551 706 11,557 3,634 9,400 29,891

Monitor — 933 203 249 — 1,898 — 3,283

Special Mention — — — — — — — —

Substandard — — — — — — — —

Total $ 1,009 $ 4,951 $ 1,754 $ 955 $ 11,557 $ 20,659 $ 9,400 $ 50,285

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:

39 unchanged sentences

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.

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.

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Past due loans as of December 31, 2021 and 2020 were as follows:

40 unchanged sentences

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.

Accruing loans past due 90 days or more decreased $ 0.86 million from December 31, 2020 to December 31, 2021.

As of December 31, 2021 and 2020, accruing loans past due 90 days or more were 0.01 % and 0.04 % 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 balance of the accruing loans past due 90 days or more decreased in 2021 as compared to 2020.

The average 90 days or more past due accruing loan balance per loan was $ 0.03 million as of December 31, 2021 compared to $ 0.09 million as of December 31, 2020.

3 unchanged sentences

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Certain impaired loan information by loan type at December 31, 2020 and 2019 was as follows:

Certain nonaccrual and TDR loan information by loan type at December 31, 2021 and 2020 was as follows:

December 31, 2021 December 31, 2020

loans (1) Accruing loans

loans (1) Interest income recognized on non-accrual Accruing loans

days or more TDR

20 unchanged sentences

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.

As of December 31, 2021, the total amount of the eligible loans in deferral (deferral of principal and/or interest) that met the requirements set forth under the CARES Act and therefore were not considered TDRs was 16 loans, totaling $ 9.4 million.

As of December 31, 2020, there were 13 loans, totaling $ 9.4 million that met the requirements and were not considered TDRs.

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.

As of December 31, 2021 and 2020, COVID-19 related payment deferrals were approximately 0.12 % and 1.20 % of total loans, respectively.

HILLS BANCORPORATION

64 unchanged sentences

23 $ 4,654 $ 4,654

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.

The Company has allocated $ 0.01 million of allowance for TDR loans and the Company had commitments to lend $ 0.06 million in additional borrowings to restructured loan customers as of December 30, 2021.

The Company allocated $ 0.25 million of allowance for TDR loans and had commitments to lend $ 0.04 million in additional borrowings to restructured loan customers as of December 31, 2020.

These commitments were in the normal course of business.

The additional borrowings were not used to facilitate payments on these loans.

The modifications of the terms of loans performed during the years ended December 31, 2021 and 2020 included extensions of the maturity date.

There were no TDR loans modified that were in payment default (defined as past due 90 days or more) during the years ended December 31, 2021 and 2020.

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Information regarding impaired loans as of and for the year ended December 31, 2020 is as follows:

Investment Unpaid

Balance Related

Allowance Average

Investment Interest

The following table presents the amortized cost basis of collateral dependent loans, by the primary collateral type, which are individually evaluated to determine expected credit losses, and the related ACL allocated to these loans:

Primary Type of Collateral

Real Estate Accounts Receivable Equipment Other Total ACL Allocation

(Amounts In Thousands)

With no related allowance recorded:

Agricultural $ 1,337 $ 1,928 $ — $ 1,518 $ 24

Commercial and financial 1,520 2,907 — 2,054 85

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

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

December 31, 2021

Agricultural $ 734 $ — $ 54 $ — $ 788 $ 1

8 unchanged sentences

Loans to individuals 20 — — — $ 20 20

Obligations of state and political subdivisions — — — — — —

$ 16,468 $ — $ 165 $ — $ 16,633 $ 384

1 unchanged sentence

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Information regarding impaired loans as of and for the year ended December 31, 2019 is as follows:

Pre-ASC 326 (CECL) adoption impaired loan information as of December 31, 2020 is as follows:

Investment Unpaid

83 unchanged sentences

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.

Post-ASC 326 CECL Adoption:

The changes in the ACL in 2021 compared to December 31, 2020 is the result of the following factors:

$ 2.75 million increase upon adoption of ASC 326 (CECL) on January 1, 2021;

changes after adoption for the year ended December 31, 2021 include improvements in the economic factor forecasts, primarily Iowa unemployment, used in the ACL calculation which resulted in a decrease of $ 2.46 million;

decrease in loan volume which resulted in a decrease of $ 0.37 million;

changes in prepayment and curtailment rates resulting in a decrease of $ 0.03 million;

decreases in historical loss rates along with net recoveries resulting in a decrease of $ 2.00 million;

decreases in the individually analyzed loans reserve of $ 0.25 million;

and increases in qualitative factors determined necessary by management which resulted in an increase of $ 0.76 million.

