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|HILLS BANCORPORATION
FORM 10-K
DECEMBER 31, 2006

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|UNITED STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
    FORM 10-K 
|-------------------------------------------------------------------------------------
|                                                                                     
|xANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|                                                                                     
|For the fiscal year ended December 31, 2006.                                         
|                                                                                     
|HILLS BANCORPORATION(Exact name of Registrant as specified in its charter)           
|                                                                                     

|Iowa                                                               |  | 42-1208067                       
|------------------------------------------------------------------ |  | ---------------------------------
|                                                                   |  |                                  
|(State or Other Jurisdiction of
    Incorporation or Organization) |  | (IRS Employer Identification No.)
|                                                                   | 
|                                                                   |  |                                  

|131 Main Street, Hills, Iowa 52235       | 
|---------------------------------------- | 
|                                         | 
|(Address of principal executive offices) | 
|                                         | 

|Registrants telephone number, including area code: (319) 679-2291
|------------------------------------------------------------------
|Securities Registered pursuant to Section 12 (b) of the Act: None 
|Securities Registered pursuant to Section 12 (g) of the Act:      
|                                                                  
|No par value common stock                                         
|                                                                  
|Title of Class                                                    
|                                                                  

|Indicate by check mark if the Registrant is well-known seasoned issuer, as defined in Rule 405 of the
Securities Act. Yes No ü
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or
Section 15(d) of the Act. Yes No ü
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section
13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter
period that the Registrant was required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. Yes ü  No__
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Registrant S-K (229.405
of this chapter) is not contained herein, and will not be contained to the best of Registrants
knowledge, in definitive proxy or information statements incorporated by reference in Part III of
this Form 10-K or any amendment to this Form 10-K. __
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or
a non-accelerated filer. See definition of accelerated filer and large accelerated filer
in Rule 12b-2 of the Exchange Act. (Check one):Large accelerated filer  Accelerated filer ü  Non-accelerated filer
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act). Yes__ No ü
While it is difficult to determine the market value of shares owned by nonaffiliates (within the meaning
of such term under the applicable regulations of the Securities and Exchange Commission), the Registrant
estimates that the aggregate market value of the Registrants common stock held by nonaffiliates
on January 31, 2007 (based upon reports of beneficial ownership that approximately 82% of the shares
are so owned by nonaffiliates and upon information communicated informally to the Registrant by various
purchasers and sellers that the sale price for the common stock is generally $50.00 per share) was
$183,735,000.
The number of shares outstanding of the Registrants common stock as of February 28, 2007 is 4,503,738
shares of no par value common stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement dated March 19, 2007 for the Annual Meeting of the Shareholders of
the Registrant to be held April 16, 2007 (the Proxy Statement) are incorporated by reference
in Part III of this Form 10-K.
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|Page 1 of 97
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|HILLS BANCORPORATIONFORM 10-K
    TABLE OF CONTENTS
|---------------------------------------------------
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|         |  |                                                                                                                  |  | Page | 
|-------- |  | ---------------------------------------------------------------------------------------------------------------- |  | ---- | 
|         |  |                                                                                                                  |  |      | 
|         |  | PART I                                                                                                           |  |      | 
|         |  |                                                                                                                  |  |      | 
|Item 1.  |  | Business                                                                                                         |  | 3    | 
|         |  | General                                                                                                          |  | 3    | 
|         |  | Competition                                                                                                      |  | 5    | 
|         |  | The Economy                                                                                                      |  | 6    | 
|         |  | Supervision and Regulation                                                                                       |  | 7    | 
|         |  | Consolidated Statistical Information                                                                             |  | 12   | 
|Item 1A. |  | Risk Factors                                                                                                     |  | 23   | 
|Item 1B. |  | Unresolved Staff Comments                                                                                        |  | 26   | 
|Item 2.  |  | Properties                                                                                                       |  | 27   | 
|Item 3.  |  | Legal Proceedings                                                                                                |  | 28   | 
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                              |  | 28   | 
|         |  |                                                                                                                 
|         |  |                                                                                                                 
|         |  |                                                                                                                  |  |      | 
|         |  | Part II                                                                                                          |  |      | 
|Item 5.  |  | Market for Registrants Common Equity, Related Stockholder Matters
    and Issuer Purchases of Equity Securities |  | 29   | 
|Item 6.  |  | Selected Financial Data                                                                                          |  | 31   | 
|Item 7.  |  | Managements Discussion and Analysis of Financial Condition and
    Results of Operation                         |  | 32   | 
|Item 7A. |  | Quantitative and Qualitative Disclosures about Market Risk                                                       |  | 49   | 
|Item 8.  |  | Consolidated Financial Statements and Supplementary Data                                                         |  | 52   | 
|Item 9.  |  | Changes In and Disagreements with Accountants on Accounting and
    Financial Disclosure                         |  | 86   | 
|Item 9A. |  | Controls and Procedures                                                                                          |  | 86   | 
|Item 9B. |  | Other Information                                                                                                |  | 88   | 
|         |  |                                                                                                                 
|         |  |                                                                                                                 
|         |  |                                                                                                                  |  |      | 
|         |  | Part III                                                                                                         |  |      | 
|Item 10. |  | Directors, Executive Officers and Corporate Governance                                                           |  | 88   | 
|Item 11. |  | Executive Compensation                                                                                           |  | 88   | 
|Item 12. |  | Security Ownership of Certain Beneficial Owners and Management and
    Related Stockholder Matters               |  | 88   | 
|Item 13. |  | Certain Relationships and Related Transactions, and Director Independence                                        |  | 88   | 
|Item 14. |  | Principal Accounting Fees and Services                                                                           |  | 88   | 
|         |  |                                                                                                                 
|         |  |                                                                                                                  |  |      | 
|         |  | Part IV                                                                                                          |  |      | 
|Item 15. |  | Exhibits, Financial Statement and Schedules                                                                      |  | 89   | 

|Page 2 of 97
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|PART I
Item 1.   Business
GENERAL
Hills Bancorporation (the Company) is a holding company principally engaged, through its
subsidiary bank, in the business of banking. The Company was incorporated December 12, 1982 and all
operations are conducted within the state of Iowa. The Company became owner of 100% of the outstanding
stock of Hills Bank and Trust Company, Hills, Iowa (Hills Bank and Trust or the Bank)
as of January 23, 1984 when stockholders of Hills Bank and Trust exchanged their shares for shares
of the Company. Effective July 1, 1996, the Company formed a new subsidiary, Hills Bank, which acquired
for cash all the outstanding shares of a bank in Lisbon, Iowa. Subsequently an office of Hills Bank
was opened in Mount Vernon, Iowa, a community that is contiguous to Lisbon. Effective November 17,
2000, Hills Bank was merged into Hills Bank and Trust. On September 20, 1996, another subsidiary,
Hills Bank Kalona, acquired cash and other assets and assumed the deposits of the Kalona, Iowa office
of Boatmens Bank Iowa, N.A. Effective October 26, 2001, Hills Bank Kalona was merged into Hills
Bank and Trust.
Through its internet website (www.hillsbank.com) the Company makes available, free of charge, by link
to the internet website of the Securities and Exchange Commission (www.sec.gov), the Annual Report
on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, all amendment to those
reports, and other filings with the Securities and Exchange Commission, as soon as reasonably practicable
after they are filed or furnished.
The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental
units and institutional customers. The Bank is actively engaged in all areas of commercial banking,
including acceptance of demand, savings and time deposits; making commercial, real estate, agricultural
and consumer loans; maintaining night and safe deposit facilities; and performing collection, exchange
and other banking services tailored for individual customers. The Bank administers estates, personal
trusts, and pension plans and provides farm management and investment advisory and custodial services
for individuals, corporations and nonprofit organizations. The Bank makes commercial and agricultural
loans, real estate loans, automobile, installment and other consumer loans. In addition, the Bank
earns substantial fees from originating mortgages that are sold in the secondary residential real
estate market without mortgage servicing rights being retained.
The Bank has an established formal loan origination policy. In general, the loan origination policy
attempts to reduce the risk of credit loss to the Bank by requiring, among other things, maintenance
of minimum loan to value ratios, evidence of appropriate levels of insurance carried by borrowers
and documentation of appropriate types and amounts of collateral and sources of expected payment.
The Banks business is not seasonal, except that loan origination fees are driven by interest
rate movements and are higher in a low rate environment. As of December 31, 2006, the Company had
no employees and the Bank had 327 full-time and 96 part-time employees.
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|Page 3 of 97
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|Item 1.   Business (Continued)
Johnson County and Linn County
The Banks primary trade area includes the Johnson County communities of Iowa City, Coralville,
Hills and North Liberty, located near Interstate 80 and Interstate 380 in Eastern Iowa. These communities
have a combined population of approximately 93,000. Johnson County, Iowa has a population of approximately
124,000. The University of Iowa in Iowa City has approximately 30,000 students and 25,800 full and
part-time employees, including 7,600 employees of The University of Iowa Hospitals and Clinics.
The Bank also operates offices in the Linn County, Iowa communities of Lisbon, Marion, Mount Vernon
and Cedar Rapids, Iowa. Lisbon has a population of approximately 1,900 and Mount Vernon, located
two miles from Lisbon, has a population of about 3,900. Both communities are strong economically
and are within easy commuting distances to Cedar Rapids and Iowa City, Iowa. Cedar Rapids has a metropolitan
population of approximately 154,000, including approximately 30,000 from adjoining Marion, Iowa and
is located approximately 10 miles west of Lisbon, Iowa and approximately 25 miles north of Iowa City
on Interstate 380. The total population of Linn County is approximately 203,000. The largest employer
in the Cedar Rapids area is Rockwell Collins, manufacturer of communications instruments, with
about 8,500 employees.
Other large employers in the Johnson and Linn County areas and their approximate number of employees
are as follows (Data source is Priority One):
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| | **Employer**                               |  | **Type of Business**             |  | **Employees** | 
| | ------------------------------------------ |  | -------------------------------- |  | ------------- | 
| |                                            |  |                                  |  |               | 
| | Cedar Rapids and Linn-Mar School Districts |  | Education                        |  | 3,500         | 
|
| | Hy-Vee Food Stores                         |  | Grocery Stores                   |  | 3,000         | 
|
| | AEGON USA, Inc.                            |  | Insurance                        |  | 2,800         | 
|
| | St. Lukes Hospital                        |  | Health Care                      |  | 2,400         | 
|
| | Mercy Medical Center                       |  | Health Care                      |  | 2,400         | 
|
| | Pearson US                                 |  | Information Services - Computers |  | 1,900         | 
|
| | Iowa City Community School District        |  | Education                        |  | 1,600         | 
|
| | Wal-Mart Stores, Inc.                      |  | Discount Store                   |  | 1,500         | 
|
| | Kirkwood Community College                 |  | Education                        |  | 1,400         | 
|
| | City of Cedar Rapids                       |  | City Government                  |  | 1,300         | 
|
| | ACT, Inc.                                  |  | Educational Testing Service      |  | 1,300         | 
|
| | Mercy Iowa City                            |  | Health Care                      |  | 1,300         | 
|
| | Quaker Oats Company                        |  | Cereals and Chemicals            |  | 1,200         | 
|
| | VA Iowa City Health Care System            |  | Health Care                      |  | 1,200         | 
|
| | Verizon Business                           |  | Telecommunication                |  | 1,000         | 

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Washington County
    The Bank has offices located in Kalona and Wellman, Iowa, which are in Washington County. Kalona is located approximately 20 miles south of Iowa City. Wellman is located approximately 5 miles west of Kalona. Kalona has a population of approximately 2,600 and Wellman has a population of about 1,400. The population of Washington County is approximately 21,700. Both Kalona and Wellman are primarily agricultural communities, but are located within easy driving distance for employment in Iowa City, Coralville and North Liberty (combined population 92,000) and Washington, Iowa (population 7,000).

|Page 4 of 97
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|Item 1.   Business (Continued)
COMPETITION
Competition among financial institutions in attracting and retaining deposits and making loans is intense.
Traditionally, our most direct competition for deposits has come from commercial banks, savings institutions
and credit unions doing business in our areas of operation. Increasingly, we have experienced additional
competition for deposits from nonbanking sources, such as securities firms, insurance companies,
money market mutual funds and financial services subsidiaries of commercial and manufacturing companies.
Competition for loans comes primarily from other commercial banks, savings instititions, consumer
finance companies, credit unions, mortgage banking companies, insurance companies and other institutional
lenders. We compete primarily on the basis of products offered, customer service and price. A number
of institutions with which we compete enjoy the benefits of fewer regulatory constraints and lower
cost structures. Some have greater assets and capital than we do and, thus, are better able to compete
on the basis of price than we are. Technological advances, which may diminish the importance of depository
institutions and other financial intermediaries in the transfer of funds between parties, could make
it more difficult for us to compete in the future.
Effective March 13, 2000, securities firms and insurance companies that elect to become financial holding
companies were allowed to acquire banks and other financial institutions. This has increased the
number of competitors and intensified the competitive environment in which the Company conducts business.
The increasingly competitive environment is primarily a result of changes in regulations and changes
in technology and product delivery systems. These competitive trends are likely to continue.
The Bank is in direct competition for loans and deposits and financial services with a number of other
banks and credit unions in Johnson and Linn County. A comparison of the number of office locations
and deposits in the two counties as of June, 2006 (Most recent date of available data from the FDIC
and national credit union websites) is as follows:
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

|                                            | **Johnson County** |        | **Linn County**                  |      
|------------------------------------------- | ------------------ | ------ | -------------------------------- | -----
|                                            |                    |        |                                  |      
|                                            | **Offices**        |        | **Deposits
      (in millions)** |      
|                                            |                    |        |                                  |      
|                                           
|Hills Bank and Trust Company                |                    | 6      |                                  | $    
|Branches of largest competing regional bank |                    | 6      |                                  |      
|Largest competing independent bank          |                    | 6      |                                  |      
|Largest competing credit union              |                    | 6      |                                  |      
|All other bank and credit union offices     |                    | 24     |                                  |      
|                                            |                    |        |                                  |      
|**Total Market in County**                  |                    | **48** |                                  | **$**
|                                            |                    |        |                                  |      

|                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Effective July 1, 2004, all limitations on bank office locations were repealed effectively allowing statewide branching. Since that date, banks have been allowed to establish an unlimited number of offices in any location in Iowa subject to regulatory approval. Since July 1, 2004, six new offices have been added in Johnson County and seven in Linn County, while the population base has increase by 15,000, or 4.81%, in the last two years.

|Page 5 of 97
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|Item 1.   Business (Continued)
      THE ECONOMY
    The Banks primary trade territory is Johnson County, Iowa. Linn County, Iowa is becoming an increasingly important market, and the Bank has five offices open in Linn County. The Bank also has two offices in Washington County, Iowa. The table that follows shows employment information as of December 31, 2006, regarding the labor force and unemployment levels in the three counties in which the Bank has office locations along with comparable data on the United States and the State of Iowa.
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

| |                   | **Labor Force** |             | **Unemployed** |  | **Rate %** |  | 
| | ----------------- | --------------- | ----------- | -------------- |  | ---------- |  | 
| |                   |                 |             |                |  |            |  | 
| | United States     |                 | 155,775,000 |                |  | 6,849,000  |  | 
| | State of Iowa     |                 | 1,697,800   |                |  | 59,200     |  | 
| | Johnson County    |                 | 77,900      |                |  | 1,900      |  | 
| | Linn County       |                 | 116,100     |                |  | 4,500      |  | 
| | Washington County |                 | 12,900      |                |  | 400        |  | 

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
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|The unemployment rate for the Banks prime market area is favorable and the rate historically has been lower than the unemployment rates for both the United States and the State of Iowa. As discussed with the employment table of large employers in Johnson and Linn County, the University of Iowas impact on the local economy is very important in maintaining acceptable employment levels. The FY 2006-2007 budget for the University of Iowa is $2.3 billion with state appropriations of approximately $318 million, or about 13.9% of the total. In addition, the University of Iowa Hospitals and Clinics have a FY 2006-2007 budget of $755 million with 1.77% coming from the State of Iowa appropriation. While the States revenues have rebounded in the past two fiscal years,
Iowa has experienced shortfalls in two of the last four budget cycles. The States budgetary constraints have not had a significant effect on the local economy. Johnson and Linn Counties have been one of the strongest economic areas in Iowa and have had substantial economic growth in the past ten years. The largest segment of the employed population is employed in manufacturing, management, professional or related occupations.
    The economies in the counties continue to be enhanced by local Iowa colleges and the University of Iowa. In addition to providing quality employment, they enroll students who provide economic benefits to the area. The following table indicates Fall 2006 enrollment.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

| | **College**                    |  | **City**                               |  | **Enrollment** |  | 
| | ------------------------------ |  | -------------------------------------- |  | -------------- |  | 
| |                                |  |                                        |  |                |  | 
| | **The University of Iowa**     |  | Iowa City                              |  | 29,979         |  | 
| | **Coe College**                |  | Cedar Rapids                           |  | 1,300          |  | 
| | **Cornell College**            |  | Mount Vernon                           |  | 1,121          |  | 
| | **Kirkwood Community College** |  | Cedar Rapids, Iowa City and Washington |  | 15,055         |  | 
| | **Mount Mercy College**        |  | Cedar Rapids                           |  | 1,482          |  | 

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The Bank also serves a number of smaller communities in Johnson, Linn and Washington counties that are more dependent upon the agricultural economy, which historically has been affected by commodity prices and weather. The average price per acre of farm land continues to be an important factor to consider when reviewing the local economy. The average price per acre in Iowa in 2006 was $3,204 compared to $2,914 in 2005, a 9.95% increase. The range of average land prices in Johnson, Linn and Washington counties is between $3,624 and $3,983 per acre. The three counties average increase was 12.06% in 2006. The Banks total agricultural loans comprise about 3.8% of the Banks total loans.

