UNITED STATESSECURITIES
AND EXCHANGE COMMISSIONWashington, D.C. 20549 FORM 10-Q QUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly
period ended September 30, 2004 Commission file number:
0-12668 Hills Bancorporation Incorporated
      in Iowa
    
    
    I.R.S.
      Employer IdentificationNo. 42-1208067  131 MAIN STREET, HILLS,
IOWA 52235 Telephone number: (319)
679-2291 Indicate by checkmark whether the
Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been subject
to such filing requirements for the past 90 days. |X| Yes      |_| No Indicate by checkmark whether the
Registrant is an accelerated filer (as defined by Rule 12b-2 of the Securities Exchange
Act of 1934). |X| Yes      |_| No APPLICABLE ONLY TO
CORPORATE ISSUERS: Indicate the number of shares
outstanding of each of the issuers classes of common stock, as of the latest
practical date. CLASS
    
    SHARES OUTSTANDING
      At October 31, 2004Common
Stock, no par value
    
    4,550,256   Page 1 of 29   HILLS BANCORPORATIONIndex
to Form 10-Q


Part IFINANCIAL
INFORMATION





Page
      NumberItem
      1. Financial StatementsConsolidated
      balance sheets, September 30, 2004 (unaudited)and
      December 31, 2003
    
    
    3Consolidated
      statements of income, (unaudited) for three and ninemonths
      ended September 30, 2004 and 2003
    
    
    4Consolidated
      statements of comprehensive income, (unaudited) forthree
      and nine months ended September 30, 2004 and 2003
    
    
    5Consolidated
      statements of stockholders equity, (unaudited)for
      nine months ended September 30, 2004 and 2003
    
    
    6Consolidated
      statements of cash flows (unaudited) for ninemonths
      ended September 30, 2004 and 2003
    
    
    7-8Notes
      to consolidated financial statements
    
    
    9-10Item
      2. Managements Discussion and Analysis of Financial Condition
                  and
      Results of Operations
    
    
    11-21Item
      3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    22Item
      4. Controls and Procedures
    
    
    23Part
      II
      OTHER INFORMATIONItem
      1. Legal proceedings
    
    
    24Item
      2. Changes in securities, use of proceeds and issuer purchases of equity
      securities
    
    
    24Item
      3. Defaults upon senior securities
    
    
    24Item
      4. Submission of matters to a vote of security holders
    
    
    24Item
      5. Other information
    
    
    24Item
      6. Exhibits and reports on Form 8-K
    
    
    24Signatures
    
    
    25Exhibits
      Index
    
    
    26Page 2 of 29



HILLS BANCORPORATION
CONSOLIDATED BALANCE SHEETS(Amounts InThousands, Except Shares)




ASSETS
    September
      30, 2004
      (Unaudited)
    
    December
      31, 2003*Cash and
      due from banks
    
    
    $
    22,659
    
    $
    24,194Investment
      securities:Available
      for sale (amortized cost September 30, 2004 $200,980;
            December 31, 2003 $214,530)
    
    
    
    203,358
    
    
    219,430Held
      to maturity (fair value September 30, 2004 $6,216;
             December 31, 2003 $8,064)
    
    
    
    6,208
    
    
    7,953Stock of
      Federal Home Loan Bank
    
    
    
    8,877
    
    
    8,774Federal funds
      sold
    
    
    
    
    
    
    13,233Loans held
      for sale
    
    
    
    3,452
    
    
    1,960Loans, net
    
    
    
    970,182
    
    
    868,194Property
      and equipment, net
    
    
    
    22,178
    
    
    22,210Tax credit
      real estate
    
    
    
    8,002
    
    
    2,282Accrued interest
      receivable
    
    
    
    7,587
    
    
    7,303Deferred
      income taxes
    
    
    
    3,944
    
    
    2,411Goodwill
    
    
    
    2,500
    
    
    2,500Other assets
    
    
    
    3,988
    
    
    3,077$
    1,262,935
    
    $
    1,183,521LIABILITIES
      AND STOCKHOLDERS EQUITYLiabilitiesNoninterest-bearing
      deposits
    
    
    $
    130,589
    
    $
    116,206Interest-bearing
      deposits
    
    
    
    802,671
    
    
    752,446Total
      deposits
    
    
    $
    933,260
    
    $
    868,652Federal
      funds purchased and securities sold under agreements to       repurchase
    
    
    
    36,670
    
    
    29,926Federal
      Home Loan Bank borrowings (FHLB)
    
    
    
    167,542
    
    
    167,574Accrued
      interest payable
    
    
    
    1,513
    
    
    1,735Other
      liabilities
    
    
    
    6,323
    
    
    4,005$
    1,145,308
    
    $
    1,071,892REDEEMABLE
      COMMON STOCK HELD BY EMPLOYEE STOCKOWNERSHIP
      PLAN (ESOP)
    
    
    $
    16,005
    
    $
    14,864STOCKHOLDERS
      EQUITYCapital
      stock, no par value; authorized 10,000,000 shares;
            issued September 30, 2004 4,550,256
      shares; December 31, 2003 
            4,550,034 shares
    
    
    $
    11,360
    
    $
    11,353Retained
      earnings
    
    
    
    104,769
    
    
    97,189Accumulated
      other comprehensive income
    
    
    
    1,498
    
    
    3,087$
    117,627
    
    $
    111,629Less
      maximum cash obligation related to ESOP shares
    
    
    
    16,005
    
    
    14,864$
    101,622
    
    $
    96,765$
    1,262,935
    
    $
    1,183,521*
Derived
from audited financial statements.See Notes to Consolidated Financial
Statements.
Page 3 of 29




HILLS BANCORPORATIONCONSOLIDATED
STATEMENTS OF INCOME (Unaudited) (Amounts In Thousands, Except Per Share Amounts)






Three
      Months Ended
      September 30,
    
    Nine
      Months Ended
      September 30,2004
    
    2003
    
    2004
    
    2003Interest
      income:Loans,
      including fees
    $
    14,685
    
    $
    13,680
    
    $
    42,156
    
    $
    40,773Investment
      securities:Taxable
    
    1,251
    
    
    1,532
    
    
    4,027
    
    
    4,757Nontaxable
    
    625
    
    
    575
    
    
    1,843
    
    
    1,780Federal
      funds sold
    
    1
    
    
    68
    
    
    22
    
    
    285Total
      interest income
    $
    16,562
    
    $
    15,855
    
    $
    48,048
    
    $
    47,595Interest
      expense:Deposits
    $
    3,513
    
    $
    4,123
    
    $
    10,411
    
    $
    13,015Federal
      funds purchased and securities sold under 
             agreements to repurchase
    