The extent to which collateral secures collateral-dependent loans is provided in the previous individually analyzed loans table and changes in the extent to which collateral secures its collateral-dependent loans are described below.

Collateral-dependent loans decreased $ 4.10 million from December 31, 2020 to December 31, 2021.

Collateral-dependent loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans.

Collateral-dependent loans also include loans that, based on management’s evaluation of current information and events, the Company expects to be unable to collect in full according to the contractual terms of the original loan agreement.

Collateral-dependent loans were 0.63 % of loans held for investment as of December 31, 2021 and 0.76 % as of December 31, 2020.

The decrease in collateral-dependent loans is due to a decrease of $ 0.55 million in loans with a specific reserve, a decrease in nonaccrual loans of $ 0.36 million, a decrease in 90 days or more accruing loans of $ 0.86 million and a decrease in TDR loans of $ 2.33 million from December 31, 2020 to December 30, 2021.

There were no significant changes noted in the extent to which collateral secures collateral-dependent loans.

The Company regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans share common risk characteristics for which expected credit loss is measured on a pool basis or if the loans do not share common risk characteristics and therefore expected credit loss is measured on an individual loan basis.

If the loans are assessed for credit losses on an individual basis, the Company determines if a specific allowance is appropriate.

In addition, the Company's management also reviews and, where determined necessary, provides allowances for particular loans based upon (1) reviews of specific borrowers and (2) management’s assessment of areas that management considers are of higher credit risk, including loans that have been restructured or where a TDR is reasonably possible.

Loans that are determined not to be collateral-dependent and for which there are no specific allowances are classified into one or more risk categories and expected credit loss is measured on a pool basis.

See Note 1 Effect of New Financial Accounting Standards for further discussion of the allowance for credit losses for loans held for investment.

Specific allowances for credit losses on loans assessed individually are established if the loan balances exceed the net present value of the relevant future cash flows or the fair value of the relevant collateral based on updated appraisals and/or updated collateral analysis for the properties if the loan is collateral dependent.

The Company may recognize a charge off or record a specific allowance related to an individually analyzed loan if there is a collateral shortfall or it is unlikely the borrower can make all principal and interest payments as contractually due.

For loans that are collateral dependent, losses are evaluated based on the portion of a loan that exceeds the fair market value of the collateral.

In general, this is the amount that the carrying value of the loan exceeds the related appraised value less estimated costs to sell the collateral.

Generally, it is the Company’s policy not to rely on appraisals that are older than one year prior to the date the credit loss 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 variables affecting its value may have changed since the appraisal was performed.

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.

Any adjustments made to the appraised value are to provide an additional charge off or specific reserve based on the applicable facts and circumstances.

In instances where there is an estimated decline in value, a specific reserve may be provided or a charge off taken pending confirmation of the amount of the loss from an updated appraisal.

Upon receipt of the new appraisals, an additional specific reserve may be provided or charge off taken based on the appraised value of the collateral.

On average, appraisals are obtained within one month of order.

1 unchanged sentence

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.

The Company also evaluates any changes in the financial condition of the borrower and guarantors (if applicable), economic conditions, and

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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.

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 credit losses.

When individual loans are reviewed for credit loss, 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.

The allowance for credit losses on individually evaluated 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.

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.

Property and Equipment

12 unchanged sentences

Included in this were $ 0.51 million and $ 0.47 million of operating lease costs, respectively, $ 0.03 million and $ 0.03 million of short term lease costs, respectively, and $ 0.05 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.

For the years ended December 31, 2021 and 2020, cash paid for amounts included in the measurement of operating lease liabilities was $ 0.51 million and $ 0.47 million, respectively, and right-of-use assets obtained in exchange for lease obligations was none and $ 0.05 million, respectively.

As of December 31, 2021 and 2020, operating lease right-of-use assets included in other assets were $ 2.47 million and $ 2.86 million, respectively.

Operating lease liabilities included in other liabilities were $ 2.53 million and $ 2.91 million, respectively.