|Page 6 of 97
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|Item 1.   Business (Continued)
SUPERVISION AND REGULATION
Financial institutions and their holding companies are extensively regulated under federal and state
law. As a result, the growth and earnings performance of the Company can be affected not only by
management decisions and general economic conditions but also by the requirements of applicable state
and federal statutes and regulations and the policies of various governmental regulatory authorities,
including the Iowa Superintendent of Banking (the Superintendent), the Board of Governors
of the Federal Reserve System (the Federal Reserve), the Federal Deposit Insurance Corporation
(the FDIC), the Internal Revenue Service and state taxing authorities and the Securities
and Exchange Commission (the SEC). The effect of applicable statutes, regulations and
regulatory policies can be significant and cannot be predicted with a high degree of certainty.
Federal and state laws and regulations generally applicable to financial institutions regulate, among
other things, the scope of business, investments, reserves against deposits, capital levels relative
to operations, the nature and amount of collateral for loans, the establishment of branches, mergers,
consolidations and dividends. The system of supervision and regulation applicable to the Company
and its subsidiary Bank establishes a comprehensive framework for their respective operations and
is intended primarily for the protection of the FDICs deposit insurance funds and the depositors,
rather than the stockholders, of financial institutions. The enforcement powers available to federal
and state banking regulators are substantial and include, among other things, the ability to assess
civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions.
The following is a summary of the material elements of the regulatory framework applicable to the Company
and its subsidiary Bank. It does not describe all of the statutes, regulations and regulatory policies
that apply, nor does it restate all of the requirements of the statutes, regulations and regulatory
policies that are described. As such, the following is qualified in its entirety by reference to
the applicable statutes, regulations and regulatory policies. Any change in applicable law, regulations
or regulatory policies may have a material effect on the business of the Company and its subsidiary Bank.
Regulation of the Company
General.  The Company, as the sole shareholder of the Bank, is a bank holding company. As a bank holding
company, the Company is registered with, and is subject to regulation by, the Federal Reserve under
the Bank Holding Company Act, as amended (the BHCA). According to Federal Reserve Board
policy, bank/financial holding companies are expected to act as a source of financial strength to
each subsidiary bank and to commit resources to support each such subsidiary. This support may be
required at times when a bank/financial holding company may not be able to provide support. Under
the BHCA, the Company is subject to periodic examination by the Federal Reserve. The Company is also
required to file with the Federal Reserve periodic reports of the Companys operations and such
additional information regarding the Company and its subsidiaries as the Federal Reserve may require.
Investments and Activities. Under the BHCA, a bank holding company must obtain Federal Reserve approval before: (i) acquiring,
directly or indirectly, ownership or control of any voting shares of another bank or bank holding
company if, after the acquisition, it would own or control more than 5% of the shares of the other
bank or bank holding company (unless it already owns or controls the majority of such shares), (ii)
acquiring all or substantially all of the assets of another bank or (iii) merging or consolidating
with another bank holding company. Subject to certain conditions (including certain deposit concentration
limits established by the BHCA), the Federal Reserve may allow a bank holding company to acquire
banks located in any state of the United States without regard to whether the acquisition is prohibited
by the law of the state in which the target bank is located. On approving interstate acquisitions,
however, the Federal Reserve is required to give effect to applicable state law limitations on the
aggregate amount of deposits that may be held by the acquiring bank holding company and its insured
depository institution affiliates in the state in which the target bank is located (provided that
those limits do not discriminate against out-of-state depository institutions or their holding companies)
and state laws which require that the target bank have been in existence for a minimum period of
time (not to exceed five years) before being acquired by an out-of-state bank holding company.
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|Page 7 of 97
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|Item 1.   Business (Continued)
Investments and Activities (cont.)  The BHCA also generally prohibits the Company from acquiring direct or indirect ownership or
control of more than 5% of the voting shares of any company which is not a bank and from engaging
in any business other than that of banking, managing and controlling banks or furnishing services
to banks and their subsidiaries. This general prohibition is subject to a number of exceptions. The
principal exception allows bank holding companies to engage in, and to own shares of companies engaged
in, certain businesses found by the Federal Reserve to be so closely related to banking . .
.. as to be a proper incident thereto. Under current regulations of the Federal Reserve,
the Company either directly or through non-bank subsidiaries would be permitted to engage in a variety
of banking-related businesses, including the operation of a thrift, sales and consumer finance, equipment
leasing, the operation of a computer service bureau (including software development) and mortgage
banking and brokerage. The BHCA generally does not place territorial restrictions on the domestic
activities of non-bank subsidiaries of bank holding companies.
Federal law also prohibits any person from acquiring control of a bank holding company
without prior notice to the appropriate federal bank regulator. Control is defined in
certain cases as the acquisition of 10% or more of the outstanding shares of a bank or a bank holding
company depending on the circumstances surrounding the acquisition.
Regulatory Capital Requirements
Bank holding companies are required to maintain minimum levels of capital in accordance with Federal
Reserve capital adequacy guidelines. If capital falls below minimum guideline levels, a bank holding
company, among other things, may be denied approval to acquire or establish additional banks or non-bank
businesses.
The Federal Reserves capital guidelines establish the following minimum regulatory capital requirements
for bank holding companies: a risk-based requirement expressed as a percentage of total risk-weighted
assets, and a leverage requirement expressed as a percentage of total assets. The risk-based requirement
consists of a minimum ratio of total capital to total risk-weighted assets of 8%, at least one-half
of which must be Tier 1 capital. The leverage requirement consists of a minimum ratio of Tier 1 capital
to total assets of 3% for the most highly rated companies, with a minimum requirement of 4% for all
others.
The risk-based and leverage standards described above are minimum requirements. Higher capital levels
will be required if warranted by the particular circumstances or risk profiles of individual banking
organizations. For example, the Federal Reserves capital guidelines contemplate that additional
capital may be required to take adequate account of, among other things, interest rate risk, or the
risks posed by concentration of credit, nontraditional activities or securities trading activities.
Further, any banking organization experiencing or anticipating significant growth would be expected
to maintain capital ratios (i.e., Tier 1 capital less all intangible assets), well above the minimum
levels. Current Federal Reserve minimum requirements for a well capitalized organization experiencing
significant growth are a leverage ratio of 5%, a Tier 1 risk-based capital ratio of 6% and total
risk-based capital ratio of 10%. As of December 31, 2006, the Company had regulatory capital in excess
of the Federal Reserves minimum and well-capitalized definition requirements, with a leverage
ratio of 9.00%, with total Tier 1 risk-based capital ratio of 12.05% and a total risk-based capital ratio of 13.31%.
Dividends.  The Iowa Business Corporation Act (IBCA) allows the Company to pay dividends only
out of its surplus (as defined and computed in accordance with the provision of the IBCA) or if the
Company has no such surplus, out of its net profits for the fiscal year in which the dividend is
declared and/or the preceding fiscal year. Additionally, the Federal Reserve has issued a policy
statement with regard to the payment of cash dividends by bank holding companies. The policy statement
provides that a bank holding company should not pay cash dividends which exceed its net income or
which can only be funded in ways that weaken the bank holding companys financial health, such
as by borrowing. The Federal Reserve also possesses enforcement powers over bank holding companies
and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices
or violations of applicable statutes and regulations. Among these powers is the ability to proscribe
the payment of dividends by banks and bank holding companies.
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|Page 8 of 97
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|Item 1.   Business (Continued)
Federal Securities Regulation. The Companys common stock is registered with the SEC under the Securities Exchange Act of 1934,
as amended (the Exchange Act). Consequently, the Company is subject to the information,
proxy solicitation, insider trading and other restrictions and requirements of the SEC under the
Exchange Act.
Regulation of the Bank
General. The Bank is an Iowa-chartered bank, the deposit accounts of which are insured by the FDICs
Bank Insurance Fund (BIF). As an Iowa-chartered, FDIC insured bank, the Bank is subject
to the examination, supervision, reporting and enforcement requirements of the Superintendent of
Banking of the State of Iowa (the Superintendent), as the chartering authority for Iowa
banks, and the FDIC, as administrator of the BIF.
Deposit Insurance.   As an FDIC-insured institution, the Bank is required to pay deposit insurance premium
assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which all insured
depository institutions are placed into one of nine categories and assessed insurance premiums based
upon their respective levels of capital and results of supervisory evaluations. Institutions classified
as well-capitalized (as defined by the FDIC) and considered healthy, pay the lowest premium while
institutions that are less than adequately capitalized (as defined by the FDIC) and considered of
substantial supervisory concern, pay the highest premium. Risk classification of all insured institutions
is made by the FDIC for each semi-annual assessment period. The Bank is currently paying the minimum
assessment under the FDICs risk assessment system.
Capital Requirements. Among the requirements and restrictions imposed upon state banks by the Superintendent are the requirements
to maintain reserves against deposits, restrictions on the nature and amount of loans, and restrictions
relating to investments, opening of bank offices and other activities of state banks. Changes in
the capital structure of state banks are also approved by the Superintendent. State banks must have
a Tier 1 risk-based leverage ratio of 6.5% plus a fully funded loan loss reserve. In certain instances,
the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement
on the Bank. In determining the Tier 1 risk-based leverage ratio, the Superintendent uses total equity
capital without unrealized securities gains and the allowance for loan losses less any intangible
assets. At December 31, 2006, the Tier 1 risk-based leverage ratio of the Bank was 8.95% and
exceeded the ratio required by the Superintendent.
Capital adequacy for banks took on an added dimension with the establishment of a formal system of
prompt corrective action under the Federal Deposit Insurance Corporation Improvement Act of 1991
(FDICIA). This system uses bank capital levels to trigger supervisory actions designed to quickly
correct banking problems. Capital adequacy zones are used by the federal banking agencies to trigger
these actions. The ratios and the definition of adequate capital are the same as those
used by the agencies in their capital adequacy guidelines.
Federal law provides the federal banking regulators of the Bank with broad power to take prompt corrective
action to resolve the problems of undercapitalized banking institutions. The extent of the regulators
powers depends on whether the institution in question is well capitalized, adequately
capitalized, undercapitalized, significantly undercapitalized or critically
undercapitalized, in each case as defined by regulation. Under prompt corrective action, banks
that are inadequately capitalized face a variety of mandatory and discretionary supervisory actions.
For example, undercapitalized banks must restrict asset growth, obtain prior approval
for business expansion, and have an approved plan to restore capital. Critically undercapitalized
banks must be placed in receivership or conservatorship within 90 days unless some other action
would result in lower long-term costs to the deposit insurance fund.
Supervisory Assessments. All Iowa banks are required to pay supervisory assessments to the Superintendent to fund the Superintendents
examination and supervision operations. Effective July 1, 2002 the Superintendent changed the method
of computation of the supervisory assessment from billing for each state examination completed based
on an hourly rate, to billing on an annual basis based on the assets of the bank, the expected hours
needed to conduct examinations of that size bank and an additional amount if more work is required.
For fiscal 2006 the assessment total was $103,772.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 9 of 97
|------------



|Item 1.   Business (Continued)
Community Investment and Consumer Protection Laws. The Community Reinvestment Act requires insured institutions to offer credit products and take other
actions that respond to the credit needs of the community. Banks and other depository institutions
also are subject to numerous consumer-oriented laws and regulations. These laws include the Truth
in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic
Funds Transfer Act, the Equal Credit Opportunity Act and the Fair Housing Act.
Dividends.  The Iowa Banking Act provides that an Iowa bank may not pay dividends in an amount greater
than its undivided profits.
The payment of dividends by any financial institution or its holding company is affected by the requirement
to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations,
and a financial institution generally is prohibited from paying any dividends if, following payment
thereof, the institution would be undercapitalized. As described above, the Bank exceeded its minimum
capital requirements under applicable guidelines as of December 31, 2006. Notwithstanding the availability
of funds for dividends, however, the Superintendent may prohibit the payment of any dividends by
the Bank if the Superintendent determines such payment would constitute an unsafe or unsound practice.
The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid
by the Bank. The Bank is subject to certain statutory and regulatory restrictions on the amount it
may pay in dividends. To maintain acceptable capital ratios in the Bank, certain of its retained
earnings are not available for the payment of dividends. To maintain a ratio of total risk-based
capital to assets of 8%, retained earnings of $16,254,000 as of December 31, 2006 are available for
the payment of dividends to the Company.
Insider Transactions. The Bank is subject to certain restrictions imposed by federal law on extensions of credit to the
Company and its subsidiaries, on investments in the stock or other securities of the Company and
its subsidiaries and the acceptance of the stock or other securities of the Company or its subsidiaries
as collateral for loans. Certain limitations and reporting requirements are also placed on extensions
of credit by the Bank to its directors and officers, to directors and officers of the Company and
its subsidiaries, to principal stockholders of the Company, and to related interests
of such directors, officers and principal stockholders. In addition, federal law and regulations
may affect the terms upon which any person becoming a director or officer of the Company or one of
its subsidiaries or a principal stockholder of the Company may obtain credit from banks with which
the Bank maintains a correspondent relationship.
Safety and Soundness Standards. The federal banking agencies have adopted guidelines that establish operational and managerial standards
to promote the safety and soundness of federally insured depository institutions. The guidelines
set forth standards for internal controls, information systems, internal audit systems, loan documentation,
credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset
quality and earnings.
In general, the safety and soundness guidelines prescribe the goals to be achieved in each area, and
each institution is responsible for establishing its own procedures to achieve those goals. If an
institution fails to comply with any of the standards set forth in the guidelines, the institutions
primary federal regulator may require the institution to submit a plan for achieving and maintaining
compliance. If an institution fails to submit an acceptable compliance plan, or fails in any material
respect to implement a compliance plan that has been accepted by its primary federal regulator, the
regulator is required to issue an order directing the institution to cure the deficiency. Until the
deficiency cited in the regulators order is cured, the regulator may restrict the institutions
rate of growth, require the institution to increase its capital, restrict the rates the institution
pays on deposits or require the institution to take any action the regulator deems appropriate under
the circumstances. Noncompliance with the standards established by the safety and soundness guidelines
may also constitute grounds for other enforcement action by the federal banking regulators, including
cease and desist orders and civil money penalty assessments.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 10 of 97
|-------------



|Item 1.   Business (Continued)
Branching Authority. Historically, Iowas intrastate branching statutes have been rather restrictive when compared
with those of other states. Iowas intrastate branching statutes were relaxed in legislation
that became effective on February 21, 2001 (the 2001 Amendment). The 2001 Amendment allowed
Iowa banks to move towards statewide branching by allowing every Iowa bank, with the approval of
its primary regulator, to establish three new bank offices anywhere in Iowa during the next three
years. The three offices are in addition to those offices allowed within certain restricted geographic
areas under prior Iowa law. Effective July 1, 2004, the 2001 Amendment repealed all limitations on
bank office location and effectively allowed statewide branching. Since that date, banks have been
allowed to establish an unlimited number of offices in any location in Iowa subject only to regulatory
approval.
Under the Riegle-Neal Act, both state and national banks are allowed to establish interstate branch
networks through acquisitions of other banks, subject to certain conditions, including certain limitations
on the aggregate amount of deposits that may be held by the surviving bank and all of its insured
depository institution affiliates. The establishment of new interstate branches or the acquisition
of individual branches of a bank in another state (rather than the acquisition of an out-of-state
bank in its entirety) is allowed by the Riegle-Neal Act only if specifically authorized by state
law. The legislation allowed individual states to opt-out of certain provisions of the
Riegle-Neal Act by enacting appropriate legislation prior to June 1, 1997. Iowa permits interstate
bank mergers, subject to certain restrictions, including a prohibition against interstate mergers
involving an Iowa bank that has been in existence and continuous operation for fewer than five years.
State Bank Activities. Under federal law and FDIC regulations, FDIC insured state banks are prohibited, subject to certain
exceptions, from making or retaining equity investments of a type, or in an amount, that are not
permissible for a national bank. Federal law and FDIC regulations also prohibit FDIC insured state
banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity
that is not permitted for a national bank or its subsidiary, respectively, unless the Bank meets,
and continues to meet, its minimum regulatory capital requirements and the FDIC determines the activity
would not pose a significant risk to the deposit insurance fund of which the Bank is a member. These
restrictions have not had, and are not currently expected to have, a material impact on the operations
of the Bank.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 11 of 97
|-------------



|Item 1.   Business (Continued)
CONSOLIDATED STATISTICAL INFORMATION
The following consolidated statistical information reflects selected balances and operations of the
Company and the Bank for the periods indicated.
The following tables show (1) average balances of assets, liabilities and stockholders equity,
(2) interest income and expense on a tax equivalent basis, (3) interest rates and interest differential
and (4) changes in interest income and expense.
AVERAGE BALANCES(Average Daily Basis)
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

|                                                                    | **Years Ended December 31** |              
|------------------------------------------------------------------- | --------------------------- | -------------
|                                                                    |                             |              
|                                                                    | **2006**                    |              
|                                                                    |                             |              
|                                                                    | **(Amounts In Thousands)**  |              
|ASSETS                                                              |                             |              
|Cash and cash equivalents                                           | **$**                       | **23,840**   
|Taxable securities                                                  |                             | **123,376**  
|Nontaxable securities                                               |                             | **82,031**   
|Federal funds sold                                                  |                             | **878**      
|Loans, net                                                          |                             | **1,217,009**
|Property and equipment, net                                         |                             | **22,301**   
|Other assets                                                        |                             | **27,984**   
|                                                                    |                             |              
|                                                                    | **$**                       | **1,497,419**
|                                                                    |                             |              
|                                                                    |                             |              
|LIABILITIES AND STOCKHOLDERS EQUITY                                |                             |              
|Noninterest-bearing demand deposits                                 | **$**                       | **135,249**  
|Interest-bearing demand deposits                                    |                             | **140,171**  
|Savings deposits                                                    |                             | **264,210**  
|Time deposits                                                       |                             | **518,313**  
|Short-term borrowings                                               |                             | **63,358**   
|FHLB borrowings                                                     |                             | **231,691**  
|Other liabilities                                                   |                             | **10,387**   
|Redeemable common stock held by
      Employee Stock Ownership Plan |                             | **20,787**   
|Stockholders equity                                                |                             | **113,253**  
|                                                                    |                             |              
|                                                                    |                             |              
|                                                                    | **$**                       | **1,497,419**
|                                                                    |                             |              

|Page 12 of 97
|-------------



|Item 1.   Business (Continued)
INTEREST INCOME AND EXPENSE
|----------------------------------------------------------
|                                                          

|                                 | **Years Ended December 31** |           
|-------------------------------- | --------------------------- | ----------
|                                 |                             |           
|                                 | **2006**                    |           
|                                 |                             |           
|                                 | **(Amounts In Thousands)**  |           
|                                
|Income:                          |                             |           
|Loans (1)                        | **$**                       | **80,393**
|Taxable securities               |                             | **4,438** 
|Nontaxable securities (1)        |                             | **4,462** 
|Federal funds sold               |                             | **40**    
|                                 |                             |           
|**Total interest income**        |                             | **89,333**
|                                 |                             |           
|                                
|Expense:                         |                             |           
|Interest-bearing demand deposits |                             | **1,372** 
|Savings deposits                 |                             | **5,318** 
|Time deposits                    |                             | **21,151**
|Short-term borrowings            |                             | **2,801** 
|FHLB borrowings                  |                             | **11,720**
|                                 |                             |           
|**Total interest expense**       |                             | **42,362**
|                                 |                             |           
|                                
|**Net interest income**          | **$**                       | **46,971**
|                                 |                             |           
|                                 |                             |           

|                                                                                           
|-------------------------------------------------------------------------------------------
|(1)  Presented on a tax equivalent basis using a rate of 35% for the three years presented.