    170
    
    
    87
    
    
    361
    
    
    297FHLB
      borrowings
    
    2,290
    
    
    2,291
    
    
    6,822
    
    
    6,799Total
      interest expense
    $
    5,973
    
    $
    6,501
    
    $
    17,594
    
    $
    20,111Net
      interest income
    $
    10,589
    
    $
    9,354
    
    $
    30,454
    
    $
    27,484Provision
      for loan losses
    
    602
    
    
    (326
    )
    
    1,117
    
    
    123Net
      interest income after provision for loan losses
    $
    9,987
    
    $
    9,680
    
    $
    29,337
    
    $
    27,361Other
      income:Net
      gain on sale of loans
    $
    292
    
    $
    1,520
    
    $
    1,259
    
    $
    3,972Trust
      fees
    
    661
    
    
    605
    
    
    2,002
    
    
    1,783Deposit
      account charges and fees
    
    926
    
    
    900
    
    
    2,722
    
    
    2,695Other
      fees and charges
    
    1,172
    
    
    1,002
    
    
    3,375
    
    
    2,802$
    3,051
    
    $
    4,027
    
    $
    9,358
    
    $
    11,252Other
      expenses:Salaries
      and employee benefits
    $
    4,156
    
    $
    3,933
    
    $
    12,427
    
    $
    11,445Occupancy
    
    575
    
    
    496
    
    
    1,583
    
    
    1,416Furniture
      and equipment
    
    810
    
    
    762
    
    
    2,394
    
    
    2,246Office
      supplies and postage
    
    304
    
    
    330
    
    
    880
    
    
    914Advertising
      and business development
    
    484
    
    
    351
    
    
    1,271
    
    
    1,021Other
    
    1,466
    
    
    1,323
    
    
    4,474
    
    
    3,856$
    7,795
    
    $
    7,195
    
    $
    23,029
    
    $
    20,898Income
      before income taxes
    $
    5,243
    
    $
    6,512
    
    $
    15,666
    
    $
    17,715Federal
      and state income taxes
    
    1,636
    
    
    2,193
    
    
    4,902
    
    
    5,888Net
      income
    $
    3,607
    
    $
    4,319
    
    $
    10,764
    
    $
    11,827Earnings
      per share:Basic
    $
    0.80
    
    $
    0.95
    
    $
    2.37
    
    $
    2.61Diluted
    
    0.79
    
    
    0.95
    
    
    2.36
    
    
    2.60See Notes to Consolidated
Financial Statements.



Page 4 of 29




HILLS BANCORPORATIONCONSOLIDATED
STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (Amounts In Thousands)






Three Months
      Ended
      September 30,
    
    Nine Months
      Ended
      September 30,2004
    
    2003
    
    2004
    
    2003Net
      income
    
    $
    3,607
    
    $
    4,319
    
    $
    10,764
    
    $
    11,827Other
      comprehensive income (loss):Unrealized
      holding gains (losses) arising during the period
    
    $
    1,436
    
    $
    (2,337
    )
    $
    (2,522
    )
    $
    (1,667
    )Income
      tax effect of unrealized gains (losses)
    
    
    (532
    )
    
    865
    
    
    933
    
    
    616Total
      other comprehensive income (loss)
    
    $
    904
    
    $
    (1,472
    )
    $
    (1,589
    )
    $
    (1,051
    )Comprehensive
      income
    
    $
    4,511
    
    $
    2,847
    
    $
    9,175
    
    $
    10,776See Notes to Consolidated
Financial Statements.




Page 5 of 29






HILLS BANCORPORATIONCONSOLIDATED
STATEMENTS OF STOCKHOLDERS EQUITY (Unaudited) (Amounts In Thousands, Except Share
Amounts)








Capital
      Stock
    
    Retained
      Earnings
    
    Accumulated
      Other
      Comprehensive
      Income (Loss)
    
    Maximum
      Cash
      Obligation
      Related
      To ESOP
      Shares
    
    TotalBalance,
      December 31, 2003
    
    
    $
    11,353
    
    $
    97,189
    
    $
    3,087
    
    $
    (14,864
    )
    $
    96,765Issuance
      of 74 shares ofcommon
      stock
    
    
    
    7
    
    
    
    
    
    
    
    
    
    
    
    7Change
      related to ESOP shares
    
    
    
    
    
    
    
    
    
    
    
    
    (1,141
    )
    
    (1,141
    )Net
      income
    
    
    
    
    
    
    10,764
    
    
    
    
    
    
    
    
    10,764Cash
      dividends ($2.10 per share)
    
    
    
    
    
    
    (3,184
    )
    
    
    
    
    
    
    
    (3,184
    )Other
      comprehensive income (loss)
    
    
    
    
    
    
    
    
    
    (1,589
    )
    
    
    
    
    (1,589
    )Balance,
      September 30, 2004
    
    
    $
    11,360
    
    $
    104,769
    
    $
    1,498
    
    $
    (16,005
    )
    $
    101,622Balance,
      December 31, 2002
    
    
    $
    10,541
    
    $
    85,773
    
    $
    4,721
    
    $
    (12,951
    )
    $
    88,084Issuance
      of 14,724 shares
    
    
    
    of
      common stock
    
    
    
    375
    
    
    
    
    
    
    
    
    
    
    
    375Change
      related to ESOP shares
    
    
    
    
    
    
    
    
    
    
    
    
    (1,619
    )
    
    (1,619
    )Net
      income
    
    
    
    
    
    
    11,827
    
    
    
    
    
    
    
    
    11,827Income
      tax benefit relatedto
      stock based compensation
    
    
    
    336
    
    
    
    
    
    
    
    
    
    
    
    336Cash
      dividends ($1.90 per share)
    
    
    
    
    
    
    (2,853
    )
    
    
    
    
    
    
    
    (2,853
    )Other
      comprehensive income (loss)
    
    
    
    
    
    
    
    
    
    (1,051
    )
    
    
    
    
    (1,051
    )Balance,
      September 30, 2003
    
    
    $
    11,252
    
    $
    94,747
    
    $
    3,670
    
    $
    (14,570
    )
    $
    95,099See Notes to Consolidated
Financial Statements.