The weighted average remaining lease term for operating leases was 9.94 years and 10.27 years, respectively, and the weighted average discount rate for operating leases was 3.49 % and 3.45 %, respectively.

33 unchanged sentences

(Effective interest rates as of December 31, 2021) (Amounts In Thousands)

Due 2020, 3.05 %

Due 2023, 3.77 %

Due 2024, 2.38 %

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 %

$ — $ 105,000

$ 105,000 $ 185,000

On December 21, 2021 the Company paid the remaining $ 105.00 million in FHLB Borrowings due in 2025 through 2027.

Fees incurred with the 2021 prepayments were $ 7.69 million and were recorded in other noninterest expenses.

On November 9, 2020 the Company paid $ 25.00 million in FHLB Borrowings due in 2020.

1 unchanged sentence

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 $ 4.55 million and $ 8.17 million at December 31, 2021 and 2020, 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.

Collateral is provided by the Company’s 1 to 4 family mortgage loans totaling none at December 31, 2021 and $ 141.75 million at December 31, 2020.

The Company has the ability to borrow against agricultural real estate, commercial real estate and multi-family loans totaling $ 300.93 million as of December 31, 2021 and $ 315.86 million as of December 31, 2020 and there was $ 0 borrowed against this collateral as of December 31, 2021 or 2020.

Accumulated Other Comprehensive Income

59 unchanged sentences

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.

There were no stock options granted in 2021 and 2020 and 5,805 in 2019.

The weighted-average fair value of options granted in 2019 was $ 21.31 per share.

8 unchanged sentences

Balance, December 31, 2018 9,020 $ 33.30 3.41 250

Exercised ( 1,200 )

Balance, December 31, 2018 9,020 $ 33.30 3.41 250

Granted 5,805

2 unchanged sentences

Balance, December 31, 2020 13,025 $ 45.92 4.47 216

Balance, December 31, 2021 13,025 $ 45.92 3.47 $ 288

Other pertinent information related to the options outstanding at December 31, 2021 is as follows:

38 unchanged sentences

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

Allowance for credit losses $ 8,849 $ 9,249

Deferred compensation and unearned restricted stock 2,239 2,401

Allowance for credit losses on off-balance sheet credit exposures 961 —

Accrued expenses 611 589

7 unchanged sentences

Goodwill 407 407

Prepaid expenses 400 431

Other 385 452

42 unchanged sentences

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.

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.

15 unchanged sentences

Community Bank Leverage Ratio 484,429 11.80 8.50

Actual For Capital Adequacy Purposes To Be Well-Capitalized Under Prompt Corrective Action Provisions

Amount Ratio Ratio Ratio

Actual For Capital Adequacy Purposes

Amount Ratio Ratio

As of December 31, 2020:

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

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

Community Bank Leverage Ratio $ 452,123 11.91 % 8.00 %

Community Bank Leverage Ratio 453,073 11.94 8.00

The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by the Bank.

13 unchanged sentences

Balance, beginning $ 54,053 $ 55,717

Net increase (decrease) due to change in related parties — 2,481

Net increase due to change in related parties 735 —

Advances 23,671 14,406

33 unchanged sentences

Interest-bearing deposits 2,900,893 2,909,243 — 2,909,243 —

Other borrowings 249 249 — 249 —

Federal Home Loan Bank borrowings — — — — —

Interest rate swaps — — — — —

Accrued interest payable 1,165 1,165 — 1,165 —

37 unchanged sentences

Federal Home Loan Bank Borrowings 105,000 115,259 — 115,259 —

Interest rate swaps 2,349 2,349 — 2,349 —

Accrued interest payable 1,733 1,733 — 1,733 —

7 unchanged sentences

(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

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.

Fair value is

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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.

20 unchanged sentences

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,

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.

Individually analyzed loans under ASC 326 CECL :

See Note 1 for further discussion of individually analyzed loans under CECL.

A loan is considered to be non-performing 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 non-performing, the amount of reserve is measured based on the fair value of the underlying collateral.

The Company makes such measurements on all material loans deemed non-performing 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.

1 unchanged sentence

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.

3 unchanged sentences

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.

Fair value is generally based upon independent

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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.

4 unchanged sentences

Unfunded loan commitments are not valued since the loans are generally priced at market at the time of funding (Level 2).