|Page 13 of 97
|-------------



|Item 1.   Business (Continued)
INTEREST RATES AND INTEREST DIFFERENTIAL
|-----------------------------------------------------------------------
|                                                                       

|                                             | **Years Ended December 31** |         
|-------------------------------------------- | --------------------------- | --------
|                                             |                             |         
|                                             | **2006**                    |         
|                                             |                             |         
|Average yields:                              |                             |         
|Loans (1)                                    |                             | **6.59**
|Loans (tax equivalent basis)                 |                             | **6.61**
|Taxable securities                           |                             | **3.60**
|Nontaxable securities                        |                             | **3.54**
|Nontaxable securities (tax equivalent basis) |                             | **5.44**
|Federal funds sold                           |                             | **4.51**
|Interest-bearing demand deposits             |                             | **0.98**
|Savings deposits                             |                             | **2.01**
|Time deposits                                |                             | **4.08**
|Short-term borrowings                        |                             | **4.42**
|FHLB borrowings                              |                             | **4.99**
|Yield on average interest-earning assets     |                             | **6.28**
|Rate on average interest-bearing liabilities |                             | **3.47**
|Net interest spread (2)                      |                             | **2.81**
|Net interest margin (3)                      |                             | **3.31**
|                                             |                             |         

|    |                                                                                                                                                                                                                                                        
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Non-accruing loans are not significant and have been included in the average loan balances for purposes
    of this computation.                                                                                                                       
|    |                                                                                                                                                                                                                                                        
|(2) | Net interest spread is the difference between the yield on average interest-earning assets and the
      yield on average interest-paying liabilities stated on a tax equivalent basis using a federal rate
      of 35% for the three years presented.
|    |                                                                                                                                                                                                                                                        
|(3) | Net interest margin is net interest income, on a tax equivalent basis, divided by average interest-earning
    assets.                                                                                                                                 

|Page 14 of 97
|-------------



|Item 1.   Business (Continued)
CHANGES IN INTEREST INCOME AND EXPENSE
|---------------------------------------------------------------------
|                                                                     

|                                                                                 | **Changes Due
      To Volume** |            | **Changes Due
      To Rates** |       | **Total 
      Changes** |      
|-------------------------------------------------------------------------------- | ------------------------------- | ---------- | ------------------------------ | ----- | ------------------------ | -----
|                                                                                 |                                 |           
|                                                                                 | **(Amounts In Thousands)**      |           
|Year ended December 31, 2006:                                                    |                                 |            |                                |       |                          |      
|Change in interest income:                                                       |                                 |            |                                |       |                          |      
|Loans                                                                            | **$**                           | **9,897**  |                                | **$** | **3,674**                |      
|Taxable securities                                                               |                                 | **(633**   | **)**                          |       | **276**                  |      
|Nontaxable securities                                                            |                                 | **278**    |                                |       | **54**                   |      
|Federal funds sold                                                               |                                 | **(206**   | **)**                          |       | **11**                   |      
|                                                                                 |                                 |           
|                                                                                 |                                 | **9,336**  |                                |       | **4,015**                |      
|                                                                                 |                                 |           
|Change in interest expense:                                                      |                                 |            |                                |       |                          |      
|Interest-bearing demand deposits                                                 |                                 | **18**     |                                |       | **(402**                 | **)**
|Savings deposits                                                                 |                                 | **150**    |                                |       | **(1,846**               | **)**
|Time deposits                                                                    |                                 | **(1,621** | **)**                          |       | **(4,475**               | **)**
|Federal funds purchased and securities sold
      under agreements to repurchase |                                 | **(954**   | **)**                          |       | **(1,098**               | **)**
|FHLB borrowings                                                                  |                                 | **(2,155** | **)**                          |       | **384**                  |      
|                                                                                 |                                 |           
|                                                                                 |                                 | **(4,562** | **)**                          |       | **(7,437**               | **)**
|                                                                                 |                                 |           
|Change in net interest income                                                    | **$**                           | **4,774**  |                                | **$** | **(3,422**               | **)**
|                                                                                 |                                 |           
|                                                                                
|Year ended December 31, 2005:                                                    |                                 |            |                                |       |                          |      
|Change in interest income:                                                       |                                 |            |                                |       |                          |      
|Loans                                                                            | $                               | 7,696      |                                | $     | 1,429                    |      
|Taxable securities                                                               |                                 | (356       | )                              |       | (98                      | )    
|Nontaxable securities                                                            |                                 | 304        |                                |       | 14                       |      
|Federal funds sold                                                               |                                 | 39         |                                |       | 168                      |      
|                                                                                 |                                 |           
|                                                                                 |                                 | 7,683      |                                |       | 1,513                    |      
|                                                                                 |                                 |           
|Change in interest expense:                                                      |                                 |            |                                |       |                          |      
|Interest-bearing demand deposits                                                 |                                 | (17        | )                              |       | (257                     | )    
|Savings deposits                                                                 |                                 | (138       | )                              |       | (1,684                   | )    
|Time deposits                                                                    |                                 | (2,001     | )                              |       | (1,266                   | )    
|Federal funds purchased and securities sold
      under agreements to repurchase |                                 | 128        |                                |       | (407                     | )    
|FHLB borrowings                                                                  |                                 | (1,215     | )                              |       | 379                      |      
|                                                                                 |                                 |           
|                                                                                 |                                 | (3,243     | )                              |       | (3,235                   | )    
|                                                                                 |                                 |           
|Change in net interest income                                                    | $                               | 4,440      |                                | $     | (1,722                   | )    
|                                                                                 |                                 |           
|                                                                                 |                                 |            |                               

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

|Page 15 of 97
|-------------



|Item 1.   Business (Continued)
      LOANS
    The following table shows the composition of loans (before deducting the allowance for loan losses) as of December 31 for each of the last five years. The table does not include loans held for sale to the secondary market.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                             

|                          | **December 31,**           |              
|------------------------- | -------------------------- | -------------
|                          |                            |              
|                          | **2006**                   |              
|                          |                            |              
|                          | **(Amounts In Thousands)** |              
|Agricultural              | **$**                      | **49,223**   
|Commercial and financial  |                            | **118,339**  
|Real estate, construction |                            | **114,199**  
|Real estate, mortgage     |                            | **983,489**  
|Loans to individuals      |                            | **31,827**   
|                          |                            |              
|**Total**                 | **$**                      | **1,297,077**
|                          |                            |              

|                                                                                      
|--------------------------------------------------------------------------------------
|There were no foreign loans outstanding for any of the years presented.               
|                                                                                      
|MATURITY DISTRIBUTION OF LOANS                                                        
|                                                                                      
|The following table shows the principal payments due on loans as of December 31, 2006:
|                                                                                      

|                                                                                    | **Amount 
      Of Loans** |           | **One Year 
      Or Less (1)** |   | **One To 
      Five Years** |  | **Over Five
      Years** |        
|----------------------------------------------------------------------------------- | -------------------------- | --------- | ------------------------------- | - | ---------------------------- |  | ------------------------- | -------
|                                                                                    |                            |          
|                                                                                    | **(Amounts In Thousands)** |          
|Commercial                                                                          | $                          | 167,562   |                                 | $ | 100,416                      |  | $                         | 55,158 
|Real Estate                                                                         |                            | 1,097,688 |                                 |   | 149,458                      |  |                           | 338,277
|Other                                                                               |                            | 31,827    |                                 |   | 12,326                       |  |                           | 18,756 
|                                                                                    |                            |          
|**Totals**                                                                          | $                          | 1,297,077 |                                 | $ | 262,200                      |  | $                         | 412,191
|                                                                                    |                            |          
|                                                                                    |                           
|The types of interest rates applicable to these principal payments are shown below: |                           
|                                                                                    |                            |           |                                 |   |                              |  |                           |        
|Fixed rate                                                                          | $                          | 579,070   |                                 | $ | 129,880                      |  | $                         | 393,098
|Variable rate                                                                       |                            | 718,007   |                                 |   | 132,320                      |  |                           | 19,093 
|                                                                                    |                            |          
|                                                                                    | $                          | 1,297,077 |                                 | $ | 262,200                      |  | $                         | 412,191
|                                                                                    |                            |          

|    |                                                                                                                                                                                           
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | A significant portion of the commercial loans are due in one year or less. A significant percentage
  of the notes are re-evaluated prior to their maturity and are likely to be extended.

|Page 16 of 97
|-------------



|Item 1.   Business (Continued)
      NONACCRUAL, PAST DUE AND RESTRUCTURED LOANS
    The following table summarizes the Companys non-accrual, past due, restructured and non-performing loans as of December 31 for each of the years presented:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                 

|                                                  | **2006**                   |            | **2005** |   | **2004** |  | **2003** |        | **2002** |  
|------------------------------------------------- | -------------------------- | ---------- | -------- | - | -------- |  | -------- | ------ | -------- | -
|                                                  |                            |           
|                                                  | **(Amounts In Thousands)** |           
|Nonaccrual loans                                  | **$**                      | **879**    |          | $ | 175      |  | $        | 808    |          | $
|Accruing loans past due
   90 days or more        |                            | **4,983**  |          |   | 1,910    |  |          | 2,313  |          |  
|Restructured loans                                |                            | ****      |          |   |         |  |          |       |          |  
|Non-performing (which includes non-accrual loans) |                            | **14,681** |          |   | 16,602   |  |          | 18,977 |          |  

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|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.
Loans are placed on non-accrual status when management believes the collection of future principal
and interest is not reasonably assured. The increase in non-accrual loans from December 31, 2005
to December 31, 2006 relates to three borrower relationships consisting of ten loans. Non-accrual
loans represent 0.07% of total loans as of December 31, 2006 compared to 0.02% of total loans as
of December 31, 2005. The non-accrual loans are considered to be impaired loans for purposes of reviewing
the adequacy of the loan loss reserve. Interest income was not materially affected by this classification.
Accruing loans past due 90 days or more increased $3.1 million from 2005 to $4,983,000 as of December
31, 2006. Real estate loans make up approximately $4.2 million, or 85%, of this total. As of December
31, 2006 and 2005, loans 90 days past due and accruing were 0.38% and 0.16% of total loans, respectively.
The Company has no individual borrower or borrowers engaged in the same or similar industry exceeding
10% of total loans. The Company has no interest-bearing assets, other than loans, that meet the non-accrual,
past due, restructured or potential problem loan criteria.
Non-performing loans decreased by $1.9 million from December 31, 2005 to December 31, 2006. Non-performing
loans include any loan that has been placed on nonaccrual status. Non-performing 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.
These loans are also considered impaired loans. The portion of non-performing loans that are real
estate loans was $9.2 million at December 31, 2006 compared to $11.3 million at December 31, 2005.
This decrease in non-performing loans is due primarily to an improvement in the credit quality of
two commercial mortgages having an aggregate balance of approximately $3.4 million as of December
31, 2005. These two loans are no longer considered impaired. This decrease is offset by the increase
in non-accrual loans noted above.
Specific allowances for losses on non-accrual and non-performing loans are established if the loan
balances exceed the net present value of the relevant future cash flows or the fair value of the
relevant collateral if the loan is collateral dependent.

|Page 17 of 97
|-------------



|Item 1.   Business (Continued)
SUMMARY OF LOAN LOSS EXPERIENCE
The following table summarizes the Banks loan loss experience for each of the last five years:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                              

|                                                                                 | **Year Ended December 31,** |           
|-------------------------------------------------------------------------------- | --------------------------- | ----------
|                                                                                 |                             |           
|                                                                                 | **2006**                    |           
|                                                                                 |                             |           
|                                                                                 | **(Amounts In Thousands)**  |           
|Allowance for loan losses
  at beginning of year                                 | **$**                       | **15,360**
|                                                                                 |                             |           
|Charge-offs:                                                                     |                             |           
|Agriculture                                                                      |                             | **40**    
|Commercial and financial                                                         |                             | **677**   
|Real estate, mortgage                                                            |                             | **529**   
|Loans to individuals                                                             |                             | **627**   
|                                                                                 |                             |           
|                                                                                 |                             | **1,873** 
|                                                                                 |                             |           
|Recoveries:                                                                      |                             |           
|Agriculture                                                                      |                             | **44**    
|Commercial and financial                                                         |                             | **863**   
|Real estate, mortgage                                                            |                             | **223**   
|Loans to individuals                                                             |                             | **222**   
|                                                                                 |                             |           
|                                                                                 |                             | **1,352** 
|                                                                                 |                             |           
|Net charge-offs (recoveries)                                                     |                             | **521**   
|                                                                                 |                             |           
|Provision for loan losses (1)                                                    |                             | **3,011** 
|                                                                                 |                             |           
|Allowance for loan losses
  at end of year                                       | **$**                       | **17,850**
|                                                                                 |                             |           
|Ratio of net charge-offs (recoveries)
  during year to average loans outstanding |                             | **0.04**  
|                                                                                 |                             |           
|                                                                                 |                             |           

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | For financial reporting purposes, management reviews the loan portfolio and determines the allowance
  for loan losses, which represents managements judgment of the probable losses inherent in the
  Companys loan portfolio. The loan loss provision is the amount necessary to adjust the allowance
  to the level considered appropriate by management. The adequacy of the allowance is reviewed quarterly
  and considers the impact of economic conditions on the borrowers ability to repay, loan collateral
  values, past collection experience, the risk characteristics of the loan portfolio and such other
  factors that deserve current recognition. The growth of the loan portfolio is a significant element
  in the determination of the provision for loan losses.

|Page 18 of 97
|-------------



|Item 1.   Business (Continued)
      ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
      The Bank regularly reviews a substantial portion of the loans in the portfolio and assesses whether the loans are impaired. If the loans are impaired, the Bank determines if a specific allowance is appropriate. In addition, the Banks management also reviews and, where determined necessary, provides allowances based upon reviews of specific borrowers and provides allowances for areas that management considers are of higher credit risk (agricultural loans and constructed model real estate homes). Loans for which there are no specific allowances are classified into one or more risk categories. Based upon the risk category assigned, the Bank allocates a percentage, as determined by management, for a required allowance needed. The percentage begins with historical loss experience factors,
 which are then adjusted for current economic factors.
    The following table presents the allowance for loan losses on loans by type of loans and the percentage in each category to total loans as of December 31, 2006, 2005, 2004, 2003 and 2002:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

|                          | **2006**           |            | **2005**                 | 
|------------------------- | ------------------ | ---------- | ------------------------ | 
|                          | **Amount**         |            | **% of Total Allowance** | 
|                          |                    |            |                          | 
|                          | **(In Thousands)** |            |                          | 
|Agriculture               | **$**              | **1,509**  |                          | 
|Commercial                |                    | **3,700**  |                          | 
|Real estate, construction |                    | **2,064**  |                          | 
|Real estate, mortgage     |                    | **9,782**  |                          | 
|Consumer                  |                    | **795**    |                          | 
|                          |                    |            |                          | 
|                          | **$**              | **17,850** |                          | 
|                          |                    |            |                          | 
|                         
|                          | **2004**           |            | **2003**                 | 
|Agriculture               | $                  | 1,736      |                          | 
|Commercial                |                    | 1,913      |                          | 
|Real estate, construction |                    | 1,471      |                          | 
|Real estate, mortgage     |                    | 7,872      |                          | 
|Consumer                  |                    | 798        |                          | 
|                          |                    |            |                          | 
|                          | $                  | 13,790     |                          | 
|                          |                    |            |                          | 
|                         
|                          | **2002**           |            |                          | 
|Agriculture               | $                  | 2,219      |                          | 
|Commercial                |                    | 1,374      |                          | 
|Real estate, construction |                    | 975        |                          | 
|Real estate, mortgage     |                    | 6,638      |                          | 
|Consumer                  |                    | 919        |                          | 
|                          |                    |            |                          | 
|                          | $                  | 12,125     |                          | 
|                          |                    |            |                          | 

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The allowance for loan losses increased $2.5 million in 2006. The increase in and changes in the allocation
of the allowance were due to volume changes of loans outstanding and a deterioration in credit quality.
Such deterioration is not considered by management to be a material change in credit quality. Due
to the volume increase in loans outstanding of $143.1 million in 2006, the allocation increased approximately
$1.3 million. The allocation for loan growth for real estate mortgage loans was $0.7 million and
reflected the $77.3 million growth in this category. The real estate construction allocation also
increased $0.7 million due to loan growth of $30.7 million. The commercial loan allocation increased
from $2.7 million at December 31, 2005 to $3.7 million at December 31, 2006 due to loan growth in
2006 of $26.8 million.

|Page 19 of 97
|-------------



|Item 1.   Business (Continued)
The increase in allocations based on current credit quality was $1.0 million. This increase is due
in part to an increase of $19.1 million in watch loans from 2005 to 2006 resulting in an additional
allocation of $0.6 million. The $19.1 million increase in watch loans is comprised of $15.1 million
of commercial loans including commercial real estate, $7.3 million in construction loans, $4.2 million
in residential mortgages and $1.6 million in agricultural loans. These increases were partially offset
by decreases in watch loans of $8.8 million in multi-family residential loans and $0.3 million in
consumer loans. Substandard loan balances were $20.5 million in 2006 and $20.6 in 2005. The increase
in allocation related to substandard loans of $0.4 million resulted from the composition of loans
included in this pool.
Residential real estate loan products that include features such as loan-to-values in excess of 100%,
interest only payments or adjustable-rate mortgages, which expose a borrower to payment increases
in excess of changes in the market interest rate, increase the credit risk of a loan. The Bank does
not offer this type of loan product.
INVESTMENT SECURITIES
The following tables show the carrying value of the investment securities, including stock of the Federal
Home Loan Bank, which are principally held by the Bank as of December 31, 2006, 2005 and 2004 and
the maturities and weighted average yields of the investment securities as of December 31, 2006:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

|                                                               | **December 31,**           |            
|-------------------------------------------------------------- | -------------------------- | -----------
|                                                               |                            |            
|                                                               | **2006**                   |            
|                                                               |                            |            
|                                                               | **(Amounts In Thousands)** |            
|Carrying value:                                                |                            |            
|Obligations of U. S. Government
     agencies and corporations | **$**                      | **106,825**
|Obligations of state and political subdivisions                |                            | **84,159** 
|                                                               |                            |            
|                                                               | **$**                      | **190,984**
|                                                               |                            |            

|
|

|                                                                       | **December 31, 2006**      |        
|---------------------------------------------------------------------- | -------------------------- | -------
|                                                                       |                            |        
|                                                                       | **Carrying
      Value**   |        
|                                                                       |                            |        
|                                                                       | **(Amounts In Thousands)** |        
|Obligations of U. S. Government agencies and corporations, maturities: |                            |        
|Within 1 year                                                          | $                          | 38,970 
|From 1 to 5 years                                                      |                            | 67,855 
|                                                                       |                            |        
|                                                                       | $                          | 106,825
|                                                                       |                            |        
|Obligations of state and political subdivisions, maturities:           |                            |        
|Within 1 year                                                          | $                          | 8,328  
|From 1 to 5 years                                                      |                            | 40,822 
|From 5 to 10 years                                                     |                            | 32,027 
|Over 10 years                                                          |                            | 2,982  
|                                                                       |                            |        
|                                                                       | $                          | 84,159 
|                                                                       |                            |        
|**Total**                                                              | $                          | 190,984
|                                                                       |                            |        

|Page 20 of 97
|-------------



|Item 1.   Business (Continued)
INVESTMENT SECURITIES
As of December 31, 2006, there were no investment securities, exceeding 10% of stockholders equity,
other than securities of the U. S. Government agencies and corporations.
The weighted average yield is based on the amortized cost of the investment securities. The yields
are computed on a tax-equivalent basis using a federal tax rate of 35%.
DEPOSITS
The following tables show the amounts of average deposits and average rates paid on such deposits for
the years ended December 31, 2006, 2005 and 2004 and the composition of the certificates of
deposit issued in denominations in excess of $100,000 as of December 31, 2006:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

|                                           | **December 31,**           |              
|------------------------------------------ | -------------------------- | -------------
|                                           |                            |              
|                                           | **2006**                   |              
|                                           |                            |              
|                                           | **(Amounts In Thousands)** |              
|Average noninterest-bearing   deposits     | **$**                      | **135,249**  
|Average interest-bearing   demand deposits |                            | **140,171**  
|Average savings deposits                   |                            | **264,210**  
|Average time deposits                      |                            | **518,313**  
|                                           |                            |              
|                                           | **$**                      | **1,057,943**
|                                           |                            |              
|                                           |                            |              

|Time certificates issued in amounts
  of $100,000 or more with maturity in: | 
|--------------------------------------------------------------------------- | 
|                                                                            | 
|                                                                            | 
|3 months or less                                                            | 
|3 through 6 months                                                          | 
|6 through 12 months                                                         | 
|Over 12 months                                                              | 
|                                                                            | 
|                                                                            | 
|                                                                            | 

|                                                  
|--------------------------------------------------
|There were no deposits in foreign banking offices.