Page 6 of 29






HILLS BANCORPORATIONCONSOLIDATED
STATEMENTS OF CASH FLOWS (Unaudited) (Amounts In Thousands)





Nine Months
      Ended
      September 30,2004
    
    2003Cash
      Flows from Operating ActivitiesNet
      income
    
    
    $
    10,764
    
    $
    11,827Adjustments
      to reconcile net income to net cashprovided
      by operating activities:Depreciation
    
    
    
    1,860
    
    
    1,694Provision
      for loan losses
    
    
    
    1,117
    
    
    123Compensation
      expensed through issuance of common stock
    
    
    
    7
    
    
    Deferred
      income taxes
    
    
    
    (600
    )
    
    521Increase
      in accrued interest receivable
    
    
    
    (284
    )
    
    (137
    )Amortization
      of bond discount
    
    
    
    961
    
    
    637Increase
      in other assets
    
    
    
    (911
    )
    
    (770
    )Increase
      in accrued interest and other liabilities
    
    
    
    2,096
    
    
    252Loans
      originated for sale
    
    
    
    (119,003
    )
    
    (294,601
    )Proceeds
      on sales of loans
    
    
    
    118,770
    
    
    300,567Net
      gain on sales of loans
    
    
    
    (1,259
    )
    
    (3,972
    )Net
      cash provided by operating activities
    
    
    $
    13,518
    
    $
    16,141Cash Flows
      from Investing ActivitiesProceeds
      from maturities of investment securities:Available
      for sale
    
    
    $
    58,674
    
    $
    53,365Held
      to maturity
    
    
    
    5,690
    
    
    3,368Purchases
      of investment securities:Available
      for sale
    
    
    
    (46,188
    )
    
    (65,375
    )Held
      to maturity
    
    
    
    (3,945
    )
    
    (3,570
    )Federal
      funds sold, net
    
    
    
    13,233
    
    
    (7,978
    )Loans
      made to customers, net of collections
    
    
    
    (103,105
    )
    
    (72,460
    )Purchases
      of property and equipment
    
    
    
    (1,828
    )
    
    (2,442
    )Investment
      in tax credit real estate
    
    
    
    (5,720
    )
    
    Net
      cash used in investing activities
    
    
    $
    (83,189
    )
    $
    (95,092
    )Cash Flows
      from Financing ActivitiesNet
      increase in deposits
    
    
    $
    64,608
    
    $
    71,860Net
      increase in federal funds purchased andsecurities
      sold under agreements to repurchase
    
    
    
    6,744
    
    
    8,892Payments
      on FHLB borrowings
    
    
    
    (32
    )
    
    (32
    )Stock
      options exercised
    
    
    
    
    
    
    375Income
      tax benefits related to stock based compensation
    
    
    
    
    
    
    336Dividends
      paid
    
    
    
    (3,184
    )
    
    (2,853
    )Net
      cash provided by financing activities
    
    
    $
    68,136
    
    $
    78,578(Continued)




Page 7 of 29






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





Nine Months
      Ended
      September 30,2004
    
    2003Decrease
      in cash and due from banks
    
    
    $
    (1,535
    )
    $
    (373
    )Cash and
      due from banks:Beginning
      of period
    
    
    
    24,194
    
    
    32,647Ending
      of period
    
    
    $
    22,659
    
    $
    32,274Supplemental
      DisclosuresCash
      payments for:Interest
      paid to depositors
    
    
    $
    10,633
    
    $
    13,303Interest
      paid on other obligations
    
    
    
    7,183
    
    
    7,096Income
      taxes
    
    
    
    4,139
    
    
    6,226Noncash
      financing activities:Increase
      in maximum cash obligation related toESOP
      shares
    
    
    $
    1,141
    
    $
    1,619See Notes to Consolidated
Financial Statements.



Page 8 of 29






HILLS
BANCORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)



Note 1.
Basis of PresentationThe
accompanying unaudited consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America for interim
financial reporting and with instructions for Form 10-Q and Regulation S-X. These
financial statements include all adjustments (consisting of normal recurring accruals)
which in the opinion of management are considered necessary for the fair presentation of
the financial position and results of operations for the periods shown. Certain prior
year amounts have been reclassified, with no effect on net income or stockholders equity,
to conform to the current year presentation.Operating
results for the nine month period ended September 30, 2004 are not necessarily indicative
of the results that may be expected for the fiscal year ending December 31, 2004. For
further information, refer to the consolidated financial statements and footnotes thereto
included in the Form 10-K Annual Report of Hills Bancorporation and subsidiary (the Company)
for the year ended December 31, 2003 filed with the Securities Exchange Commission on
March 11, 2004.Note 2.
Earnings Per ShareBasic
earnings per share amounts are computed by dividing net income (the numerator) by the
weighted average number of common shares outstanding (the denominator) during the period.
Diluted per share amounts assume the conversion, exercise or issuance of all potential
common stock equivalents unless the effect is to reduce the loss or increase the income
per common share from continuing operations.On
April 13, 2004, the Company declared a three-for-one stock split effected in the form of
a dividend, for the 1,516,752 shares of common stock issued and outstanding as of April
19, 2004. The additional shares were issued as a result of the stock split and were
mailed to the shareholders as of April 26, 2004. All shares and earnings per share
numbers have been restated for the stock split.The
computation of basic and diluted earnings per share for the periods presented is as
follows:Three months
      ended
      September 30,
    
    Nine months
      ended
      September 30,2004
    
    2003
    
    2004
    
    2003Common
      shares outstanding at the beginning of the period
    
    
    4,550,256
    
    
    4,503,162
    
    
    4,550,034
    
    
    4,503,162Weighted
      average number of net shares issued
    
    
    0
    
    
    44,172
    
    
    178
    
    
    26,502Weighted
      average shares outstanding (basic)
    
    
    4,550,256
    
    
    4,547,334
    
    
    4,550,212
    
    
    4,529,664Weighted
      average of potential dilutive sharesattributable
      to stock options granted, computed underthe
      treasury stock method
    
    
    14,605
    
    
    11,967
    
    
    14,933
    
    
    10,350Weighted
      average number of shares (diluted)
    
    
    4,564,861
    
    
    4,559,301
    
    
    4,565,145
    
    
    4,540,014Net income
      (In Thousands)
    
    $
    3,607
    
    $
    4,319
    
    $
    10,764
    
    $
    11,827Earnings
      per share:Basic
    
    $
    0.80
    
    $
    0.95
    
    $
    2.37
    
    $
    2.61Diluted
    
    $
    0.79
    
    $
    0.95
    
    $
    2.36
    
    $
    2.60Page 9 of 29






HILLS BANCORPORATIONNOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Unaudited)


Note 3.
Recent Accounting PronouncementIn December, 2003, the Financial
Accounting Standards Board (FASB) issued a revised Interpretation No. 46,
Consolidation of Variable Interest Entities (FIN 46). FIN 46 addresses
consolidation by business enterprises of variable interest entities that have certain
characteristics. It requires a business enterprise that has a controlling interest in a
variable interest entity (as defined by FIN 46) to include the assets, liabilities, and
results of the activities of the variable interest entity in the consolidated financial
statements of the business enterprise. FIN 46 applies to a public entity that is not a
small business issuer no later than the end of the first reporting period that ends after
March 15, 2004. The impact of adopting FIN 46 on the Companys financial condition
and results of operations was not material.