HILLS BANCORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

8 unchanged sentences

State and political subdivisions — 263,516 — 263,516

Mortgage-backed securities and collateralized mortgage obligations — 9,446 — 9,446

Other securities (FHLB, FHLMC and FNMA) — 34,467 — 34,467

Derivative Financial Instruments

Interest rate swaps — — — —

Total $ 243,925 $ 307,429 $ — $ 551,354

8 unchanged sentences

Other securities (FHLB, FHLMC and FNMA) — 35,160 — 35,160

Derivative Financial Instruments

Interest rate swaps — ( 2,349 ) — ( 2,349 )

Total $ 148,646 $ 259,726 $ — $ 408,372

108 unchanged sentences

Forfeiture of common stock ( 455 ) ( 257 ) ( 262 )

(Increase) decrease in other assets ( 515 ) ( 100 ) 162

(Decrease) increase in other liabilities ( 3,554 ) 1,036 574

Increase in other assets ( 221 ) ( 515 ) ( 100 )

Increase (decrease) in other liabilities 290 ( 3,554 ) 1,036

Net cash and cash equivalents provided by operating activities 12,991 11,604 9,041

7 unchanged sentences

Net cash and cash equivalents used by financing activities ( 11,915 ) ( 15,618 ) ( 7,669 )

(Decrease) increase in cash and cash equivalents ( 4,014 ) 1,372 ( 273 )

Increase (decrease) in cash and cash equivalents 1,076 ( 4,014 ) 1,372

Cash and cash equivalents:

1 unchanged sentence

Ending of year $ 2,176 $ 1,100 $ 5,114

Supplemental Disclosures

Noncash financing activities:

Increase (decrease) in maximum cash obligation related to ESOP shares $ 2,684 $ ( 4,497 ) $ 2,956

Commitments and Contingencies

8 unchanged sentences

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

The outbreak of Coronavirus Disease 2019 (“COVID-19”) continues 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.

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.

Health Organization 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.

The Company’s business is dependent upon the willingness and ability of its employees and customers to conduct banking and other financial transactions.

While significant progress has been made to combat the outbreak of COVID-19, and while it appears that the epidemiological and macroeconomic conditions are trending in a positive direction, if there is a resurgence in the virus, the Company could experience further adverse effects on its business, financial condition, results of operations and cash flows.

See Note 3 for further discussion regarding the financial impact of COVID-19.

32 unchanged sentences

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:

The minimum future rental commitments as of December 31, 2021 for all non-cancellable leases relating to Bank premises were as follows:

Year ending December 31:

7 unchanged sentences

Net interest income $ 26,233 $ 26,196 $ 27,024 $ 25,009 $ 104,462

Provision for loan losses 4,649 8 ( 157 ) ( 142 ) 4,358

Credit loss (benefit) expense ( 2,984 ) ( 1,659 ) 82 ( 946 ) ( 5,507 )

Other income 9,038 7,982 8,244 8,200 33,464

16 unchanged sentences

Diluted earnings per share 0.75 1.25 1.22 0.90 4.12

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Derivative Financial Instruments

2 unchanged sentences

Derivative instruments are recognized as either assets or liabilities in the accompanying consolidated financial statements and are measured at fair value.

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 Bank’s objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates.

The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amount to be exchanged between the counterparties.

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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.

The Bank terminated one interest rate swap in December 2020 and the other matured in November 2020, therefore the Bank was no t required to pledge collateral as of December 31, 2021 and 2020.

Cash Flow Hedges:

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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.

For accounting purposes, these swap transactions were 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 Bank terminated 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:

Amount Fair Value Balance

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

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:

In connection with the termination of the swap, the related FHLB borrowings were paid off.

There were no remaining derivative instruments designated as cash flow hedges as of December 31, 2021 and 2020.

There were no gains or losses recognized on the Bank's derivative instruments designated as cash flow hedges for the year ended December 31, 2021.

The table below identifies the gains and losses recognized on the Bank’s derivative instruments designated as cash flow hedges for the year ended December 31, 2020:

Recognized in OCI Reclassified from AOCI into Income Recognized in Income on Derivatives

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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 —

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 4, 2022.

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Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-K

Item 7A. Quantitative and Qualitative Disclosures About Market Risk