|Page 21 of 97
|-------------



|Item 1.   Business (Continued)
      RETURN ON STOCKHOLDERS EQUITY AND ASSETS
    The following table presents the return on average assets, return on average stockholders equity, the dividend payout ratio and average stockholders equity to average assets ratio for the years ended December 31, 2006, 2005 and 2004:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                              

|                                                     | 2006 |           | 2005  |  | 2004  |  
|---------------------------------------------------- | ---- | --------- | ----- |  | ----- | -
|
|
|Return on average assets                             |      | **1.04**  | **%** |  | 1.12  | %
|Return on average stockholders equity               |      | **13.74** |       |  | 14.47 |  
|Dividend payout ratio                                |      | **23.75** |       |  | 22.44 |  
|Average stockholders equity to average assets ratio |      | **7.56**  |       |  | 7.73  |  

|                                                                                                                                                                                                                                                                                                                           
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|SHORT-TERM BORROWINGS
    The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates of federal funds purchased and securities sold under agreements to repurchase during 2006, 2005 and 2004:
|                                                                                                                                                                                                                                                                                                                           

|                                            | 2006  |            | 2005  |   | 2004   |  
|------------------------------------------- | ----- | ---------- | ----- | - | ------ | -
|
|
|
|Outstanding balance as of December 31       | **$** | **59,063** |       | $ | 34,537 |  
|Weighted average interest rate at year end  |       | **4.40**   | **%** |   | 3.45   | %
|Maximum month-end balance                   |       | **96,039** |       |   | 52,849 |  
|Average month-end balance                   |       | **63,358** |       |   | 30,044 |  
|Weighted average interest rate for the year |       | **4.42**   | **%** |   | 2.49   | %

|                                                                                                                                                                                                                                                         
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|FEDERAL HOME LOAN BANK BORROWINGS
    The following table shows outstanding balances, weighted average interest rates at year end, maximum month-end balances, average month-end balances and weighted average interest rates during 2006, 2005 and 2004:
|                                                                                                                                                                                                                                                         

|                                            | 2006  |             | 2005  |   | 2004    |  
|------------------------------------------- | ----- | ----------- | ----- | - | ------- | -
|
|
|
|Outstanding balance as of December 31       | **$** | **235,379** |       | $ | 223,161 |  
|Weighted average interest rate at year end  |       | **5.00**    | **%** |   | 5.00    | %
|Maximum month-end balance                   |       | **248,161** |       |   | 223,161 |  
|Average month-end balance                   |       | **231,691** |       |   | 190,438 |  
|Weighted average interest rate for the year |       | **4.99**    | **%** |   | 5.22    | %

|Page 22 of 97
|-------------



|Item 1A. Risk Factors
The performance of our Company is subject to various risks. We consider the risks described below to
be the most significant risks we face, but such risks are not the only risk factors that could affect
us. Additional risks and uncertainties not currently known to us or that we currently deem to be
immaterial also may materially and adversely affect our business, financial condition or results
of operations. For a discussion of the impact of risks on our financial condition and results of
operations in recent years and on forward looking statements contained in this report, reference
is made to Item 7 below.
We may be adversely affected by economic conditions in the local economies in which we conduct our
operations, and in the United States in general.
Unfavorable or uncertain economic and market conditions may adversely affect our business and profitability.
Our business faces various material risks, including credit risk and the risk that the demand for
our products and services will decrease. Foreign or domestic terrorism or geopolitical events could
shock commodity and financial markets and cause an economic downturn. In an economic downturn, our
credit risk and litigation expense would increase. Also, decreases in consumer confidence, real estate
values, interest rates and investment returns, usually associated with a downturn, could make the
types of loans we originate less profitable.
We may incur losses because of ineffective risk management processes and strategies.
We seek to monitor and control our risk exposure through a variety of financial, credit, operational,
compliance and legal reporting systems. We employ risk monitoring and risk mitigation techniques,
but those techniques and the judgments that accompany their application may not be adequate to deal
with unexpected economic and financial events or the specifics and timing of such events. Thus, we
may, in the course of our activities, incur losses despite our risk management efforts.
Our profitability and liquidity may be adversely affected by a deterioration in the credit quality
of, or defaults by, third parties who owe us money or other assets.
We are exposed to the risk that third parties that owe us money or other assets will not perform their
obligations. These parties may default on their obligations to us due to bankruptcy, lack of liquidity,
operational failure or other reasons. Our rights against third parties may not be enforceable in
all circumstances. In addition, a deterioration in the credit quality of third parties whose securities
or obligations we hold could result in losses and/or adversely affect our ability to use those securities
or obligations for liquidity purposes.
A failure in our operational systems or infrastructure, or those of third parties, could impair our
liquidity, disrupt our business, damage our reputation and cause losses.
Shortcomings or failures in our internal processes, people or systems could lead to impairment of our
liquidity, financial loss, disruption of our business, liability to our customers, regulatory interventions
or damage to our reputation. Our financial, accounting, data processing or other operating systems
and facilities may fail to operate properly or become disabled as a result of events that are wholly
or partially beyond our control, adversely affecting our ability to process transactions. We also
face the risk of operational failure or termination of any of the clearing agents, exchanges, clearing
houses or other financial intermediaries we use to facilitate transactions. Any such failure or termination
could adversely affect our ability to effect transactions, service our customers and manage exposure to risk.
Despite the contingency plans and facilities we have in place, our ability to conduct business may
be adversely impacted by a disruption in the infrastructure that supports our business and the communities
in which we are located. This may include a disruption involving electrical, communications, transportation
or other services used by us or by third parties with which we conduct business. If a disruption
occurs in one location and our employees in that location are unable to occupy our offices or communicate
with or travel to other locations, our ability to service and interact with our customers may suffer
and we may be unable to successfully implement contingency plans that depend on communication or travel.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 23 of 97
|-------------



|Item 1A. Risk Factors (Continued)
Our operations rely on the secure processing, storage and transmission of confidential and other information
in our computer systems and networks. Although we take protective measures and endeavor to modify
them as circumstances warrant, our computer systems, software and networks may be vulnerable to unauthorized
access, computer viruses or other malicious code and other events that could have a security impact.
If one or more of such events occur, this potentially could jeopardize our or our customers
confidential and other information processed and stored in, and transmitted through, our computer
systems and networks, or otherwise cause interruptions or malfunctions in our, our customers
or third parties operations, which could result in significant losses or damage to our reputation.
We may be required to expend significant additional resources to modify our protective measures or
to investigate and remedy vulnerabilities or other exposures. In the event of such a security breach,
we may be subject to litigation and financial losses that are either not insured against or not fully
covered through any insurance maintained by us.
Changing interest rates may adversely affect our profits.
Our income and cash flows depend to a great extent on the difference between the interest rates earned
by us on interst-earning assets such as loans and investment securities and the interest rates paid
by us on interest-bearing liabilities such as deposits and borrowings. If interest rates decrease,
our net interest income could be negatively affected if interest earned on interest-earning assets,
such as loans, mortgage-related securities, and other investment securities, decreases more quickly
than interest paid on interest-bearing liabilities, such as deposits and borrowings. This would cause
our net income to go down. In addition, if interest rates decline, our loans and investments may
be prepaid earlier than expected, which may also lower our income. Rising interest rates may hurt
our income because they may reduce the demand for loans and the value of our investment securities.
Higher interest rates could adversely affect housing and other sectors of the economy that are interest-rate
sensitive. Higher interest rates could cause deterioration in the quality of our loan portfolio.
Interest rates are highly sensitive to many factors that are beyond our control, including general
economics conditions and monetary policies established by the Federal Reserve Board. Interest rates
do and will continue to fluctuate, and we cannot predict future Federal Reserve Board actions or
other factors that will cause rates to change.
We experience intense competition for loans and deposits.
Competition among financial institutions in attracting and retaining deposits and making loans is intense.
Traditionally, our most direct competition for deposits has come from commercial banks, savings institutions
and credit unions doing business in our areas of operation. Increasingly, we have experienced additional
competition for deposits from nonbanking sources, such as securities firms, insurance companies,
money market mutual funds and corporate and financial services subsidiaries of commercial and manufacturing
companies. Competition for loans comes primarily from other commercial banks, savings institutions,
consumer finance companies, credit unions, mortgage banking companies, insurance companies and other
institutional lenders. We compete primarily on the basis of products offered, customer service and
price. A number of institutions with which we compete enjoy the benefits of fewer regulatory constraints
and lower cost structures. Some have greater assets and capital than we do and, thus, are better
able to compete on the basis of price that we are. The increasingly competitive environment is primarily
a result of changes in regulation and changes in technology and product delivery systems. These competitive
trends are likely to continue.
We are subject to substantial regulation which could adversely affect our business and operations.
As a financial institution, we are subject to extensive state and federal regulation and supervision
which materially affects our business. Such regulation and supervision is primarily intended for
the protection of customers and deposit insurance funds. Statutes, regulations and policies to which
we are subject may be changed at any time, and the interpretation and the application of those laws
and regulations by our regulators is also subject to change. There can be no assurance that future
changes in such statutes, regulations and policies or in their interpretation or application will
not adversely affect us. We have established policies, procedures and systems designed to comply
with these regulatory and operational risk requirements. However, we face complexity and costs in
our compliance efforts. Adverse publicity and damage to our reputation arising from the failure or
perceived failure to comply with legal, regulatory or contractual requirements could affect our ability
to attract and retain customers or could result in enforcement actions, fines, penalties and lawsuits.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 24 of 97
|-------------



|Item 1A. Risk Factors (Continued)
If we do not continue to meet or exceed regulatory capital requirements and maintain our well-capitalized
status, there could be an adverse effect on the manner in which we do business and on the confidence
of our customers in us.
Under regulatory capital adequacy guidelines, we must meet guidelines that involve quantitative measures
of assets, liabilities and certain off-balance sheet items. Failure to meet minimum capital requirements
could have a material effect on our financial condition and could subject us to a variety of enforcement
actions, as well as certain restrictions on our business. Failure to maintain the status of well
capitalized under the regulatory framework could adversely affect the confidence that our customers
have in us, which can lead to a decline in the demand for our products and affect the prices that
we are able to charge for our products and services.
If we are not able to anticipate and keep pace with rapid changes in technology, or do not respond
to rapid technological changes in our industry, our business can be adversely affected.
Our financial performance depends, in part, on our ability to develop and market new and innovative
services, and to adopt or develop new technologies that differentiate our products or provide cost
efficiencies. The risks inherent in this process include rapid technological change in the industry,
our ability to access technical and other information from customers, and the significant and ongoing
investments required to bring new services to market in a timely fashion at competitive prices. A
further risk is the introduction by competitors of services that could replace or provide lower-cost
alternatives to our products and services.
Our performance may be adversely affected if we are unable to hire and retain qualified employees.
Our performance is largely dependent on the talents and efforts of our employees. Competition in the
financial services industry for qualified employees is intense. Our ability to compete effectively
depends on our ability to attract new employees and to retain and motivate our existing employees.
Our allowance for loan losses may not be adequate to cover actual losses.
Like all financial institutions, we maintain an allowance for loan losses to provide for loan defaults
and non-performance. Our allowance for loan losses is based on our historical loss experience as
well as an evaluation of the risks associated with its loan portfolio, including the size and composition
of the loan portfolio, current economic conditions and concentrations within the portfolio. Our allowance
for loan losses may not be adequate to cover actual losses, and future provisions for loan losses
could materially and adversely affect our financial results.
Our reported financial results depend in part on managements selection of accounting methods
and certain assumptions and estimates.
Our accounting policies and methods are fundamental to how we record and report our financial condition
and results of operations. Our management must exercise judgment in selecting and applying many of
these accounting policies and methods so they comply with generally accepted accounting principles
(GAAP) and reflect managements judgment of the most appropriate manner to report our financial
condition and results. In some cases, management must select the accounting method to apply from
two or more acceptable methods, any of which might be reasonable under the circumstances yet might
result in our reporting materially different results than would have been reported under a different
method.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 25 of 97
|-------------



|Item 1A. Risk Factors (Continued)
Changes in accounting standards could materially impact our financial statements.
From time to time, the Financial Accounting Standards Board (FASB) changes the financial accounting
and reporting standards that govern the preparation of our financial statements. These changes can
be hard to predict and can materially impact how we record and report financial condition and results
of operations. In some cases, we could be required to apply a new or revised standard retroactively,
resulting in restatement of prior period financial statements.
We are exposed to risk of environmental liability when we take title to properties.
In the course of our business, we may foreclose on and take title to real estate. As a result, we could
be subject to environmental liabilities with respect to these properties. We may be held liable to
a governmental entity or to third parties for property damage, personal injury, investigation and
clean-up costs incurred by these parties in connection with environmental contamination or may be
required to perform investigation or remediation activities that could be substantial. In addition,
if we are the owner or former owner of a contaminated site, it may be subject to common law claims
by third parties based on damages and costs resulting from environmental contamination emanating
from the property. If we become subject to significant environmental liabilities, our financial condition
and results of operations could be adversely affected.
Item 1B. Unresolved Staff Comments
None.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 26 of 97
|-------------



|Item 2.   Properties
The Companys office and the main office of the Bank are located at 131 Main Street, Hills, Iowa.
This is a brick building containing approximately 45,000 square feet. A portion of the building was
built in 1977, a two-story addition was completed in 1984, and a two-story brick addition was completed
in February 2001. With the completion of the 2001 addition, the entire Banks processing and
administrative systems, including trust, were consolidated in Hills, Iowa.
The other offices of Hills Bank and Trust, which are owned by the Bank except as, otherwise indicated
below, are as follows:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

|1.  | The Iowa City office, located at 1401 South Gilbert Street, is a one-story brick building containing approximately 15,400 square feet. The branch has five drive-up teller lanes and a drive-up, 24-hour ATM. The Banks trust department customer service representatives are located here. This building was constructed in 1982 and has been expanded several times, most recently in 1998.   
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                                                                                                                                                                                                                                                                  
|2.  | The Coralville office is a two-story building built in 1972 and expanded in 2001 that contains approximately 23,000 square feet of space. This office is equipped with four drive-up teller lanes and one ATM and is used primarily for retail banking services.                                                                                                                                 
|    |                                                                                                                                                                                                                                                                                                                                                                                                  
|3.  | A 2,800 square foot branch bank in North Liberty, Iowa was opened for business in 1986. This office is a full-service location including three drive-up teller lanes and a drive-up ATM.                                                                                                                                                                                                         
|    |                                                                                                                                                                                                                                                                                                                                                                                                  
|4.  | The Bank leases an office at 201 South Clinton Street in downtown Iowa City with approximately 5,800 square feet. The office has two 24-hour ATMs and is located in the Old Capitol Town Center. The lease expires in 2014 with four additional five year terms available at the Banks option.                                                                                                 
|    |                                                                                                                                                                                                                                                                                                                                                                                                  
|5.  | In December 2001, the Bank opened a new East Side office location at 2621 Muscatine Avenue, Iowa City. The office is a 5,800 square foot, one-story building, and it has three drive-up lanes and a drive-up ATM.                                                                                                                                                                                
|    |                                                                                                                                                                                                                                                                                                                                                                                                  
|6.  | The Lisbon office is a two-story brick building in Lisbon, Iowa with approximately 3,000 square feet of banking retail space located on the first floor. The building was extensively remodeled in 1996 and has one drive-up lane and a walk-up, 24-hour ATM.                                                                                                                                    
|    |                                                                                                                                                                                                                                                                                                                                                                                                  
|7.  | The Mount Vernon office opened in February 1998 with the completion of a full-service, 4,200 square foot office, with four drive-up lanes and a drive-up ATM.                                                                                                                                                                                                                                    
|    |                                                                                                                                                                                                                                                                                                                                                                                                  
|8.  | In February 2000, the Bank opened a 2,900 square foot branch office in downtown Cedar Rapids that is leased. In April 2001, an additional contiguous 2,100 square feet of space was leased and then remodeled for retail banking purposes. The leases expire in 2011 and have one five year renewal option.                                                                                      
|    |                                                                                                                                                                                                                                                                                                                                                                                                  
|9.  | The Kalona office is a 6,400 square foot building that contains a walk-up 24-hour ATM and one drive-up lane. This is an older building that was remodeled in late 1998.                                                                                                                                                                                                                          
|    |                                                                                                                                                                                                                                                                                                                                                                                                  
|10. | In March of 2002, the Bank opened its eleventh office, and the second office location in the Cedar Rapids market. The new 7,200 square foot one-story building has three drive-up lanes and a drive-up ATM. The location of the office is on Williams Boulevard in Southwest Cedar Rapids.                                                                                                       
|    |                                                                                                                                                                                                                                                                                                                                                                                                  
|11. | A full service office opened on February 10, 2003 in Marion, Iowa, after extensive remodeling of the property located at 800 11th Street. The office is a two-story building having approximately 8,400 square feet with three drive-up lanes and a drive-up ATM.                                                                                                                                
|    |                                                                                                                                                                                                                                                                                                                                                                                                  
|12. | In June of 2005, the Bank opened a limited purpose office at the Oaknoll Retirement Residence in Iowa City. The office is open on the second and fourth Tuesday of each month. The office opens deposit accounts, provides deposit services, trust and investment services and check cashing. It does not perform loan origination services. This office is neither owned nor leased by the Bank.

|Page 27 of 97
|-------------



|Item 2.   Properties (Continued)
|--------------------------------
|                                

|13. | In September of 2006, the Bank opened an office in Wellman, Iowa, its second location in Washington County. The office consists of two buildings with the primary office space located at 228 8th Avenue. The secondary location houses a drive-up ATM.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|All of the properties owned by the Bank are free and clear of any mortgages or other encumbrances of
any type.
Item 3.   Legal Proceedings
There are no material pending legal proceedings. Neither the Company nor the Bank holds any properties
that are the subject of hazardous waste clean-up investigations.
Item 4.   Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders for the three months ended December 31, 2006.

|Page 28 of 97
|-------------



|PART II
      Item 5.  Market for the Registrants Common Equity, Related Stockholder Matters and Issuer                                    Purchasesof Equity Securities
      There is no established trading market for the Companys common stock. Its stock is not listed with any exchange or quoted in an automated quotation system of a registered securities association, nor is there any broker/dealer acting as a market maker for its stock. The Companys stock is not actively traded. As of February 28, 2007, the Company had 1,541 stockholders.
    Based on the Companys stock transfer records and information informally provided to the Company, its stock trading transactions have been as follows:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

|Year     |  | Number of Shares Traded |            | Number of Transactions |  | High Selling Price |  | Low Selling Price |           | 
|-------- |  | ----------------------- | ---------- | ---------------------- |  | ------------------ |  | ----------------- | --------- | 
|
|**2006** |  |                         | **71,696** |                        |  | **36**             |  | **$**             | **50.00** | 
|2005     |  |                         | 11,858     |                        |  | 27                 |  |                   | 46.50     | 
|2004     |  |                         | 8,842      |                        |  | 22                 |  |                   | 37.00     | 

| |         |                                                                                                                                                                                                                                                                                           
| | ------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | **(1)** | 2006 transactions included repurchases by the Company of 66,521 shares of stock under the 2005 Stock Repurchase Plan approved on August 8, 2005 (the Repurchase Plan). 2006 transactions made under the Repurchase Plan were made at prices that ranged from $46.50 to $50.00 per share.
| |         |                                                                                                                                                                                                                                                                                           
| | **(2)** | 2005 transactions included repurchases by the Company of 1,400 shares of stock under the Repurchase Plan. 2005 transactions made under the Repurchase Plan were made at prices that ranged from $45.00 to $46.50 per share.                                                               

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The Company paid aggregate annual cash dividends in 2006, 2005 and 2004 of $3,696,000, $3,412,000 and
$3,185,000 respectively, or $.81 per share in 2006, $.75 per share in 2005 and $.70 per share in
2004. In January 2007, the Company declared and paid a dividend of $.86 per share totaling $3,873,000.
The decision to declare any such cash dividends in the future and the amount thereof rests within
the discretion of the Board of Directors and will remain subject to, among other things, certain
regulatory restrictions imposed on the payment of dividends by the Bank, and the future earnings,
capital requirements and financial condition of the Company.