In March, 2004, the SEC issued Staff
Accounting Bulletin No. 105, Application of Accounting Principles to Loan
Commitments (SAB 105). SAB 105 summarizes the views of the SEC staff
regarding the application of generally accepted accounting principles to loan commitments
accounted for as derivative instruments. SAB 105 will act to significantly limit
opportunities to recognize an asset related to a commitment to originate a mortgage loan
that will be held for sale prior to funding the loan. SAB 105 pertains to recognizing and
disclosing loan commitments and is effective for commitments to originate mortgage loans
to be held for sale that are entered into after March 31, 2004. The Company adopted the
provisions of SAB 105 beginning April 1, 2004. Adoption of SAB 105 did not have a material
impact on the Companys financial position or results of operations.


At its March 2004 meeting, the
Emerging Issues Task Force (EITF) revisited EITF Issue No. 03-1, The
Meaning of Other-Than-Temporary Impairment and its Application to Certain
Investments (EITF No. 03-1). Effective with reporting periods beginning
after June 15, 2004, companies carrying certain types of debt and equity securities at
amounts higher than the securities fair values will have to use more detailed
criteria to evaluate whether to record a loss and will have to disclose additional
information about unrealized losses. The Company has reviewed the revised EITF No. 03-1
and had planned to implement these additional procedures effective with the quarter
beginning on July 1, 2004, however the FASB has since issued a statement of financial
position deferring the effective date of the revised EITF No- 03-1 until further
implementation issues may be resolved. Adoption of the new issuance could have an impact
on the Companys financial position and results of operations but the extent of any
impact will vary due to the fact that the model, as issued, calls for many judgments and
additional evidence gathering as such evidence exists at each securities valuation date.
Page 10 of 29







HILLS BANCORPORATION



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


The following is managements
discussion and analysis of the financial condition of Hills Bancorporation (Hills
Bancorporation or the Company) and its banking subsidiary Hills Bank and
Trust Company (the Bank) at September 30, 2004, when compared with December
31, 2003 and of their results of operations for the nine months ended September 30, 2004
and 2003 and for the three months ended September 30, 2004 and 2003.


Special Note Regarding
Forward Looking Statements


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


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



The
strength of the United States economy in general and the strength of the local economies
in which the Company conducts its operations which may be less favorable than expected
and may result in, among other things, a deterioration in the credit quality and value of
the Companys assets.
The
effects of, and changes in, laws, regulations and policies affecting banking, securities,
insurance and monetary and financial matters as well as any laws otherwise affecting the
Company.
The
effects of changes in interest rates (including the effects of changes in the rate of
prepayments of the Companys assets) and the policies of the Board of Governors of
the Federal Reserve System.
The
ability of the Company to compete with other financial institutions as effectively as the
Company currently intends due to increases in competitive pressures in the financial
services sector.
The
ability of the Company to obtain new customers and to retain existing customers.
The
timely development and acceptance of products and services, including products and
services offered through alternative delivery channels such as the Internet.
Technological
changes implemented by the Company and by other parties, including third party vendors,
which may be more difficult or more expensive than anticipated or which may have
unforeseen consequences to the Company and its customers.
The
ability of the Company to develop and maintain secure and reliable electronic systems.Page 11 of 29





HILLS BANCORPORATION


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



The
ability of the Company to retain key executives and employees and the difficulty that the
Company may experience in replacing key executives and employees in an effective manner.
Consumer
spending and saving habits which may change in a manner that affects the Companys
business adversely.
The
economic impact of terrorist attacks and military actions.
Business
combinations and the integration of acquired businesses and assets which may be more
difficult or expensive than expected.
The
costs, effects and outcomes of existing or future litigation.
Changes
in accounting policies and practices, as may be adopted by state and federal regulatory
agencies and the Financial Accounting Standards Board.
The
ability of the Company to manage the risks associated with the foregoing as well as
anticipated.These risks and uncertainties should
be considered in evaluating forward-looking statements and undue reliance should not be
placed on such statements. Additional information concerning the Company and its business,
including other factors that could materially affect the Companys financial results,
is included in the Companys filings with the Securities and Exchange Commission.


Critical Accounting
Policy


The Companys financial
statements are prepared in accordance with accounting principles generally accepted in the
United States of America. The financial information contained within these statements is,
to a significant extent, financial information that is based on approximate measures of
the financial effects of transactions and events that have already occurred. Based on its
consideration of accounting policies that involve the most complex and subjective
decisions and assessments, management has identified its most critical accounting policies
to be those which are related to the allowance for loan losses. The Companys
allowance for loan loss methodology incorporates a variety of risk considerations, both
quantitative and qualitative in establishing an allowance for loan loss 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 non-performing loans, and other factors. Quantitative factors also
incorporate known information about individual loans, including borrowers
sensitivity to interest rate movements. Qualitative factors include the general economic
environment in the Companys markets, including economic conditions throughout the
Midwest and in particular, the state of certain industries. Size and complexity of
individual credits in relation to loan structure, existing loan policies and pace of
portfolio growth are other qualitative factors that are considered in the methodology. As
the Company adds new products and increases the complexity of its loan portfolio, it will
enhance its methodology accordingly. This discussion and analysis should be read in
conjunction with the Companys financial statements and the accompanying notes
presented elsewhere herein, as well as the Managements Discussion and Analysis of
Financial Condition and Results of Operation that is included. Although management
believes the levels of the allowance as of September 30, 2004 and December 31, 2003 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.



Page 12 of 29






HILLS BANCORPORATION


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


Balance Sheet Review at
September 30, 2004 compared to December 31, 2003.


Assets and Liabilities
Review


Total assets at September 30, 2004
were $1.263 billion and such amount represents an increase of $79.4 million from December
31, 2003. The largest individual change in assets was a $102 million increase in net loans
outstanding. The growth in net loans outstanding reflects a continued strong local economy
in the Companys primary trade area which is Johnson and Linn Counties. The Federal
Reserve Open Market Committee has raised the federal funds target rate from 1.00%,
effective June 30, 2004, to a current 1.75% on September 21, 2004. The three increases in
this target rate came after the period from May 16, 2000 to June 25, 2003 when the rate
was decreased thirteen times from 6.50% to 1.00%. The federal funds rate change usually
has a direct effect on the national prime rate and as of September 30, 2004 it has
increased to 4.75%. This prime rate change has not had a material effect on the loan
portfolio since the majority of the loans are real estate based loans and are not priced
off the prime rate. However, management expects that these rate changes over time will be
reflected in higher rates in the government bond market and in mortgage rates.