|Page 29 of 97
|-------------



|PART II
      Item 5.  Market for the Registrants Common Equity, Related Stockholder Mattersand Issuer Purchases of Equity Securities (Continued)
    The following table sets forth the Companys equity compensation plan information as of December 31, 2006, all of which relates to stock options issued under stock option plans approved by stockholders of the Company:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                

|Plan Category                                                          |  | Number of securities
      to be issued upon exercise
      of outstanding options,
      warrants and rights
      (a) |  | Weighted-average exercise
      price of outstanding
      options, warrants and rights
      (b) |       | Number of securities remaining
      available for future issuance under
      equity compensation plans
      [excluding securities reflected in column (a)]
      (c) |        
|---------------------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------- | ----- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------
|
|                                                                      
|Equity compensation
      plans approved by
      security holders     |  | 57,195                                                                                                                  |  | $                                                                                                 | 26.79 |                                                                                                                                                                         | 116,981
|                                                                      
|Equity compensation
      plans not approved
      by security holders |  |                                                                                                                        |  |                                                                                                   | N/A   |                                                                                                                                                                         |       
|                                                                      
|**Total**                                                              |  | 57,195                                                                                                                  |  | $                                                                                                 | 26.79 |                                                                                                                                                                         | 116,981

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|There are no stock option plans that have not been approved by the stockholders.
On July 26, 2005, the Companys Board of Directors authorized a program to repurchase up to a
total of 750,000 shares of the Companys common stock (the 2005 Stock Repurchase Program).
This authorization will expire on December 31, 2009. The Company expects the purchases pursuant to
the 2005 Stock Repurchase Program to be made from time to time in private transactions at a price
equal to the most recent quarterly independent appraisal of the shares of the Companys common
stock and with the Board reviewing the overall results of the 2005 Stock Repurchase Program on a
quarterly basis. The amount and timing of stock repurchases will be based on various factors, such
as the Boards assessment of the Companys capital structure and liquidity, the amount
of interest shown by shareholders in selling shares of stock to the Company at their appraised value,
and applicable regulatory, legal and accounting factors.
The following table sets forth information about the Companys stock purchases pursuant to the
2005 Stock Repurchase Program for the quarter ended December 31, 2006:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

|Period in 2006            |  | Total number of shares
      purchased |        | Average price paid per 
      share |   | Total number of shares 
      purchased as part of
      publicly announced plans 
      or programs |  | Maximum number of
      shares that may yet be 
      purchased under the
      plans or programs |       
|------------------------- |  | -------------------------------------- | ------ | ----------------------------------- | - | ---------------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------- | ------
|
|October 1 to October 31   |  |                                        | 145    |                                     | $ | 49.00                                                                                                |  |                                                                                                   | 11,237
|                          |  |                                        |        |                                    
|November 1 to November 30 |  |                                        | 4,284  |                                     |   | 50.00                                                                                                |  |                                                                                                   | 15,521
|                          |  |                                        |        |                                    
|December 1 to December 31 |  |                                        | 52,400 |                                     |   | 50.00                                                                                                |  |                                                                                                   | 67,921
|                          |  |                                        |        |                                    
|**Total**                 |  |                                        | 56,829 |                                     | $ | 50.00                                                                                                |  |                                                                                                   | 67,921

|Page 30 of 97
|-------------



|Item 6.   Selected Financial Data
CONSOLIDATED FIVE-YEAR STATISTICAL SUMMARY
|----------------------------------------------------------------------------
|                                                                            

|                                                          | 2006  |               | 2005  |   | 2004      |   | 2003 |           | 2002 |  
|--------------------------------------------------------- | ----- | ------------- | ----- | - | --------- | - | ---- | --------- | ---- | -
|
|YEAR-END TOTALS (Amounts in Thousands)                    |       |               |       |   |           |   |      |           |      |  
|Total assets                                              | **$** | **1,551,233** |       | $ | 1,433,649 |   | $    | 1,290,449 |      | $
|Investment securities                                     |       | **190,984**   |       |   | 209,001   |   |      | 218,016   |      |  
|Federal funds sold                                        |       | ****         |       |   |          |   |      |          |      |  
|Loans held for sale                                       |       | **3,808**     |       |   | 702       |   |      | 3,908     |      |  
|Loans, net                                                |       | **1,279,227** |       |   | 1,141,716 |   |      | 998,231   |      |  
|Deposits                                                  |       | **1,107,409** |       |   | 1,036,414 |   |      | 957,236   |      |  
|Federal Home Loan Bank borrowings                         |       | **235,379**   |       |   | 223,161   |   |      | 167,542   |      |  
|Redeemable common stock                                   |       | **20,940**    |       |   | 20,634    |   |      | 16,336    |      |  
|Stockholders equity                                      |       | **118,639**   |       |   | 109,479   |   |      | 103,803   |      |  
|                                                          |       |               |       |   |           |   |      |           |      |  
|EARNINGS (Amounts in Thousands)                           |       |               |       |   |           |   |      |           |      |  
|Interest income                                           | **$** | **87,618**    |       | $ | 74,403    |   | $    | 65,324    |      | $
|Interest expense                                          |       | **42,362**    |       |   | 30,363    |   |      | 23,885    |      |  
|Provision for loan losses                                 |       | **3,011**     |       |   | 2,101     |   |      | 1,470     |      |  
|Other income                                              |       | **14,611**    |       |   | 12,808    |   |      | 12,542    |      |  
|Other expenses                                            |       | **34,364**    |       |   | 32,861    |   |      | 31,965    |      |  
|Income taxes                                              |       | **6,933**     |       |   | 6,684     |   |      | 6,351     |      |  
|Net income                                                |       | **15,559**    |       |   | 15,202    |   |      | 14,195    |      |  
|                                                          |       |               |       |   |           |   |      |           |      |  
|PER SHARE                                                 |       |               |       |   |           |   |      |           |      |  
|Net income:                                               |       |               |       |   |           |   |      |           |      |  
|Basic                                                     | **$** | **3.42**      |       | $ | 3.34      |   | $    | 3.12      |      | $
|Diluted                                                   |       | **3.39**      |       |   | 3.32      |   |      | 3.11      |      |  
|Cash dividends                                            |       | **0.81**      |       |   | 0.75      |   |      | 0.70      |      |  
|Book value as of December 31                              |       | **26.34**     |       |   | 24.00     |   |      | 22.82     |      |  
|Increase (decrease) in book value
     due to:            |       |               |       |   |           |   |      |           |      |  
|ESOP obligation                                           |       | **(4.65**     | **)** |   | (4.52     | ) |      | (3.59     | )    |  
|Accumulated other
        comprehensive income (loss)     |       | **(0.28**     | **)** |   | (0.39     | ) |      | 0.13      |      |  
|                                                          |       |               |       |   |           |   |      |           |      |  
|SELECTED RATIOS                                           |       |               |       |   |           |   |      |           |      |  
|Return on average assets                                  |       | **1.04**      | **%** |   | 1.12      | % |      | 1.15      | %    |  
|Return on average equity                                  |       | **13.74**     |       |   | 14.47     |   |      | 14.34     |      |  
|Return on average equity net of ESOP
     obligation      |       | **11.61**     |       |   | 12.29     |   |      | 12.39     |      |  
|Net interest margin                                       |       | **3.31**      |       |   | 3.56      |   |      | 3.70      |      |  
|Average stockholders equity to
     average total assets |       | **7.56**      |       |   | 7.73      |   |      | 8.04      |      |  
|Dividend payout ratio                                     |       | **23.75**     |       |   | 22.44     |   |      | 22.44     |      |  

|Page 31 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial ConditionAnd Results of
Operation
The following discussion by management is presented regarding the financial results for Hills Bancorporation
(The Company) for the dates and periods indicated. The discussion should be read in conjunction
with the Selected Consolidated Five-Year Statistical Summary and our consolidated financial
statements and the accompanying notes thereto included or incorporated by reference elsewhere in
this document.
An overview of the year 2006 is presented following the section discussing a special note regarding
forward looking statements.
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 32 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial ConditionAnd Results of
Operation (Continued)
|---------------------------------------------------------------------------------------------------------
|                                                                                                         

| |  | 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 that may be adopted by state and federal regulatory agencies
    and the Financial Accounting Standards Board.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                                                            
| |  | The ability of the Company to manage the risks associated with the foregoing as well as anticipated.                                                       

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|These risks and uncertainties should be considered in evaluating forward-looking statements, and undue
reliance should not be placed on such statements. Additional information concerning the Company and
its business, including other factors that could materially affect the Companys financial results,
is included in the Companys filings with the Securities and Exchange Commission.
Overview
The Company is a bank holding company engaged, through its wholly-owned subsidiary bank, in the business
of commercial banking. The Companys subsidiary is Hills Bank and Trust Company, Hills, Iowa
(theBank). The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service commercial
bank extending its services to individuals, businesses, governmental units and institutional customers
primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Mount Vernon, Kalona,
Wellman, Cedar Rapids and Marion, Iowa. The Bank opened its Wellman location in September 2006.
The Companys net income for 2006 was $15,559,000 compared to $15,202,000 in 2005. Diluted earnings
per share were $3.39 and $3.32 for the years ended December 31, 2006 and 2005, respectively.
The Banks net interest income is the largest component of the Banks revenue, and it is
a function of the average earning assets and the net interest margin percentage. Net interest margin
is the ratio of tax equivalent net interest income to average earning assets. For the year ended
December 31, 2006, the Bank achieved a net interest margin of 3.31% compared to 3.56% in 2005, which
resulted in a decrease of $3.4 million in net interest income attributable to the reduction in the
net interest margin percentage. This decrease was more than offset by an increase of $4.8 million
in net interest income attributable to growth of $137.8 million in the Banks average earning
assets. Together, these factors resulted in a $1.4 million increase in net interest income on a tax-equivalent
basis.

|Page 33 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of






Operation  (Continued)
Highlights with respect to items on the Companys balance sheet as of December 31, 2006 included
the following:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                

| | Net loans totaling $1.283 billion.                                                                               
|- | -----------------------------------------------------------------------------------------------------------------
|  |                                                                                                                  
| | Loan growth in 2006 of $143.1 million and deposit growth of $71.0 million in 2006.                               
|  |                                                                                                                  
| | Short-term borrowings increased $24.5 million and Federal Home Loan Bank borrowings increased $12.2
    million. 
|  |                                                                                                                  
| | Stockholders equity increased $9.2 million in 2006, with dividends having been paid in 2006 of
    $3.7 million.

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The return on average equity was 13.74% in 2006 compared to 14.47% in 2005. The returns for the three
previous years, 2004, 2003 and 2002, were 14.34%, 15.36% and 14.05%, respectively. The total equity
of the Company remains strong as of December 31, 2006 with total risk-based capital at 13.31% and
Tier 1 risk-based capital at 12.05%. The minimum regulatory guidelines are 8% and 4% respectively.
The Company continues to increase the dividend per share with $.81, $.75 and $.70 having been paid
out in the years ended December 31, 2006, 2005 and 2004, respectively.
A detailed discussion of the financial position and results of operations follows this overview.
Critical Accounting Policies
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 of the Companys critical accounting policies should be read in conjunction with
the Companys financial statements and the accompanying notes presented elsewhere herein, as
well as other relevant portions of Managements Discussion and Analysis of Financial Condition
and Results of Operations. Although management believes the levels of the allowance as of December
31, 2006 and 2005 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.
Financial Position
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

|Year End Amounts (Amounts In Thousands)          | 2006  |               | 2005 |   | 2004      |  | 2003 |           | 2002 |  
|------------------------------------------------ | ----- | ------------- | ---- | - | --------- |  | ---- | --------- | ---- | -
|
|                                                
|Total assets                                     | **$** | **1,551,233** |      | $ | 1,433,649 |  | $    | 1,290,449 |      | $
|                                                 |       |               |      |   |          
|Investment securities                            |       | **190,984**   |      |   | 209,001   |  |      | 218,016   |      |  
|                                                 |       |               |      |   |          
|Loans, net of allowance for losses (Net Loans) |       | **1,283,035** |      |   | 1,142,418 |  |      | 1,002,139 |      |  
|                                                 |       |               |      |   |          
|Deposits                                         |       | **1,107,409** |      |   | 1,036,414 |  |      | 957,236   |      |  
|                                                 |       |               |      |   |          
|Federal Home Loan Bank borrowings                |       | **235,379**   |      |   | 223,161   |  |      | 167,542   |      |  
|                                                 |       |               |      |   |          
|Stockholders equity                             |       | **118,639**   |      |   | 109,479   |  |      | 103,803   |      |  

|Page 34 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of
Operations  (Continued)
Total assets at December 31, 2006 increased $117.6 million, or 8.20%, from the prior year-end. Asset
growth from 2004 to 2005 was $143.2 million and represented an 11.10% increase. The largest growth
in assets occurred in Net Loans, which had an increase of $140.6 million and $140.3 million for the
years ended December 31, 2006 and 2005, respectively. Net Loans include loans held for sale to the
secondary market of $3.8 million compared to $0.7 million at the end of 2005.
Loan demand remained strong in 2006 despite the increase in interest rates. The rise in interest rates
is also discussed in the net income overview that follows this financial position review. In 2006,
the federal funds target rate has been raised by the Federal Reserve Open Market Committee from 4.25%
to 5.25% with four increases of 0.25% each for a total of 1.00%. The upward movement of the federal
funds target rate started on June 30, 2004 when the rate was increased from 1.00% to 1.25% and has
increased 17 times thru December 31, 2006. The last increase was on June 29, 2006. The Federal Reserve
Open Market Committee did not raise the target rate at its August, September, October or December
2006 meetings. Interest rates on loans are generally affected by these increases since interest rates
for the U.S. Treasury market normally increase when the Federal Reserve Board raises the federal
funds rate. In pricing of loans and deposits, the Bank considers the U.S. Treasury indexes as benchmarks
in determining interest rates. Increases in interest rates may at some point materially reduce loan
demand and slow the economy, but at the current interest rate levels, demand for loans remains good.
The average rate index increases for 2006 compared to 2005, for the one, three and five year indexes
were 1.22%, 0.79% and .64%, respectively. During this same period, the average federal funds rate
increased from 3.20% in 2005 to 4.82%. These changes caused a flattening of the investment yield
curve and also the large increase in short-term federal funds of 163 basis points with only a 64
point increase in the five year index.
Loans secured by real estate represent the largest increase in loan growth. These loans increased $77.3
million in 2006 and increased $108.2 million in 2005. The real estate loans for one-to-four family
residential properties accounted for increases of $65.3 million in 2006 and $46.4 million in 2005.
Commercial real estate loans increased a net $34.8 million for 2006 and $50.3 million for 2005. The
other large increase for loans occurred for commercial loans which in 2006 increased a total of $26.8
million and $21.0 million in 2005. The overall economy in the Companys principal place of business,
Johnson and Linn Counties, remains in good condition with unemployment levels that remain low. Competition
for quality loans and deposits will continue to be a challenge. In both counties, new banks and credit
unions have been opened in the last few years. Between 2004 and 2006, six new banking locations were
added in Johnson County and seven in Linn County. The thirteen new locations include an office of
one of the states largest credit unions. The increased competition for both loans and deposits
could result in a lower interest rate margin that could result in lower net interest income if the
volume of loans and deposits does not increase to offset any such reduction in the interest margin.
Total deposits increased by $71.0 million in 2006. Short-term borrowings, which include federal funds
purchased and securities sold under agreements to repurchase, increased from $34.5 million to $59.1
million. Federal funds purchased increased by $3.8 million, and repurchase agreements increased $20.8
million. Deposits increased by $79.2 million in 2005. As of June 30, 2006, Johnson County total deposits
were $2.2 billion and the Companys deposits were $781 million, which represent a 34.8% market
share. At June 30, 2005, deposits were $771 million or a 37.0% market share. At $4.1 billion as of
June 30, 2006, the Linn County deposit market is about twice the size of the Johnson County deposit
market. The five Linn County offices of the Company had deposits of $232 million or a 5.7% share
of the market. The Companys Linn County deposits at June 30, 2005 were $172 million and represented
a 4.5% market share.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 35 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of Operation  (Continued)
      Investment securities decreased by $18.02 million in 2006. In 2005, investment securities decreased by $9.02 million. The investment portfolio consists of $178.1 million of securities that are stated at fair value, with any unrealized gain or loss, net of income taxes, reported as a separate component of stockholders equity. The securities portfolio, which includes tax exempt securities and stock of the FHLB that is required for borrowings, is used for liquidity and pledging purposes and to provide a rate of return that is acceptable to management. See Footnote 2 to the Companys financial statements.
      During 2006, the major funding sources for the growth in loans were the $71.0 million increase in deposits and additional funding from repurchase agreements, federal funds purchased and the Federal Home Loan Bank (FHLB). In 2005, the major source of funding for the growth in loans was deposit growth of $79.2 million. Total advances from the FHLB were $235.4 million and $223.2 million for 2006 and 2005, respectively. It is expected that the FHLB funding source will be used in the future when loan growth exceeds deposit increases and the interest rates on funds borrowed from the FHLB are favorable compared to other funding alternatives.
      Stockholders equity was $118.6 million at December 31, 2006 compared to $109.5 million at December 31, 2005. The Companys capital resources are discussed in detail in the Liquidity and Capital Resources section. Over the last five years, the Company has realized cumulative earnings of $70.7 million and paid shareholders dividends of $15.8 million, or 22.3% of earnings, while still maintaining capital ratios in excess of regulatory requirements.
      Net Income Overview
    Net income and diluted earnings per share for the last five years are as presented below:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

| | Year     |  | Net Income |            | % Increase (Decrease) |          | E.P.S.- Diluted |  |      
| | -------- |  | ---------- | ---------- | --------------------- | -------- | --------------- |  | -----
|
|
| | **2006** |  | **$**      | **15,559** |                       | **2.35** | **%**           |  | **$**
| | 2005     |  |            | 15,202     |                       | 7.09     |                 |  |      
| | 2004     |  |            | 14,195     |                       | (0.05    | )               |  |      
| | 2003     |  |            | 14,269     |                       | 24.47    |                 |  |      
| | 2002     |  |            | 11,464     |                       | 13.01    |                 |  |      

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Net income for 2006 increased by $0.4 million or 2.35% and diluted earnings per share increased 2.11%.
A significant factor that aided in increasing the level of profit in 2006 was the growth of average
earning assets. This item accounted for a $4.7 million increase in the net interest income on a tax-equivalent
basis and more than offset the increased provision for loan losses of $0.9 million and the decrease
in net interest margin. The increase in operating expenses of $1.5 million for the year was offset
by a $1.8 million increase in other income.
Annual fluctuations in the Companys net income continue to be driven primarily by two important
factors. The first important factor is net interest margin. Net interest income of $45.3 million
in 2006 was derived from the Companys $1.423 billion of average earning assets and its net
interest margin of 3.31%, compared to $1.286 billion of average earning assets and a 3.56% net interest
margin in 2005. The importance of net interest margin is illustrated by the fact that a decrease
in the net interest margin of only 10 basis points to 3.21% would result in a $1.4 million decrease
in income before taxes. Similarly, an increase in the net interest margin of 10 basis points to 3.41%
would increase income before income taxes by $1.4 million. Net interest margin decreased in 2005
to 3.56% from 3.70% in 2004.