The tables below set forth the
composition of the loan portfolio as of September 30, 2004 and December 31, 2003 (dollars
in thousands), along with changes in the allowance for loan losses and non-performing loan
information:




September
      30, 2004
    
    December 31,
      2003Amount
    
    Percent
    
    Amount
    
    PercentAgricultural
    
    $
    38,261
    
    
    3.89
    %
    $
    38,153
    
    
    4.33
    %Commercial
      and financial
    
    
    56,490
    
    
    5.74
    
    
    47,938
    
    
    5.44Real estate:Construction
    
    
    71,561
    
    
    7.27
    
    
    66,644
    
    
    7.57Mortgage
    
    
    784,211
    
    
    79.71
    
    
    696,453
    
    
    79.07Loans to
      individuals
    
    
    33,329
    
    
    3.39
    
    
    31,591
    
    
    3.59$
    983,852
    
    
    100.00
    %
    $
    880,779
    
    
    100.00
    %Less allowance
      for loan losses
    
    
    (13,670
    )
    
    
    
    
    (12,585
    )Loans, net
    
    $
    970,182
    
    
    
    
    $
    868,194Changes in the allowance for loan
losses for the periods shown in the following table were as follows:






Three months
      ended
      September 30,
    
    Nine months
      ended
      September 30,2004
    
    2003
    
    2004
    
    2003(Amounts
      in thousands)
    
    (Amounts
      in thousands)Balance,
      beginning
    
    $
    13,060
    
    $
    12,740
    
    $
    12,585
    
    $
    12,125Provision
      charged to expense
    
    
    602
    
    
    (326
    )
    
    1,117
    
    
    123Recoveries
    
    
    299
    
    
    488
    
    
    858
    
    
    1,298Loans
      charged off
    
    
    (291
    )
    
    (477
    )
    
    (890
    )
    
    (1,121
    )Balance,
      ending
    
    $
    13,670
    
    $
    12,425
    
    $
    13,670
    
    $
    12,425Page 13 of 29





HILLS BANCORPORATION


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


Non-performing loan information at
September 30, 2004 and December 31, 2003, was as follows:





September
      30, 2004
    
    December
      31, 2003(Amounts
      in thousands)Impaired
      loans, non-accrual
    
    
    $
    2,350
    
    $
    3,944Loans past
      due ninety days or more and still accruing
    
    
    
    2,298
    
    
    2,296Restructured
      loans
    
    
    
    
    
    
    Investment securities decreased $17.8
million as detailed in the table that follows. The decrease was the result of the
maturities of the securities. The funds received were used to fund the loan increases for
the first nine months. In addition, federal funds sold were reduced $13.2 million to
provide funds for the loan growth. In addition to these changes, the Companys
investment in tax credit real estate increased as a result of its purchase of a $5.7
million property in Iowa City, Iowa (the Iowa City Tax Credit Property).


The carrying values of investment
securities for September 30, 2004 and December 31, 2003 are summarized in the following
table (dollars in thousands):




September
      30, 2004
    
    December 31,
      2003Amount
    
    Percent
    
    Amount
    
    PercentSecurities
      available for saleU.S.
      Treasury
    
    $
    
    
    
    
    %
    $
    6,138
    
    
    2.80
    %U.S.
      Government agenciesand
      corporations
    
    
    134,640
    
    
    66.21
    
    
    152,710
    
    
    69.59State
      and politicalsubdivisions
    
    
    68,718
    
    
    33.79
    
    
    60,582
    
    
    27.61Total
      securitiesavailable
      for sale
    
    $
    203,358
    
    
    100.00
    %
    $
    219,430
    
    
    100.00
    %Securities
      held to maturity,State
      and politicalsubdivisions
    
    $
    6,208
    
    
    100.00
    %
    $
    7,953
    
    
    100.00
    %Total deposits increased $64.6
million. This increase in deposits includes two large deposits that total $43.8 million of
public funds. The Company was the successful bidder for these bond proceeds which will be
disbursed over the next two years. The deposits are priced at similar rates as FHLB
advances for the expected maturities. Federal funds purchased and securities sold under
agreements to repurchase increased from $30.0 million to $36.7 million. Federal funds
purchased increased $18.9 million and repurchase agreements were down $12.2 million. In
the opinion of the Companys management, the Company continues to have sufficient
liquidity resources available to fund expected additional loan growth.



Page 14 of 29






HILLS BANCORPORATION


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


Dividends and Equity


In January 2004, Hills Bancorporation
paid a dividend of $3,184,000 or $2.10 per share, a 10.53% increase from the $1.90 per
share paid in January 2003. After payment of the dividend and the adjustment for
accumulated other comprehensive income, stockholders equity as of September 30, 2004
totaled $101,622,000. Under risk-based capital rules, the total amount of risk based
capital is 14.00% of risk-adjusted assets, and is substantially in excess of required
minimums.


Discussion of operations
for the nine months ended September 30, 2004 and 2003.


Net Income


The Companys net income for the
nine months ended September 30, 2004 was $10.8 million compared to $11.8 million for the
same period in 2003. The decrease in net income of $1,063,000 was primarily due to the
following:



Increase (Decrease)
      In Net Income(Amounts
      in Thousands)
    Net
      interest income
    
    $
    2,970
    Provision
      for loan losses
    
    
    (994
    )
    Net gain
      on sale of loans
    
    
    (2,713
    )
    Other income
    
    
    819
    Other expenses
    
    
    (2,131
    )
    Income taxes
    
    
    986$
    (1,063
    )Each of these items listed for the
change in net income is discussed in detail in the appropriate section that follows.



Page 15 of 29






HILLS BANCORPORATION


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


Net Interest Income


Net interest income is the excess of
the interest and fees received on interest-earning bearing assets over the interest
expense of the interest-bearing liabilities. The factors that have the greatest impact on
net interest income are the volume of average earning assets and the net interest margin.
The net interest margin for the first nine months of 2004 was 3.58% compared to 3.45% in
2003 for the same period. The measure is shown on a tax-equivalent basis using a tax rate
of 34% to make the interest earned on taxable and non-taxable assets more comparable. The
table below shows the change in average balances and average rates between years and the
effect on the net interest income on a tax equivalent basis for the nine months ended in
2004 compared to 2003 as shown in the following table:




Increase (Decrease)Change
      In
      Average Balance
    
    Change
      In
      Average Rate
    
    Volume 
      Changes
    
    Rate
      Changes
    
    Net 
      Change(Amounts
      In Thousands)Interest
      income:Loans,
      net
    
    $
    96,580
    
    
    (0.48
    )%
    $
    4,612
    
    $
    (3,235
    )
    $
    1,377Taxable
      securities
    
    
    4,797
    
    
    (0.77
    )
    
    138
    
    
    (800
    )
    
    (662
    )Nontaxable
      securities
    
    
    7,028
    
    
    (0.39
    )
    
    299
    
    
    (204
    )
    
    95Federal
      funds sold
    
    
    (35,499
    )
    
    (0.19
    )
    
    (258
    )
    
    (5
    )
    
    (263
    )$
    72,906
    
    
    
    
    $
    4,791
    
    $
    (4,244
    )
    $
    547Interest
      expense:Interest-bearing
      demand deposits
    
    $
    24,742
    
    
    (0.39
    )
    $
    156
    
    $
    (418
    )
    $
    (262
    )Savings
      deposits
    
    
    24,984
    
    
    (0.32
    )
    
    165
    
    
    (529
    )
    
    (364
    )Time
      deposits
    
    
    (8,226
    )
    
    (0.60
    )
    
    (185
    )
    
    (1,769
    )
    
    (1,954
    )Federal
      funds purchased and securitiessold
      under agreements to repurchase
    
    
    11,227
    
    
    (0.59
    )
    
    137
    
    
    (73
    )
    
    64FHLB
      borrowings
    
    
    (32
    )
    
    
    
    
    (1
    )
    
    
    
    
    (1
    )$
    52,695
    
    
    
    
    $
    272
    
    $
    (2,789
    )
    $
    (2,517
    )Change
      in net interest income
    
    
    
    
    
    
    
    $
    4,519
    
    $
    (1,455
    )
    $
    3,064A summary of the net interest spread
and margin is as follows:



(Tax Equivalent Basis)
    
    
    2004
    
    2003Yield
      on average interest-earning assets
    
    
    5.61
    %
    
    5.93
    %Rate on average
      interest-bearing liabilities
    
    
    2.40
    
    
    2.90Net interest
      spread
    
    
    3.21
    %
    
    3.03
    %Effect of
      noninterest-bearing funds
    
    
    0.37
    
    
    0.42Net interest
      margin (tax equivalent interest incomedividend
      by average interest-earning assets)
    
    
    3.58
    %
    
    3.45
    %Page 16 of 29



HILLS BANCORPORATION


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


Provision for Loan Losses


The provision for loan losses was
$1,117,000 and $123,000 for the nine months ended September 30, 2004 and 2003,
respectively. The Company experienced net charge-offs for this time period in 2004 of
$32,000 and net recoveries of $177,000 in 2003. The provision adjustment computed on a
quarterly basis is a result of managements determination of the quality of the loan
portfolio and the adequacy of the allowance for loan losses. The provision reflects a
number of factors, including the size of the loan portfolio, loan concentrations and the
level of impaired loans which are all non-accrual and loans past due ninety days or more.
In addition, management considers the credit quality of the loan portfolio based on review
of problem and watch loans, including loans with historically higher credit risks
(primarily agricultural loans). The Companys review of the portfolio at September
30, 2004 resulted in the level of potential problem loans increasing approximately $1
million from the December 31, 2003 balances. One year ago, for the nine months ended
September 30, 2003, the loans identified for the loan loss review increased only $300,000.


The allowance for loan losses totaled
$13,670,000 at September 30, 2004 compared to $12,585,000 at December 31, 2003. The
allowance represented 1.39% and 1.43% of outstanding loans at September 30, 2004 and
December 31, 2003, respectively. The allowance was based on managements
consideration of a number of factors, including loan concentrations, loans with higher
credit risks (primarily agriculture loans and spec real estate construction) and overall
increases in net loans outstanding. The methodology used in 2004 is consistent with the
prior year.


Net Gain on Sale of Loans


Net gain on sale of loans for the
nine months ended September 30, 2004 was $1,259,000 compared to $3,972,000 for the same
period ended September 30, 2003. The decreased fees in the secondary market were expected
from the levels experienced in the first three quarters of 2003. The number of loans sold
in 2004 was approximately 40% of the volume in 2003. Also, some discounting of fees
occurred in 2004 to maintain market share. The decrease in the volume of loans is due to
the fact that many consumers had taken advantage of lower rates in 2003 to refinance
loans.


Other Income


Trust fees increased $219,000 in the
first nine months of 2004 compared to 2003 due to the increase in total assets under
management. Assets under management have increased $110.2 million in the last year to
$674.8 million. Approximately 51% of the trust assets are held in common stocks, and the
asset growth has been partially due to higher stock prices over the last twelve months.
For example, the Dow Jones Industrial Average is up just over 6% in the twelve months
ended September 30, 2004. Other fees and charges increased to $3,375,000 in 2004 from
$2,802,000 in 2003. Approximately $292,000 of the increased revenue from fees and charges
is in ATM service fees, debit card fees and credit card merchant fees. In addition, rental
revenue from tax credit real estate properties is $172,000 higher due to an additional
property added in January 2004.
Page 17 of 29






HILLS BANCORPORATION


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


Other Expenses


Total other expenses were $23.0
million and $20.9 million for the nine months ended September 30, 2004 and 2003,
respectively. This increase of $2.1 million includes salaries and employee benefits which
were $982,000 higher. The increase in direct salaries was $562,000 or 6.41%. The increase
is due to salary adjustments for 2004 and an increase in the average number of full-time
equivalent employees. Medical expenses of the Companys self-funding plan increased
by $264,000 for the nine months from one year ago and are primarily the result of higher
medical costs and more employees covered in the plan.


Occupancy and furniture and equipment
expense increased $315,000 from one year ago to a total of $3,977,000. The change included
an increase in depreciation expense on equipment of $156,000 due to a full year of
depreciation for 2003 additions and new equipment added in 2004. Also, property taxes were
$72,000 higher due to new construction of offices in the prior year at two locations and
the full value of the improvements being assessed.


Advertising and business development
expenses were $1,271,000 for the nine months ended September 30, 2004 compared to
$1,021,000 for the nine months ended September 30, 2003. The increase of $250,000 included
costs associated with the 100th Anniversary celebration of the Companys
subsidiary Bank in 2004 that were approximately $110,000. The balance of the increase was
primarily in direct mail expense and product promotion. Both areas saw increased emphasis
for 2004 in marketing retail deposits and home equity loans.