|Page 36 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of






Operation  (Continued)
The second significant factor affecting the Companys net income is the provision for loan losses.
The majority of the Companys interest-earning assets are in loans outstanding, which amounted
to $1.3 billion at the end of 2006. The growth in the loans outstanding was a principal factor in
the increase in the Companys allowance for loan losses to $17.9 million at December 31, 2006.
The loan loss provision, which is the amount necessary to adjust the allowance to the level considered
appropriate by management, totaled $3,011,000, $2,101,000 and $1,470,000 for 2006, 2005 and 2004,
respectively. (See Note 3 to the Financial Statements.) A discussion in detail is included in the
Provisions for Loan Losses section below.
Net income for 2005 was $15,202,000, or diluted earnings per share of $3.32. For 2005, diluted earnings
per share increased $.21 per share. Net income for the year ended December 31, 2005, represented
a $1,007,000 increase over the reported income for the same period in 2004. Net interest income,
including fees, increased $2.6 million for the year ended December 31, 2005 compared to 2004. This
increase in net interest income was due to an increase in average earning assets of $126.1 million
in 2005. The increase in net interest income was partially offset by a $0.6 million increase in the
loan loss provision. Noninterest income increased 2.12% in 2005 to $12,808,000. Noninterest expense
increased from $31,965,000 in 2004 to $32,861,000 in 2005, or 2.80%.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 37 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of Operation (Continued)
      Net Interest Income
      Net interest income is the excess of the interest and fees received on interest-earning 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 volume of average earning assets has continued to grow each year, primarily due to new loans. The net interest margin decreased in 2006 to 3.31% and this compares to 3.56% in 2005, 3.70% in 2004, 3.53% in 2003 and 3.59% in 2002. The measure is shown on a tax-equivalent basis using a rate of 35% to make the interest earned on taxable and nontaxable assets more comparable.
    Net interest income on a tax-equivalent basis changed in 2006 as follows:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

|                                 |   |         | Increase (Decrease) | 
|-------------------------------- | - | ------- | ------------------- | 
|
|
|
|
|Interest income:                 |   |         |                     | 
|                                 |   |         |                     | 
|Loans, net                       | $ | 156,998 |                     | 
|                                 |   |         |                     | 
|Taxable securities               |   | (17,961 | )                   | 
|                                 |   |         |                     | 
|Nontaxable securities            |   | 5,173   |                     | 
|                                 |   |         |                     | 
|Federal funds sold               |   | (6,417  | )                   | 
|                                 |   |         |                     | 
|                                 | $ | 137,793 |                     | 
|                                 |   |         |                     | 
|                                 |   |         |                     | 
|Interest expense:                |   |         |                     | 
|Interest-bearing demand deposits | $ | (4,695  | )                   | 
|                                 |   |         |                     | 
|Savings deposits                 |   | 4,943   |                     | 
|                                 |   |         |                     | 
|Time deposits                    |   | 50,435  |                     | 
|                                 |   |         |                     | 
|Short-term borrowings            |   | 33,314  |                     | 
|                                 |   |         |                     | 
|FHLB borrowings                  |   | 41,253  |                     | 
|                                 |   |         |                     | 
|                                 | $ | 125,250 |                     | 
|                                 |   |         |                     | 
|Change in net interest income    |   |         |                     | 
|                                 |   |         |                     | 

|                                                     
|-----------------------------------------------------
|Net interest income changes for 2005 were as follows:
|                                                     

|                              | Change In
      Average
      Balance |         | Effect Of
      Volume
      Changes |   | Effect Of
      Rate
      Changes |   | Net
      Change |       
|----------------------------- | ------------------------------------- | ------- | ------------------------------------ | - | ---------------------------------- | - | ---------------- | ------
|
|
|Interest-earning assets       | $                                     | 126,099 |                                      | $ | 7,683                              |   | $                | 1,513 
|Interest-bearing liabilities  |                                       | 106,549 |                                      |   | (3,243                             | ) |                  | (3,235
|                              |                                       |         |                                     
|Change in net interest income |                                       |         |                                      | $ | 4,440                              |   | $                | (1,722
|                              |                                       |         |                                     

|Page 38 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of Operation (Continued)
    A summary of the net interest spread and margin is as follows:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                            

|(Tax Equivalent Basis)                                                                             | 2006 |      | 2005 |  | 2004 |  
|-------------------------------------------------------------------------------------------------- | ---- | ---- | ---- |  | ---- | -
|                                                                                                   |     
|                                                                                                  
|Yield on average interest-earning assets                                                           |      | 6.28 | %    |  | 5.91 | %
|Rate on average interest-bearing liabilities                                                       |      | 3.47 |      |  | 2.77 |  
|                                                                                                   |      |     
|Net interest spread                                                                                |      | 2.81 |      |  | 3.14 |  
|Effect of noninterest-bearing funds                                                                |      | 0.50 |      |  | 0.42 |  
|                                                                                                   |      |     
|Net interest margin (tax equivalent interest income
   divided by average interest-earning assets) |      | 3.31 | %    |  | 3.56 | %
|                                                                                                   |      |     

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Provision for Loan Losses
The provision for loan losses totaled $3,011,000, $2,101,000 and $1,470,000 for 2006, 2005 and 2004
respectively. Loan charge-offs net of recoveries were $521,000 in 2006 and $531,000 in 2005 and $265,000
in 2004. The loan loss provision is the amount necessary to adjust the allowance to the level considered
appropriate by management. The provision adjustment is computed on a quarterly basis and is a result
of managements determination of the quality of the loan portfolio. The provision reflects a
number of factors, including the size of the loan portfolio, loan concentrations, the impact on the
borrowers ability to repay, loan collateral values, the level of impaired loans and loans past
due ninety days or more. In addition, management considers the credit quality of the loans based
on managements review of problem and watch loans, including loans with historical higher credit
risks (primarily agricultural loans).
Other factors that are considered in determining the credit quality of the Companys loan portfolio
are the vacancy rates for both residential and commercial and retail space, current equity the borrower
has in the property and overall financial strength of the customer including cash flow to continue
to fund loan payments. The Company also considers the state of the total economy including unemployment
levels, vacancy rates of rental units and demand for commercial and retail space. In most instances,
the borrowers have used in their rental projections of income at least a 10% vacancy rate. As of
December 31, 2006, the unemployment levels in Johnson County and Linn County were 2.5% and 3.9%,
respectively, compared to 2.7% and 4.6% in December of 2005. These levels compare favorably to the
State of Iowa at 3.5% and the national unemployment level at 4.5%, which were 4.5% and 4.9%, respectively
in December, 2005. The residential rental vacancy rates in 2006 in Johnson County, the largest trade
area for the Company, were estimated at 10.0% in Iowa City and Coralville and 10.00% in the Cedar
Rapids area. The estimated vacancy rates for both markets were 10% one year ago. The State of Iowa
vacancy rate is 13.1% and the national rate is 9.9% with the Midwest rate at 12.6%. These vacancy
rates one year ago were 9.4%, 9.9% and 13.4%, respectively. The Company continues to consider those
vacancy rates among other factors in its current evaluation of the real estate portion of its loan portfolio.
The amount of problem or watch loans considered in the reserve computation increased by approximately
$1.2 million in 2005 and by approximately $1.1 million from the end of 2003 to 2004. The increase
was related to real estate mortgage loans. Overall loan balances for such loans continue to increase
significantly. Some softness in the rental market place has been observed, although loan delinquency
is about at the same level as the preceding year. The allowance for loan losses balance is also affected
by the charge-offs and recoveries for the periods presented. For the years ended December 31, 2006,
2005 and 2004, recoveries were $1,352,000, $1,644,000, and $1,103,000, respectively; charge-offs
were $1,873,000, $2,175,000 and $1,368,000 in 2006, 2005 and 2004, respectively.

|Page 39 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial ConditionAnd Results of

Operation (Continued)
The allowance for loan losses totaled $17,850,000 at December 31, 2006 compared to $15,360,000 at December
31, 2005. The percentage of the allowance to outstanding loans was 1.37% and 1.33% at December 31,
2006 and 2005, respectively. The percentage increase was due to loan growth (fueled primarily by
an increase in demand for real estate mortgage loans) and an increase in the amount of problem
or watch loans as a percentage of total loans outstanding. 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 2006 is consistent with the methodology used in
the prior year.
Agricultural loans totaled $49,223,000 and $43,730,000 at December 31, 2006 and 2005, respectively.
The level of agriculture loans during the last five years compared to total loans has varied from
a high of 4.78% in 2002 to a low of 3.78% in 2005. Management has assessed the risks for agricultural
loans to be higher than other loans due to unpredictable commodity prices, the effects of weather
on crops and uncertainties regarding government support programs. In particular, loans that are in
the swine production segment continue to be of major concern as prices for hogs are subject to severe
fluctuations.
The University of Iowa, because of its 23,600 employees and because of its total budget in Johnson
County, has a tremendous impact on the economy of the Banks primary trade area. In 2006 and
2005, the University of Iowa helped Johnson Countys economy remain strong. The economy of the
state of Iowa has recovered somewhat from recent weakness, but the University continues to suffer
from budget limitations. For its fiscal year beginning July 1, 2006, the University expects continued
budget constraints. The possible effects on the local economy cannot be predicted, but such budget
limitations may weaken the economy in future years.
Other Income
The other income of the Company was $14,611,000 in 2006 compared to $12,808,000 in 2005. The net increase
of $1,803,000 was the result of a combination of factors discussed below. In 2005, the total other
income increased $266,000 from 2004. The amount of the net gain on sale of secondary market mortgage
loans in each year can vary significantly. The gain was $859,000 in 2006, $1,074,000 in 2005 and
$1,495,000 in 2004. The number of loans sold in 2006 was approximately 94% of the volume in 2005
and 69% of the activity experienced in 2004. Also, the fee per loan in 2005 was approximately 17%
higher than the fee per loan in 2006. The volume of activity in these types of loans is directly
related to the level of interest rates. Many consumers took advantage of the rates and refinanced
their mortgages prior to 2004. In 2004, 2005 and 2006, rates did not drop sufficiently to make it
feasible for a large volume of refinancing to occur. The servicing of the loans sold into the secondary
market is not retained by the Company so these loans do not provide an ongoing stream of income.
Trust fees increased $433,000 to $3,423,000 in 2006. Trust fees increased $270,000 in 2005. As of December
31, 2006, the Banks Trust Department had $857 million in assets under management compared to
$787 million and $694 million at December 31, 2005 and 2004, respectively. Trust fees are based on
total assets under management. The trust assets that are the most volatile are those that are held
in common stocks, which amount to approximately 55% of assets under management. In 2006, the market
value of such common stock increased. In 2005, the market value was stable. As an example of the
changes in market value, the Dow Jones Industrial Average increased over 16% in 2006 and over 3%
in 2004. This average decreased less than 1% in 2005.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 40 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial ConditionAnd Results of

Operation (Continued)
Service charges and fees increased $1,023,000 in 2006 to $6,927,000 from $5,904,000 in 2005. Such charges
and fees include fees on deposit accounts and credit card processing fees on merchant accounts. Service
fees on deposit accounts increased $729,000 in 2006 compared to the prior year as a result of new
fee income strategies implemented in the third quarter of 2005. Other noninterest income was $2,621,000
in 2006 and $2,332,000 in 2005. Debit card interchange fees increased by $225,000 and point of sale
pin interchange income increased by $134,000. Both of the increases were due to volume changes in
debit card usage and are included in other noninterest income. Total other income was partially offset
by $234,000 in investment securities losses in 2005. In 2006 and 2004, no securities losses were reported.
Service charges and fees increased by $650,000 from 2004 to 2005, resulting in total fees of $5,904,000
in 2005. Service fees on deposit accounts increased $196,000 in 2005 compared to 2004 due to increased
volume, debit card interchange fees increased $362,000 and credit card processing fee income was
up $91,000.
Other Expenses
Total other expenses were $34,364,000 and $32,861,000 for the years ended December 31, 2006 and 2005,
respectively. The increase is $1,503,000 or 4.57% in 2006 and $896,000 or 2.80% in 2005. Salaries
and employee benefits, the largest component of non-interest expense increased $1,379,000 in 2006,
an 8.07% change. This increase includes $918,000 in direct salaries, a 7.19% increase which resulted
from annual pay adjustments and the addition of twelve employees in 2006. Another component of salaries
and employee benefits expense is compensation expense related to the officers deferred compensation
plan and costs associated with restricted common stock awarded to various officers, which decreased
by $199,000. This decrease is primarily the result of the change in the appraised value of the Companys
common stock. Effective June 30, 2005, as a result of the Companys program to repurchase up
to a total of 750,000 shares of the Companys common stock, the Company began obtaining a quarterly
independent appraisal of the shares of stock. Previously, the Company was obtaining an independent
appraisal of the shares of stock on an annual basis for the Companys ESOP. Due to the 2005
Stock Repurchase Program, no marketability discount was given on the new quarterly appraisals and
the result was the removal by the independent appraiser of a 10% minority interest adjustment. The
appraisal value of the stock based on the latest appraisal is $50.00 per share, which resulted in
a per share increase of $3.50 for 2006. This compares to a $9.50 per share increase in 2005. The
final appraisal for each quarter will be completed approximately forty days after each quarter end
and sixty days after year-end. Medical expenses included with salaries and benefits increased to
$1.5 million from $1.2 million in 2005. Beginning in 2005, the Company changed its medical plan from
a self-insured plan to a full-premium plan. The actual claims paid in 2005 that were incurred but
not reported prior to December 31, 2004 were under the plan administrators estimate by $132,000
and that reduced the 2005 expense. In addition, premiums for the medical plan increased 12% in 2006.
Occupancy expense increased $67,000 with increases of $34,000 in property taxes and $20,000 in utilities
in 2006. In 2006, furniture and equipment expense included depreciation expense of $1,817,000 and
$1,069,000 in equipment and software maintenance contracts. These expenses one year ago were $1,835,000
for depreciation and $983,000 for the maintenance contracts. The increase in maintenance contract
expense in 2006 is due to the equipment and software purchased during the year and the related maintenance
contracts.
Advertising and business development totaled $1,843,000 in 2006, a $58,000 decrease from the prior
year. In 2005, as a result of the Companys scorecard points awarded for credit card charges,
the Bank incurred costs of $247,000 compared to $179,000 in 2006. The decrease of $68,000 is due
to fewer points being redeemed in 2006. Also, charitable contributions decreased $57,000 to $31,000
in 2006; in 2005 charitable contributions included a $50,000 donation to the American Red Cross to
assist the victims of Hurricane Katrina.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 41 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of
Operation  (Continued)
Outside services decreased $111,000 in 2006 to $4,888,000 as of December 31, 2006 compared to the same
period in 2005. Outside services include professional fees, courier services and ATM fees, and processing
charges for the merchant credit card program, retail credit cards and other data processing services.
Professional fees decreased $242,000 from 2005 to a total of $1,472,000 for 2006. 2005 expenses included
$226,000 for consulting fees for new fee income strategies. Credit card, debit card and merchant
card processing increased $81,000 due to a volume increase in transactions.
Total other expenses were $31,965,000 for the year ended December 31, 2004. The increase in expenses
in 2005 was $896,000. This included an increase of $441,000 in salaries and benefits, which was the
direct result of salary adjustments for 2005. Medical expenses included with salaries and benefits
decreased to $1.2 million from $1.3 million in 2005. Advertising and business development expenses
decreased $330,000 in 2005. This change was due in part to a $160,000 decrease in the redemption
of scorecard points awarded for credit card charges. In addition, there was an increase in outside
services of $424,000. Outsourcing of internal audit work in 2005 accounted for $29,000 of the increase
and consulting fees for new income strategy were $226,000 of the increase.
Income Taxes
Income tax expense was $6,933,000, $6,684,000 and $6,351,000 for the years ended December 31, 2006,
2005 and 2004, respectively. Income taxes as a percentage of income before income taxes were 30.82%
in 2006, 30.54% in 2005 and 30.91% in 2004. The amount of tax credits were $566,000, $678,000 and
$596,000 for 2006, 2005 and 2004, respectively. In 2005, the final tax credits were taken on one
tax credit property. The decrease in tax credits in 2006 reflects credits for the remaining tax credit
property.
Impact of Recently Issued Accounting Standards
As of January 1,2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123
(revised 2004), Share-Based Payment(FAS 123R) which requires companies to recognize in compensation expense the grant-date fair value
of stock awards issued to employees and directors. The Company adopted FAS 123R using the modified
prospective transition method. In accordance with the modified prospective transition method, the
Companys Consolidated Financial Statements for prior periods have not been restated to reflect
the impact of FAS 123R. As a result of applying FAS l23R, the Company recognized share-based compensation
expense of $ 44,000 for the year ended December 31, 2006.
As of January 1, 2006, the Company has elected to use the guidance issued by the FASB in Position FAS
No. l23R-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards(FSP FAS 123R-3). FSP FAS 123R-3 provides a practical exception when a company transitions
to the accounting requirements of FAS 123R. FAS 123R requires a company to calculate the pool of
excess tax benefits available to absorb tax deficiencies recognized subsequent to adopting FAS 123R,
termed the Additional Paid in Capital Pool (APIC Pool), assuming the company had been
following the recognition provisions prescribed by FAS 123. The adoption of the FSP does not have
an impact on the Companys overall results of operations.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 42 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of






Operation  (Continued)
Impact of Recently Issued Accounting Standards (cont.)
In March 2004, the Emerging Issues Task Force (EITF) revisited EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application of Certain Investments.Effective with reporting periods beginning after June 15, 2004 revised EITF No. 03-1 would have required
companies carrying certain types of debt and equity securities at amounts higher than the securities
fair market values to use more detailed criteria to evaluate whether to record a loss and to disclose
additional information about unrealized losses. The FASB subsequently issued a staff position deferring
the effective date of the measurement and recognition provisions of the revised EITF No. 03-1 until
further implementation issues could be resolved. On November 3, 2005, the FASB issued a Staff Position
(FSP) that addresses the determination as to when an investment is considered impaired, whether that
impairment is other than temporary, and the measurement of an impairment loss. This FSP also includes
accounting considerations subsequent to the recognition of an other-than-temporary impairment and
requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary
impairments. The guidance in the FSP shall be applied to reporting periods beginning after December
15, 2005. Adoption of the FSP did not have a material 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.
In December 2004, the FASB issued FASB Statement No. 153, Exchanges of Nonmonetary Assets,which eliminates an exception in APB 29 for recognizing nonmonetary exchanges of similar productive
assets at fair value and replaces it with an exception for recognizing exchanges of nonmonetary assets
at fair value that do not have commercial substance. This Statement is effective for the Company
for nonmonetary asset exchanges occurring on or after January 1, 2006. The adoption of this Statement
did not have a significant effect on the Companys financial statements.
In May 2005, the FASB issued FASB Statement No. 154, Accounting Changes and Error Corrections.Statement 154 establishes, unless impracticable, retrospective application as the required method for
reporting a change in accounting principle in the absence of explicit transition requirements specific
to a newly adopted accounting principle. The Company implemented the provisions of this statement
as of January 1, 2006 and it did not have a significant effect on its financial statements.
In March 2006, the FASB issued FASB Statement No. 156 (FAS 156), Accounting for Servicing of Financial Assets and amendment of FASB Statement No. 140 (FAS 140),
Accounting for Transfers and Extinguishment of Liabilities.  FAS 156 requires that all separately recognized servicing assets and servicing liabilities be
initially measured at fair value, if practicable, and permits the Company to elect either the fair
value measurement method with changes in fair value reflected in earnings or the amortization method
as defined in FAS 140 for subsequent measurements. FAS 156 is effective for the Company as of January
1, 2007. The adoption of this statement will not have a significant effect on the Companys
financial statements.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes.FIN 48 requires that the Company recognize in its financial statements, the impact of a tax position
if that position is more likely than not of being sustained on audit based on the technical merits
of the position. The provisions of FIN 48 are effective as of January 1, 2007. The adoption of the
Interpretation will not have a significant effect on the Companys financial statements.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 43 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of






Operation  (Continued)
Impact of Recently Issued Accounting Standards (cont.)
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year
Financial Statements(SAB 108). SAB 108 provides interpretive guidance on how the effects of the carryover or
reversal of prior year misstatements should be considered in quantifying a current year misstatement.
The SEC staff believes that registrants should quantify errors using both a balance sheet and an
income statement approach and evaluate whether either approach results in quantifying a misstatement
that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108
is effective for years ending on or after November 15, 2006. The adoption of SAB 108 did not have
any effect on the Companys financial statements.
In September 2006, the FASB issued FASB Statement No. 157, Fair Value Measurements.The Statement provides a single definition of fair value, a framework for measuring fair value and
expanded disclosures concerning fair value. Previously, different definitions of fair value were
contained in various accounting pronouncements that prescribe fair value as the relevant measure
of value, except FAS 123R and related interpretation and pronouncements that require or permit measurement
similar to fair value but are not intended to measure fair value. The Statement is effective for
financial statements issued for year beginning after November 15, 2007. The Company is currently
evaluating the impact that the Statement will have on its consolidated financial statements.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 44 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of






Operation  (Continued)
Interest Rate Sensitivity and Liquidity Analysis
At December 31, 2006, the Companys interest rate sensitivity report is as follows (amounts in
thousands):
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                            

|                                                             | Repricing
      Maturities
      Immediately |          | Days |   | More Than
      One Year |   | Total |        
|------------------------------------------------------------ | -------------------------------------------- | -------- | ---- | - | ------------------------ | - | ----- | -------
|
|
|                                                             |                                              |         
|Earning assets:                                              |                                              |          |      |   |                          |   |       |        
|Investment
     securities                                   | $                                            |         |      | $ | 1,940                    |   | $     | 5,005  
|Loans                                                        |                                              | 7,337    |      |   | 183,425                  |   |       | 35,693 
|                                                             |                                              |         
|**Total**                                                    |                                              | 7,337    |      |   | 185,365                  |   |       | 40,698 
|                                                             |                                              |         
|Sources of funds:                                            |                                              |          |      |   |                          |   |       |        
|Interest-bearing
     checking and
     savings accounts     |                                              | 133,022  |      |   |                         |   |       |       
|Certificates of
     deposit                                 |                                              |         |      |   | 24,381                   |   |       | 75,918 
|Other borrowings -
     FHLB                                 |                                              |         |      |   | 10,000                   |   |       | 20,000 
|Federal funds and
     repurchase
     agreements            |                                              | 59,063   |      |   |                         |   |       |       
|                                                             |                                              |         
|                                                             |                                              | 192,085  |      |   | 34,381                   |   |       | 95,918 
|                                                             |                                              |          |      |   |                          |   |       |        
|Other sources,
     primarily
     noninterest-
     bearing |                                              |         |      |   |                         |   |       |       
|                                                             |                                              |         
|**Total sources**                                            |                                              | 192,085  |      |   | 34,381                   |   |       | 95,918 
|                                                             |                                              |         
|Interest
   Rate Gap                                         | $                                            | (184,748 | )    | $ | 150,984                  |   | $     | (55,220
|                                                             |                                              |         
|                                                            
|Cumulative Interest
   Rate Gap
  at December 31, 2006       | $                                            | (184,748 | )    | $ | (33,764                  | ) | $     | (88,984
|                                                             |                                              |          |      |  

|Page 45 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of






Operation  (Continued)
The table set forth above includes the portion of the balances in interest-bearing checking, savings
and money market accounts that management has estimated to mature within one year. The classifications
are used because the Banks historical data indicates that these have been very stable deposits
without much interest rate fluctuation. Historically, these accounts would not need to be adjusted
upward as quickly in a period of rate increases so the interest risk exposure would be less than
the re-pricing schedule indicates. The FHLB borrowings are classified based on either their due date
or if they are callable on their most likely call date based on the interest rate.
Effects of Inflation
The consolidated financial statements and the accompanying notes have been prepared in accordance with
generally accepted accounting principles. These principles require the measurement of financial position
and operating results in terms of historical dollar amounts without considering the changes in the
relative purchasing power of money over time due to inflation. The impact of inflation is reflected
in the increased cost of the Companys operations. Unlike industrial companies, nearly all of
the assets and liabilities of the Company are monetary in nature. As a result, interest rates have
a more significant impact in the Companys performance than do the effects of general levels
of inflation. Interest rates do not necessarily move in the same direction or to the same extent
as the price of goods and services. In the current economic environment, liquidity and interest rate
adjustments are features of the Companys asset/liability management, which are important to
the maintenance of acceptable performance levels. The Company attempts to maintain a balance between
monetary assets and monetary liabilities, over time, to offset the potential effects of changing interest rates.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 46 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of
Operation (Continued)
Liquidity and Capital Resources
On an unconsolidated basis, the Company had cash balances of $983,000 as of December 31, 2006.
In 2006, the Company received dividends of $3,696,000 from its subsidiary Bank and used those funds
to pay dividends to its stockholders of $3,696,000.
The ability of the Company to pay dividends to its shareholders is dependent upon the earnings and
capital adequacy of its subsidiary Bank, which affects the Banks dividends to the Company.
The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in
dividends. In order to maintain acceptable capital ratios in the subsidiary Bank, certain of its
retained earnings are not available for the payment of dividends. Retained earnings available for
the payment of dividends to the Company totaled approximately $16,254,000, $13,720,000 and $13,282,000
as of December 31, 2006, 2005 and 2004, respectively. As of December 31, 2006 and 2005, stockholders
equity, before deducting for the maximum cash obligation related to the ESOP, was $139,579,000 and
$130,113,000 respectively. This measure of stockholders equity as a percent of total assets
was 9.00% at December 31, 2006 and 9.08% at December 31, 2005. As of December 31, 2006, total equity
was 7.65% of assets compared to 7.64% of assets at the prior year end.
The Company and the Bank are subject to the Federal Deposit Insurance Corporation Improvement Act of
1991, and the Bank is subject to Prompt Corrective Action Rules as determined and enforced by the
Federal Reserve. These regulations establish minimum capital requirements that member banks must
maintain.
As of December 31, 2006, risk-based capital standards require 8% of risk-weighted assets. At least
half of that 8% must consist of Tier I core capital (common stockholders equity, non-cumulative
perpetual preferred stock and minority interest in the equity accounts of consolidated subsidiaries),
and the remainder may be Tier II supplementary capital (perpetual debt, intermediate-term preferred
stock, cumulative perpetual, long-term and convertible preferred stock, and loan loss reserve up
to a maximum of 1.25% of risk-weighted assets). Total risk-weighted assets are determined by weighting
the assets according to their risk characteristics. Certain off-balance sheet items (such as standby
letters of credit and firm loan commitments) are multiplied by credit conversion factors
to translate them into balance sheet equivalents before assigning them risk weightings. Any bank
having a capital ratio less than the 8% minimum required level must, within 60 days, submit to the
Federal Reserve a plan describing the means and schedule by which the Bank shall achieve the applicable
minimum capital ratios.
The Bank is an insured state bank, incorporated under the laws of the state of Iowa. As such, the Bank
is subject to regulation, supervision and periodic examination by the Superintendent of Banking of
the State of Iowa (the Superintendent). Among the requirements and restrictions imposed
upon state banks by the Superintendent are the requirements to maintain reserves against deposits,
restrictions on the nature and amount of loans which may be made by state banks, and restrictions
relating to investments, opening of bank offices and other activities of state banks. Changes in
the capital structure of state banks are also approved by the Superintendent. State banks must have
a Tier 1 risk-based leverage ratio of 6.5% plus a fully funded loan loss reserve. In certain circumstances,
the Superintendent may mandate higher capital, but the Superintendent has not imposed such a requirement
on the Bank. In determining the Tier 1 risk-based leverage ratio, the Superintendent uses total equity
capital without unrealized securities gains and the allowance for loan losses less any intangible
assets. At December 31, 2006, the Tier 1 risk-based leverage ratio of the Bank was 8.95% and exceeded
the ratio required by the Superintendent.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 47 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of Operation (Continued)
    The actual amounts of risk-based capital and risk-based capital ratios as of December 31, 2006 and the minimum regulatory requirements for the Company and the Bank are presented below (amounts in thousands):
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                             

|                          | Actual |         | For Capital
      Adequacy
      Purposes |  | To Be Well
      Capitalized Under
      Prompt Corrective
      Action Provisions |  
|------------------------- | ------ | ------- | ----------------------------------------- |  | ---------------------------------------------------------------------------------- | -
|
|
|
|As of December 31, 2006:  |        |         |                                           |  |                                                                                    |  
|Company:                  |        |         |                                           |  |                                                                                    |  
|Total risk-based capital  | $      | 152,737 |                                           |  | 13.31                                                                              | %
|                          |        |         |                                           | 
|Tier 1 risk-based capital |        | 138,344 |                                           |  | 12.05                                                                              |  
|                          |        |         |                                           | 
|Leverage ratio            |        | 138,344 |                                           |  | 9.00                                                                               |  
|                          |        |         |                                           | 
|Bank:                     |        |         |                                           |  |                                                                                    |  
|Total risk-based capital  |        | 151,983 |                                           |  | 13.25                                                                              |  
|                          |        |         |                                           | 
|Tier 1 risk-based capital |        | 137,599 |                                           |  | 11.99                                                                              |  
|                          |        |         |                                           | 
|Leverage ratio            |        | 137,599 |                                           |  | 8.95                                                                               |  

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The Bank is classified as well capitalized by FDIC capital guidelines.
On a consolidated basis, 2006 cash flows from operations provided $16,454,000; proceeds of net securities
sold provided $18,351,000 and net increases in deposits provided $70,995,000. These cash flows were
invested in Net Loans of $140,522,000. Also, net borrowings from the FHLB increased by $12,218,000
to assist in the funding of the Banks increased loan demand. In addition, $2,199,000 was used
to purchase property and equipment.
At December 31, 2006, the Bank had total outstanding loan commitments and unused portions of lines
of credit totaling $200,786,000 (see Note 14 to the Financial Statements). Management believes that
its liquidity levels are sufficient at this time, but the Bank may increase its liquidity by limiting
the growth of its assets, by selling more loans in the secondary market or selling portions of loans
to other banks through participation agreements. It may also obtain additional funds from the Federal
Home Loan Bank (FHLB). The Bank as of December 31, 2006 can obtain an additional $206 million from
the FHLB based on the current real estate mortgage loans held. In addition, the Bank has arranged
$105 million of credit lines at three banks. The borrowings under these credit lines would be secured
by the Banks investment securities.
While the Bank has off-balance sheet commitments to fund additional borrowings of customers, it does
not use other off-balance-sheet financial instruments, including interest rate swaps, as part of
its asset and liability management. Contractual commitments to fund loans are met from the proceeds
of federal funds sold or investment securities and additional borrowings. Many of the contractual
commitments to extend credit will not be funded because they represent the credit limits on credit
cards and home equity lines of credits.

|Page 48 of 97
|-------------



|Item 7.   Managements Discussion and Analysis of Financial Conditionand Results of Operation (Continued)
      Contractual Obligations and Commitments
    As disclosed in Note 14 to the financial statements, the Company has certain obligations and commitments to make future payments under contracts. The following table summarizes significant contractual obligations and other commitments as of December 31, 2006:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                               

|                                   | Payments Due By Period |        
|---------------------------------- | ---------------------- | -------
|
|
|
|
|                                   |                        |        
|**Contractual obligations:**       |                        |        
|Long-term debt obligations         | $                      | 235,379
|Operating lease obligations        |                        | 1,319  
|                                   |                        |        
|**Total contractual obligations:** | $                      | 236,698
|                                   |                        |        
|                                   |                        |        
|**Other commitments:**             |                        |        
|Lines of credit                    | $                      | 200,786
|Standby letters of credit          |                        | 10,107 
|                                   |                        |        
|**Total other commitments**        | $                      | 210,893
|                                   |                        |        

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Item 7A.   Quantitative and Qualitative Disclosures About Market Risk
Related Party Transactions
The Banks primary transactions with related parties are the loan and deposit relationships it
maintains with officers, directors and entities related to these individuals. The Bank makes loans
to related parties under substantially the same interest rates, terms and collateral as those prevailing
for comparable transactions with unrelated persons. In addition, these parties may maintain deposit
account relationships with the Bank that also are on the same terms as with unrelated persons. As
of December 31, 2006 and 2005, loan balances to related individuals and businesses totaled $32,638,000
and $35,797,000, respectively. Deposits from these related parties totaled $7,512,000 and $6,875,000
as of December 31, 2006 and 2005, respectively.
Commitments and Trends
The Company and the Bank have no material commitments or plans that will materially affect liquidity
or capital resources. Property and equipment may be acquired in cash purchases, or they may be financed
if favorable terms are available.
Market Risk Exposures
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 interest rates increase over an extended period of time. Inversely, the Companys
yields and cost of funds will decrease when market rates decline. The Company is able to manage these
swings to some extent by attempting to control the maturity or rate adjustments of its interest-earning
assets and interest-bearing liabilities over given periods of time.

|Page 49 of 97
|-------------



|Item 7A.   Quantitative and Qualitative Disclosures About Market Risk (Continued)
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.
Based on the data following, net interest income should decline with instantaneous increases in interest
rates while net interest income should increase with instantaneous declines in interest rates. Generally,
during periods of increasing interest rates, the Companys interest rate sensitive liabilities
would re-price faster than its interest rate sensitive assets causing a decline in the Companys
interest rate spread and margin. This would tend to reduce net interest income because the resulting
increase in the Companys cost of funds would not be immediately offset by an increase in its
yield on earning assets. In times of decreasing interest rates, fixed rate assets could increase
in value and the lag in re-pricing of interest rate sensitive assets could be expected to have a
positive effect on the Companys net interest income.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 50 of 97
|-------------



|Item 7A.   Quantitative and Qualitative Disclosures About Market Risk (Continued)
The following table, which presents principal cash flows and related weighted average interest rates
by expected maturity dates, provides information about the Companys loans, investment securities
and deposits that are sensitive to changes in interest rates.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                      

|                              | 2007 |         | 2008 |   | 2009   |   | 2010 |         | 2011 |   | Thereafter |   | Total |        | Fair Value |  
|----------------------------- | ---- | ------- | ---- | - | ------ | - | ---- | ------- | ---- | - | ---------- | - | ----- | ------ | ---------- | -
|
|
|Assets:                       |      |         |      |   |        |   |      |         |      |   |            |   |       |        |            |  
|Loans, fixed:                 |      |         |      |   |        |   |      |         |      |   |            |   |       |        |            |  
|Balance                       | $    | 129,880 |      | $ | 96,567 |   | $    | 110,055 |      | $ | 98,946     |   | $     | 87,530 |            | $
|Average
        interest rate |      | 6.66    | %    |   | 6.16   | % |      | 6.33    | %    |   | 6.36       | % |       | 7.10   | %          |  
|                              |      |         |      |   |        |   |      |        
|Loans, variable:              |      |         |      |   |        |   |      |         |      |   |            |   |       |        |            |  
|Balance                       | $    | 132,320 |      | $ | 8,481  |   | $    | 5,043   |      | $ | 2,406      |   | $     | 3,163  |            | $
|Average
        interest rate |      | 8.97    | %    |   | 7.71   | % |      | 8.57    | %    |   | 8.40       | % |       | 8.38   | %          |  
|                              |      |         |      |   |        |   |      |        
|Investments (1):              |      |         |      |   |        |   |      |         |      |   |            |   |       |        |            |  
|Balance                       | $    | 47,298  |      | $ | 44,013 |   | $    | 36,442  |      | $ | 17,856     |   | $     | 10,366 |            | $
|Average
     interest rate    |      | 3.80    | %    |   | 4.52   | % |      | 4.55    | %    |   | 4.64       | % |       | 4.83   | %          |  
|                              |      |         |      |   |        |   |      |        
|Liabilities:                  |      |         |      |   |        |   |      |         |      |   |            |   |       |        |            |  
|Liquid
     deposits (2):     |      |         |      |   |        |   |      |         |      |   |            |   |       |        |            |  
|Balance                       | $    | 388,559 |      | $ |       |   | $    |        |      | $ |           |   | $     |       |            | $
|Average
        interest rate |      | 1.75    | %    |   | 0.00   | % |      | 0.00    | %    |   | 0.00       | % |       | 0.00   | %          |  
|                              |      |         |      |   |        |   |      |        
|Deposits,
   certificates:    |      |         |      |   |        |   |      |         |      |   |            |   |       |        |            |  
|Balance                       | $    | 447,351 |      | $ | 76,637 |   | $    | 28,379  |      | $ | 17,423     |   | $     | 6,769  |            | $
|Average
     interest rate    |      | 4.68    | %    |   | 4.29   | % |      | 3.82    | %    |   | 4.24       | % |       | 4.55   | %          |  

|    |                                                                                                                             
|--- | ----------------------------------------------------------------------------------------------------------------------------
|(1) | Includes all available-for-sale investments, held-to-maturity investments, federal funds and Federal
  Home Loan Bank stock.
|    |                                                                                                                             
|(2) | Includes passbook accounts, NOW accounts, Super NOW accounts and money market funds.                                        

|Page 51 of 97
|-------------



|Item 8.   Consolidated Financial Statements and Supplementary Data
The consolidated financial statements and supplementary data are included on Pages 53 through 85.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 52 of 97
|-------------



|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |                                                                         
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | KPMG LLP2500 Ruan Center
      666 Grand Avenue
    Des Moines, IA 50309
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Report of Independent Registered Public Accounting Firm
The Board of Directors and StockholdersHills Bancorporation:
We have audited the accompanying consolidated balance sheets of Hills Bancorporation and subsidiaries
as of December 31, 2006 and 2005, and the related consolidated statements of income, comprehensive
income, stockholders equity, and cash flows for each of the years in the three-year period
ended December 31, 2006. These consolidated financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these consolidated financial statements
based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material
respects, the financial position of Hills Bancorporation and subsidiaries as of December 31, 2006
and 2005, and the results of their operations and their cash flows for each of the years in the three-year
period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board
(United States), the effectiveness of Hills Bancorporations internal control over financial
reporting as of December 31, 2006, based on criteria established inInternal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report
dated March 9, 2007 expressed an unqualified opinion on managements assessment of, and
the effective operation of, internal control over financial reporting.