Other expenses for the nine month
period presented are $4.5 million in 2004 compared to $3.9 million in 2003. Included in
this expense category are merchant card processing charges, debit card processing and ATM
charges that were $150,000 higher in 2004 than 2003 due to increased volume of activity.
Also, expenses associated with the rental of tax credit real estate increased from
$360,000 in the nine months ended September 30, 2003 to $595,000 for the same period in
2004. The increase is due to the addition in January of 2004 of the Iowa City Tax Credit
Property.


Income Taxes


Income tax expense was $4,902,000 and
$5,888,000 for the nine months ended September 30, 2004 and 2003, respectively. The
corresponding percentage of income taxes compared to income before income taxes is 31.29%
in 2004 and 33.24% in 2003. The percentage in 2004 is lower due to additional income tax
credits available from the purchase in early 2004 of the Iowa City Tax Credit Property.
The total tax credits were $395,000 and $175,000 for the nine months ended September 30,
2004 and 2003, respectively.



Page 18 of 29






HILLS BANCORPORATION


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


Discussion of operations
for the three months ended September 30, 2004 and 2003.


Net Income


Net income decreased from $4,319,000
in 2003 to $3,607,000 in 2004. As discussed in the nine month review of net income, one of
the major factors was the decrease in gain on sale of secondary market loans from
$1,520,000 in 2003 to $292,000 in 2004. Net of income taxes, this would account for
approximately an $810,000 decrease in net income. All the other significant differences
net to an amount of less than $100,000. Those items include an increase in the net
interest margin of $1,235,000; the provision for loan losses increasing by $927,000, a
$252,000 increase in other income and a $600,000 increase in other expenses. Changes in
each of these items occurred for reasons similar to those discussed in the nine month
review of net income.


Net Interest Income


Net interest income increased for the
three month period ended September 30, 2004 by $1.2 million from the similar period in
2003. The net interest margin in 2004 improved to 3.59% compared to 3.39% in 2003. The
increase in the volume of interest earning assets accounted for a significant portion of
the net interest income improvement along with savings on interest bearing liabilities.Net
interest income on a tax-equivalent basis changes for the three months ended September 30,
2004 and 2003 are as follows:






Change
      InAverage Balance
    
    Change
      InAverage Rate
    
    Increase (Decrease)Volume Changes
    
    Rate Changes
    
    Net Change(Amounts
      In Thousands)Interest
      income:Loans,
      net
    
    
    $
    107,605
    
    
    (0.29
    )%
    $
    1,657
    
    $
    (661
    )
    $
    996Taxable
      securities
    
    
    
    (7,778
    )
    
    (0.56
    )
    
    (87
    )
    
    (184
    )
    
    (271
    )Nontaxable
      securities
    
    
    
    9,757
    
    
    (0.33
    )
    
    137
    
    
    (62
    )
    
    75Federal
      funds sold
    
    
    
    (33,509
    )
    
    1.13
    
    
    (66
    )
    
    (1
    )
    
    (67
    )$
    76,075
    
    
    
    
    $
    1,641
    
    $
    (908
    )
    $
    733Interest
      expense:Interest-bearing
      demand deposits
    
    
    $
    13,925
    
    
    (0.26
    )
    $
    26
    
    $
    (93
    )
    $
    (67
    )Savings
      deposits
    
    
    
    26,405
    
    
    (0.04
    )
    
    46
    
    
    (18
    )
    
    28Time
      deposits
    
    
    
    (2,002
    )
    
    (0.54
    )
    
    (30
    )
    
    (540
    )
    
    (570
    )Federal
      funds purchased and securitiessold
      under agreements to repurchase
    
    
    
    17,548
    
    
    (0.12
    )
    
    117
    
    
    (36
    )
    
    81FHLB
      borrowings
    
    
    
    (31
    )
    
    
    
    
    
    
    
    
    
    
    $
    55,845
    
    
    
    
    $
    159
    
    $
    (687
    )
    $
    (528
    )Change in
      net interest income
    
    
    
    
    
    
    
    
    $
    1,482
    
    $
    (221
    )
    $
    1,261A summary of the net interest spread and
margin is as follows:



(Tax Equivalent Basis)
    
    2004
    
    2003Yield
      on average interest-earning assets
    
    
    5.59
    %
    
    5.72
    %Rate on average
      interest-bearing liabilities
    
    
    2.37
    
    
    2.73Net interest
      spread
    
    
    3.22
    %
    
    2.99
    %Effect of
      noninterest-bearing funds
    
    
    0.37
    
    
    0.40Net interest
      margin (tax equivalent interest income
        dividend by average interest-earning assets)
    
    
    3.59
    %
    
    3.39
    %Page 19 of 29






HILLS BANCORPORATION


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


Provision for Loan Losses


The provision for loan losses was
$602,000 for the quarter ended September 30, 2004 compared to a reduction in the expense
of $325,000 one year ago. As discussed in the results for the nine months, the allowance
for loan losses was increased due to managements analysis of the outstanding loans
at September 30, 2004, which resulted in a higher level of problem loans.


Other Income


As explained in the preceding
discussion of the nine months results, net gain on sale of loans was substantially less in
2004 as compared to 2003 which was an excellent year for loans sold on the secondary
market. Interest rates were more favorable in 2003 and the third quarter of 2003 was the
second highest level of gain on sale of loans since the Company started the program over
ten years ago. The total gain on sale of loans in 2003 was $1,520,000, which was
$1,228,000 more than the quarter ended September 30, 2004. Other income items for debit
card fees and ATM service fees were up $96,000 for the quarter ended September 30, 2004,
as compared to the same quarter of 2003.


Other Expenses


Total expenses for the 2004 quarter
compared to the 2003 quarter increased $600,000. Of the additional expenses, $223,000
represented salaries and employee benefits related to an increase in full and part time
employees, coupled with normal year-end salary adjustments in 2004. The direct salary
expense increase was $65,000 and medical claims and insurance increased $121,000 in 2004
compared to 2003. Advertising and business development expenses increased $133,000 in
comparing the quarters. As for the nine months, this included direct mail and product
promotion items to assist in the retail growth of the Company. Other expenses were
$143,000 higher in the 2004 quarter than in the comparable 2003 quarter, with $95,000 of
this increase relating to increases in rental expenses on tax credit real estate. As a
result of an increase in the volume of activity, credit card processing increased $77,000.


Income Taxes


Income tax expense as a percentage of
income before taxes decreased from 33.66% in 2003 to 31.20% in 2004. The decrease is due
to an additional $73,000 in tax credits available as a result of the new tax credit real
estate investment in 2004.





Page 20 of 29




HILLS BANCORPORATION


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


Liquidity


The Company actively monitors and
manages its liquidity position with the objective of maintaining sufficient cash flows to
fund operations, meet client commitments, take advantage of market opportunities and
provide a margin against unforeseeable liquidity needs. Federal funds sold and investment
securities available for sale are readily marketable assets. Maturities of all investment
securities are managed to meet the Companys normal liquidity needs, to respond to
market changes or to adjust the Companys interest rate risk position. Federal funds
sold and investment securities available for sale comprised 16.10% of the Companys
total assets at September 30, 2004, compared to 19.66% at December 31, 2003.


The Company has historically
maintained a stable deposit base and a relatively low level of large deposits, which has
mitigated the volatility in the Companys liquidity position. As of September 30,
2004, the Company had borrowed $167.5 million from the FHLB of Des Moines. The amount of
advances from the FHLB of Des Moines is $32,000 less than at December 31, 2003. These
advances were used as a means of providing both long and short-term, fixed-rate funding
for certain assets and managing interest rate risk. The Company had additional borrowing
capacity available from the FHLB of approximately $171 million at September 30, 2004.


As additional sources of liquidity,
the Company has the ability to borrow up to $10 million from the Federal Reserve Bank of
Chicago, and lines of credit with two banks totaling $106 million. Those two lines of
credit require the pledging of investment securities when drawn upon.


The combination of high levels of
potentially liquid assets, low dependence on volatile liabilities and additional borrowing
capacity provided sources of liquidity for the Company which management considered
sufficient at September 30, 2004.




Page 21 of 29




HILLS BANCORPORATION



Item 3.  Quantitative and
Qualitative Disclosures About Market Risk


Market Risk Management


Market risk is the risk of loss
arising from adverse changes in market prices and rates. The Companys market risk is
comprised primarily of interest rate risk resulting from its core banking activities of
lending and deposit gathering. Interest rate risk measures the impact on earnings from
changes in interest rates and the effect on current fair market values of the
Companys assets, liabilities and off-balance sheet contracts. The Companys
objective is to measure this risk and manage the balance sheet to avoid unacceptable
potential for economic loss. Management continually develops and applies strategies to
mitigate market risk, some of which are described below. Exposure to market risk is
reviewed on a regular basis by the asset/liability committee at the bank. Management does
not believe that the Companys primary market risk exposures and the manner in which
those exposures have been managed to date in 2004, changed significantly when compared to
2003.


Asset/Liability
Management


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


The Bank maintains an asset/liability
committee, which meets at least quarterly to review the interest rate sensitivity position
and to review various strategies as to interest rate risk management. In addition, the
Bank uses a simulation model to review various assumptions relating to interest rate
movement. The model attempts to limit rate risk even if it appears the Banks asset
and liability maturities are perfectly matched and a favorable interest margin is present.


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


Net interest income should decline
with instantaneous increases in interest rates while net interest income should increase
with instantaneous declines in interest rates. Generally, during periods of increasing
interest rates, interest rates paid by the Company on the Companys interest rate
sensitive liabilities would re-price faster than interest rates received by the Company on
its interest rate sensitive assets, causing a decline in the Companys interest rate
spread and margin. This would tend to reduce net interest income because the resulting
increase in the Companys cost of funds would not be immediately offset by an
increase in its yield on earning assets. In times of decreasing interest rates, fixed rate
assets could increase in value and the lag in re-pricing of interest rate sensitive assets
could be expected to have a positive effect on the Companys net interest income.
Page 22 of 29




HILLS BANCORPORATION



Item 4.  Controls and
Procedures


As of the end of the period covered
by this report, the Company carried out an evaluation, under the supervision and with the
participation of the Companys management, including the Companys Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the design and
operations of the Companys disclosure controls and procedures, and as defined in
Exchange Act Rule 13a-15(e). Based upon that evaluation, the Companys Chief
Executive Officer and Chief Financial Officer concluded that the Companys disclosure
controls and procedures are effective in recording, processing, summarizing and reporting,
on a timely basis, information required to be disclosed by the Company in the reports it
files with the Securities and Exchange Commission. There have been no changes in the
Companys internal controls over financial reporting that occurred during the
Companys most recent fiscal quarter that has materially affected, or is reasonably
likely to materially affect, the Companys internal control over financial reporting.


Page 23 of 29




HILLS
BANCORPORATIONPART II  OTHER INFORMATION



Item 1.
Legal ProceedingsNo
material legal proceedings are pending.

Item 2.
Changes in Securities, Use of Proceeds and Issuer Purchases of Equity SecuritiesThere
were no changes in securities.

Item 3.
Defaults upon Senior SecuritiesHills
Bancorporation has no senior securities.

Item 4.
Submission of Matters to a Vote of Security HoldersNo
matters were submitted to a vote of security holders during the quarter ended September
30, 2004.

Item 5.
Other InformationNone

Item 6.
Exhibits and Reports on Form 8-KExhibits31
Certifications
under Section 302 of the Sarbanes-Oxley Act of 200232
Certifications
under Section 906 of the Sarbanes-Oxley Act of 2002Reports
on Form 8-KA
report on Form 8-K was filed on September 16, 2004, which reported that the Companys
Board of Directors elected James A. Nowak as a director of Hills Bancorporation and its
wholly-owned subsidiary, Hills Bank and Trust Company on September 14, 2004. Mr. Nowak
will serve on the audit committee of Hills Bancorporation beginning immediately and has
been designated as the audit committee financial expert as defined in Rule 401(h) of
Regulation S-K.Page 24 of 29




SIGNATURES


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


HILLS BANCORPORATION


Date:
      November 5, 2004
      
    
    By:
      /s/ Dwight O. Seegmiller
      Dwight O.
      Seegmiller, Director and PresidentDate: November
      5, 2004
      
    
    By: /s/ James
      G. Pratt
      James G.
      Pratt, Treasurer and Chief Accounting OfficerPage 25 of 29




HILLS BANCORPORATIONQUARTERLY
REPORT OF FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2004



Exhibit
      Number
    Description
    Page Number
      In The Sequential
      Numbering System
      September 30, 2004 Form 10-Q31
    
    Certifications
      under Section 302 of the Sarbanes-Oxley Act of 2002
    
    
    27-
      28 of 2932
    
    Certifications
      under Section 906 of the Sarbanes-Oxley Act of 2002
    
    
    29 of 29Page 26 of 29