Des Moines, IowaMarch 9, 2007

|Page 53 of 97
|-------------



|HILLS BANCORPORATION                 
|-------------------------------------
|                                     
|                                     
|CONSOLIDATED BALANCE SHEETS          
|December 31, 2006 and 2005           
|(Amounts In Thousands, Except Shares)
|                                     

|                                                                                                                         |  |     
|------------------------------------------------------------------------------------------------------------------------ |  | ----
|ASSETS                                                                                                                   |  | 2006
|                                                                                                                         | 
|Cash and cash equivalents (Note 10)                                                                                      |  | $   
|Investment securities (Notes 2 and 6):                                                                                   |  |     
|Available for sale at fair value
(amortized cost 2006 $180,106; 2005 
           $199,673)                               |  |     
|Held to maturity at amortized cost (fair value 2006 $177; 2005 $225)                                                     |  |     
|Stock of Federal Home Loan Bank                                                                                          |  |     
|Loans held for sale                                                                                                      |  |     
|Loans, net (Notes 3, 7 and 11)                                                                                           |  |     
|Property and equipment, net (Note 4)                                                                                     |  |     
|Tax credit real estate                                                                                                   |  |     
|Accrued interest receivable                                                                                              |  |     
|Deferred income taxes, net (Note 9)                                                                                      |  |     
|Goodwill                                                                                                                 |  |     
|Other assets                                                                                                             |  |     
|                                                                                                                         |  |     
|                                                                                                                         |  | $   
|                                                                                                                         |  |     
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                     |  |     
|                                                                                                                         | 
|Liabilities                                                                                                              |  |     
|Noninterest-bearing deposits                                                                                             |  | $   
|Interest-bearing deposits (Note 5)                                                                                       |  |     
|                                                                                                                         |  |     
|Total deposits                                                                                                           |  |     
|Short-term borrowings (Note 6)                                                                                           |  |     
|Federal Home Loan Bank borrowings (Note 7)                                                                               |  |     
|Accrued interest payable                                                                                                 |  |     
|Other liabilities                                                                                                        |  |     
|                                                                                                                         |  |     
|                                                                                                                         |  |     
|                                                                                                                         |  |     
|Commitments and Contingencies (Notes 8 and 14)                                                                           |  |     
|                                                                                                                         |  |     
|Redeemable Common Stock Held By Employee Stock
     Ownership Plan (ESOP) (Note 8)                                       |  |     
|                                                                                                                         |  |     
|Stockholders Equity (Note 10)                                                                                           |  |     
|Capital stock, no par value; authorized 10,000,000 shares;
          issued 2006 4,571,659 shares; 2005 4,563,637 shares |  |     
|Paid in capital                                                                                                          |  |     
|Retained earnings                                                                                                        |  |     
|Accumulated other comprehensive income (loss)                                                                            |  |     
|Treasury stock at cost (2006 67,921 shares; 2005 1,400 shares)                                                           |  |     
|                                                                                                                         |  |     
|                                                                                                                         |  |     
|Less maximum cash obligation related to ESOP shares (Note 8)                                                             |  |     
|                                                                                                                         |  |     
|                                                                                                                         |  |     
|                                                                                                                         |  |     
|                                                                                                                         |  | $   
|                                                                                                                         |  |     

|                                               
|-----------------------------------------------
|See Notes to Consolidated Financial Statements.
|Page 54 of 97                                  



|HILLS BANCORPORATION                            
|------------------------------------------------
|                                                
|                                                
|CONSOLIDATED STATEMENTS OF INCOME               
|Years Ended December 31, 2006, 2005 and 2004    
|(Amounts In Thousands, Except Per Share Amounts)
|                                                

|                                                                         |      |        |     
|------------------------------------------------------------------------ | ---- | ------ | ----
|                                                                         | 2006 |        | 2005
|                                                                         |     
|Interest income:                                                         |      |        |     
|Loans, including fees                                                    | $    | 80,240 |     
|Investment securities:                                                   |      |        |     
|Taxable                                                                  |      | 4,438  |     
|Nontaxable                                                               |      | 2,900  |     
|Federal funds sold                                                       |      | 40     |     
|                                                                         |      |       
|Total interest income                                                    |      | 87,618 |     
|                                                                         |      |       
|Interest expense:                                                        |      |        |     
|Deposits                                                                 |      | 27,841 |     
|Short-term borrowings                                                    |      | 2,801  |     
|FHLB borrowings                                                          |      | 11,720 |     
|                                                                         |      |       
|Total interest expense                                                   |      | 42,362 |     
|                                                                         |      |       
|Net interest income                                                      |      | 45,256 |     
|Provision for loan losses (Note 3)                                       |      | 3,011  |     
|                                                                         |      |       
|Net interest income after provision 
                    for loan losses |      | 42,245 |     
|                                                                         |      |       
|Other income:                                                            |      |        |     
|Net gain on sale of loans                                                |      | 859    |     
|Net losses on sale of investment securities                              |      |       |     
|Trust fees                                                               |      | 3,423  |     
|Service charges and fees                                                 |      | 6,927  |     
|Rental revenue on tax credit real estate                                 |      | 781    |     
|Other noninterest income                                                 |      | 2,621  |     
|                                                                         |      |       
|                                                                         |      | 14,611 |     
|                                                                         |      |       
|Other expenses:                                                          |      |        |     
|Salaries and employee benefits                                           |      | 18,468 |     
|Occupancy                                                                |      | 2,222  |     
|Furniture and equipment                                                  |      | 3,443  |     
|Office supplies and postage                                              |      | 1,297  |     
|Advertising and business development                                     |      | 1,843  |     
|Outside services                                                         |      | 4,888  |     
|Rental expenses on tax credit real estate                                |      | 958    |     
|Other noninterest expenses                                               |      | 1,245  |     
|                                                                         |      |       
|                                                                         |      | 34,364 |     
|                                                                         |      |       
|Income before income taxes                                               |      | 22,492 |     
|Income taxes (Note 9)                                                    |      | 6,933  |     
|                                                                         |      |       
|Net income                                                               | $    | 15,559 |     
|                                                                         |      |       
|                                                                        
|Earnings per share:                                                      |      |        |     
|Basic                                                                    | $    | 3.42   |     
|Diluted                                                                  |      | 3.39   |     
|                                                                         |      |        |     
|See Notes to Consolidated Financial Statements.                         

|Page 55 of 97
|-------------



|HILLS BANCORPORATION                           
|-----------------------------------------------
|                                               
|CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
|Years Ended December 31, 2006, 2005 and 2004   
|(Amounts In Thousands)                         
|                                               

|                                                                                                                               |      |        |     
|------------------------------------------------------------------------------------------------------------------------------ | ---- | ------ | ----
|                                                                                                                               | 2006 |        | 2005
|                                                                                                                               |     
|                                                                                                                              
|Net income                                                                                                                     | $    | 15,559 |     
|                                                                                                                              
|Other comprehensive income (loss),                                                                                             |      |        |     
|Unrealized gains (losses) on securities:                                                                                       |      |        |     
|Unrealized holding gains (losses) arising during the year,
        net of income taxes 2006 $320; 2005 ($1,443); 2004 ($1,474) |      | 518    |     
|                                                                                                                              
|Less: reclassification adjustment for losses included 
          in net income,net of income taxes                             |      |       |     
|                                                                                                                               |      |       
|                                                                                                                              
|Other comprehensive income (loss)                                                                                              |      | 518    |     
|                                                                                                                               |      |       
|                                                                                                                              
|Comprehensive income                                                                                                           | $    | 16,077 |     
|                                                                                                                               |      |       

|                                               
|-----------------------------------------------
|See Notes to Consolidated Financial Statements.
|Page 56 of 97                                  



|HILLS BANCORPORATION                           
|-----------------------------------------------
|                                               
|CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
|Years Ended December 31, 2006, 2005 and 2004   
|(Amounts In Thousands, Except Share Amounts)   
|                                               

|                                                             |  |                       |        |                         |   |                                                                
|------------------------------------------------------------ |  | --------------------- | ------ | ----------------------- | - | ---------------------------------------------------------------
|                                                             |  | Paid In
      Capital |        | Retained
      Earnings |   | Accumulated
      Other
      Comprehensive
      Income (Loss)
|                                                             | 
|                                                            
|Balance, December 31, 2003                                   |  | $                     | 11,353 |                         | $ | 97,189                                                         
|                                                             |  |                      
|Issuance of 222 shares of 
      common stock                |  |                       | 7      |                         |   |                                                               
|Forfeiture of 600 shares
      of common stock               |  |                       | (18    | )                       |   |                                                               
|Change related to ESOP shares                                |  |                       |       |                         |   |                                                               
|Net income                                                   |  |                       |       |                         |   | 14,195                                                         
|Income tax benefit related toshare-based compensation        |  |                       | 22     |                         |   |                                                               
|Cash dividends ($.70 per share)                              |  |                       |       |                         |   | (3,185                                                         
|Other comprehensive (loss)                                   |  |                       |       |                         |   |                                                               
|                                                             |  |                      
|Balance, December 31, 2004                                   |  | $                     | 11,364 |                         | $ | 108,199                                                        
|                                                             |  |                      
|Issuance of 14,882 shares of
      common stock              |  |                       | 619    |                         |   |                                                               
|Forfeiture of 901shares
      of common stock                |  |                       | (29    | )                       |   |                                                               
|Change related to ESOP shares                                |  |                       |       |                         |   |                                                               
|Net income                                                   |  |                       |       |                         |   | 15,202                                                         
|Income tax benefit related to
      share-based compensation |  |                       | 16     |                         |   |                                                               
|Cash dividends ($.75 per share)                              |  |                       |       |                         |   | (3,412                                                         
|Purchase of 1,400 shares
      of common stock               |  |                       |       |                         |   |                                                               
|Other comprehensive (loss)                                   |  |                       |       |                         |   |                                                               
|                                                             |  |                      
|Balance, December 31, 2005                                   |  | $                     | 11,970 |                         | $ | 119,989                                                        
|                                                             |  |                      
|Issuance of 9,715 shares of
      common stock               |  |                       | 346    |                         |   |                                                               
|Forfeiture of 1,693 shares
      of common stock             |  |                       | (63    | )                       |   |                                                               
|Share-based compensation                                     |  |                       | 44     |                         |   |                                                                
|Income tax benefit related to
      share-based compensation |  |                       | 67     |                         |   |                                                               
|Change related to ESOP shares                                |  |                       |       |                         |   |                                                               
|Net income                                                   |  |                       |       |                         |   | 15,559                                                         
|Cash dividends ($.81 per share)                              |  |                       |       |                         |   | (3,696                                                         
|Purchase of 66,521 shares
      of common stock              |  |                       |       |                         |   |                                                               
|Other comprehensive income                                   |  |                       |       |                         |   |                                                               
|                                                             |  |                      
|Balance, December 31, 2006                                   |  | $                     | 12,364 |                         | $ | 131,852                                                        
|                                                             |  |                      
|                                                             | 
|See Notes to Consolidated Financial Statements.              | 

|Page 57 of 97
|-------------



|HILLS BANCORPORATION                        
|--------------------------------------------
|                                            
|CONSOLIDATED STATEMENTS OF CASH FLOWS       
|Years Ended December 31, 2006, 2005 and 2004
|(Amounts In Thousands)                      
|                                            

|                                                                                                                |  |      |         
|--------------------------------------------------------------------------------------------------------------- |  | ---- | --------
|                                                                                                                |  | 2006 |         
|                                                                                                                | 
|Cash Flows from Operating Activities                                                                            |  |      |         
|Net income                                                                                                      |  | $    | 15,559  
|Adjustments to reconcile net income to net cash and 
        cash equivalents provided by operating activities: |  |      |         
|Depreciation                                                                                                    |  |      | 2,403   
|Provision for loan losses                                                                                       |  |      | 3,011   
|Net losses on sale of investment securities                                                                     |  |      |        
|Share-based compensation                                                                                        |  |      | 44      
|Compensation expensed through issuance of common stock                                                          |  |      | 207     
|Income tax benefits related to share-based compensation                                                         |  |      | 67      
|Forfeiture of common stock                                                                                      |  |      | (63     
|Provision for deferred income taxes                                                                             |  |      | (1,114  
|Increase in accrued interest receivable                                                                         |  |      | (1,673  
|Amortization of discount on investment securities, net                                                          |  |      | 504     
|(Increase) decrease in other assets                                                                             |  |      | 236     
|Increase in accrued interest and other liabilities                                                              |  |      | 379     
|Loans originated for sale                                                                                       |  |      | (104,286
|Proceeds on sales of loans                                                                                      |  |      | 102,039 
|Net gain on sales of loans                                                                                      |  |      | (859    
|                                                                                                                |  |     
|Net cash and cash equivalents provided by 
                    operating activities                             |  |      | 16,454  
|                                                                                                                |  |     
|                                                                                                               
|Proceeds from maturities of investment securities:                                                              |  |      |         
|Available for sale                                                                                              |  |      | 40,270  
|Held to maturity                                                                                                |  |      | 45      
|Proceeds from sales of investment securities available for sale                                                 |  |      |        
|Purchases of investment securities:                                                                             |  |      |         
|Available for sale                                                                                              |  |      | (21,964 
|Held to maturity                                                                                                |  |      |        
|Federal funds sold, net                                                                                         |  |      |        
|Loans made to customers, net of collections                                                                     |  |      | (140,522
|Purchases of property and equipment                                                                             |  |      | (2,199  
|Investment in tax credit real estate, net                                                                       |  |      | 484     
|                                                                                                                |  |     
|Net cash used in investing activities                                                                           |  |      | (123,886
|                                                                                                                |  |     

|           
|-----------
|(Continued)

|Page 58 of 97
|-------------



|HILLS BANCORPORATION                             
|-------------------------------------------------
|                                                 
|CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
|Years Ended December 31, 2006, 2005 and 2004     
|(Amounts In Thousands)                           
|                                                 

|                                                                       |  |  |     
|---------------------------------------------------------------------- |  |  | ----
|                                                                       |  |  | 2006
|                                                                       | 
|Cash Flows from Financing Activities                                   |  |  |     
|Net increase in deposits                                               |  |  |     
|Net (increase) decrease in short-term borrowings                       |  |  |     
|Borrowings from FHLB                                                   |  |  |     
|Payments on FHLB borrowings                                            |  |  |     
|Stock options exercised                                                |  |  |     
|Purchase of treasury stock                                             |  |  |     
|Dividends paid                                                         |  |  |     
|                                                                       |  | 
|Net cash provided by financing activities                              |  |  |     
|                                                                       |  | 
|                                                                      
|Increase (decrease) in cash and cash equivalents                       |  |  | $   
|                                                                       |  |  |     
|Cash and cash equivalents:                                             |  |  |     
|Beginning of year                                                      |  |  |     
|                                                                       |  | 
|End of year                                                            |  |  | $   
|                                                                       |  | 
|                                                                      
|Supplemental Disclosures 
    Cash payments for:                       |  |  |     
|Interest paid to depositors                                            |  |  | $   
|Interest paid on other obligations                                     |  |  |     
|Income taxes                                                           |  |  |     
|                                                                       |  |  |     
|Noncash financing activities:                                          |  |  |     
|Increase in maximum cash obligation related to
            ESOP shares |  |  | $   

|                                               
|-----------------------------------------------
|See Notes to Consolidated Financial Statements.
|Page 59 of 97                                  



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 1.   Nature of Activities and Significant Accounting Policies
Nature of activities: Hills Bancorporation (the Company) is a holding company engaged in the business
of commercial banking. The Companys subsidiary is Hills Bank and Trust Company, Hills, Iowa
(the Bank), which is wholly-owned. The Bank is a full-service commercial bank extending
its services to individuals, businesses, governmental units and institutional customers primarily
in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona,
Wellman, Cedar Rapids and Marion, Iowa.
The Bank competes with other financial institutions and nonfinancial institutions providing similar
financial products. Although the loan activity of the Bank is diversified with commercial and agricultural
loans, real estate loans, automobile, installment and other consumer loans, the Banks credit
is concentrated in real estate loans. All of the Companys operations are considered to be one
reportable operating segment.
Accounting estimates: The preparation of financial statements in conformity with accounting principles generally accepted
in the United States of America requires management to make estimates and assumptions that affect
the reported amount of assets and liabilities and disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts of revenues and expenses during
the reporting period. Actual results could differ from those estimates.
Certain significant estimates: The allowance for loan losses, fair values of securities and other financial instruments, and
share-based compensation expense involves 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, 2006 may change in the near-term future and that the effect could be material
to the consolidated financial statements.
Principles of consolidation: The consolidated financial statements include the accounts of the Company and its subsidiary.
All significant intercompany balances and transactions have been eliminated in consolidation.
Revenue recognition: Interest income on loans and investment securities is recognized on the accrual method. Loan origination
fees are recognized when the loans are sold. Trust fees, deposit account service charges and other
fees are recognized when the services are provided or when customers use the services.
Investment securities: Held-to-maturity securities consist solely of debt securities, which the Company has the positive
intent and ability to hold to maturity and are stated at amortized cost.
Available-for-sale securities consist of debt securities not classified as trading or held to maturity.
Available-for-sale securities are stated at fair value, and unrealized holding gains and losses,
net of the related deferred tax effect, are reported as a separate component of stockholders
equity. There were no trading securities as of December 31, 2006 and 2005.
Stock of the Federal Home Loan Bank is carried at cost.
Premiums on debt securities are amortized over the earliest of the call date or the maturity 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.
Unrealized losses judged to be other than temporary are charged to operations for both securities available
for sale and securities held to maturity, and a new cost basis of the securities written down is
established.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 60 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 1.   Nature of Activities and Significant Accounting Policies (Continued)
Loans:  Loans are stated at the amount of unpaid principal, reduced by the allowance for loan
losses. Interest income is accrued on the unpaid balances as earned.
Loans held for sale are stated at the lower of aggregate cost or estimated fair value. Loans are sold
on a non-recourse basis with servicing released and gains and losses are recognized based on the
difference between sales proceeds and the carrying value of the loan.
The 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.
Loans are considered non-performing when, based on current information and events, it is probable the
Bank will not be able to collect all amounts due. A non-performing loan includes any loan that has
been placed on nonaccrual status. 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
non-performing 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 non-performing loans or of collateral value is reported as bad debt expense in the same
manner in which impairment initially was recognized or as a reduction in the amount of bad debt expense
that otherwise would be reported. Interest income on non-performing loans is recognized on the cash basis.
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.
Loan fees and origination costs are reflected in the consolidated statements of income as collected
or incurred. Compared to the net deferral method, this practice had no significant effect on income
in any of the years presented.
Transfers of financial assets: Transfers of financial assets are accounted for as sales, when control over the assets has been
surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have
been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain
it from taking advantage of that right) to pledge or exchange the transferred assets and (3) the
Company does not maintain effective control over the transferred assets through an agreement to repurchase
them before their maturity or the ability to unilaterally cause the holder to return specific assets.
Credit related financial instruments: In the ordinary course of business, the Company has entered into commitments to extend credit,
including commitments under credit card arrangements, commercial letters of credit and standby letters
of credit. Such financial instruments are recorded when they are funded.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 61 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 1.   Nature of Activities and Significant Accounting Policies (Continued)
Tax credit real estate: Tax credit real estate represents two multi-family rental properties and an assisted living
rental property, all which are affordable housing projects as of December 31, 2006. The Bank has
a 99% limited partnership interest in each limited partnership. The investment in each was completed
after the projects had been developed by the general partner. The properties are recorded at cost
less accumulated depreciation. The Company evaluates the recoverability of the carrying value on
a regular basis. If the recoverability was determined to be in doubt, a valuation allowance would
be established by way of a charge to expense. Depreciation expense is provided on a straight-line
basis over the estimated useful life of the assets. Expenditures for normal repairs and maintenance
are charged to expense as incurred.
The financial condition, results of operations and cash flows of each limited partnership is consolidated
in the Companys financial statements. 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.
Property and equipment: Property and equipment is stated at cost less accumulated depreciation. Depreciation is computed
using primarily declining-balance methods over the estimated useful lives of 7-40 years for buildings
and improvements and 3-10 years for furniture and equipment.
Deferred income taxes: Deferred income taxes are provided under the liability method whereby deferred tax assets are
recognized for deductible temporary differences and net operating loss, and tax credit carryforwards
and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences
are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred
tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely
than not that some or all of the deferred tax assets will not be realized. Deferred tax assets and
liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
Goodwill:   Goodwill represents the excess of cost over the fair value of the net assets acquired,
and FASB Statement No. 142 provides for the elimination of the amortization of goodwill and other
intangibles that are determined to have an indefinite life, and requires, at a minimum, annual impairment
tests for intangibles that are determined to have an indefinite life. The carrying amount of goodwill
as of December 31, 2006 and 2005 totaled $2,500,000.
Other real estate:    Other real estate represents property acquired through foreclosures and settlements
of loans. Property acquired is carried at the lower of the principal amount of the loan outstanding
at the time of acquisition, plus any acquisition costs, or the estimated fair value of the property,
less disposal costs. Subsequent write downs estimated on the basis of later valuations, gains or
losses on sales and net expenses incurred in maintaining such properties are charged to other non-interest
expense. Other real estate is included in other assets and totaled $801,000 and $1,152,000 as of
2006 and 2005, respectively.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 62 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 1.   Nature of Activities and Significant Accounting Policies (Continued)
    Earning per share:    Basic earnings per share is computed using the weighted average number of actual common shares outstanding during the period. Diluted earnings per share reflects the potential dilution that would occur from the exercise of common stock options outstanding. The following table presents calculations of earnings per share:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

|                                                                                                                                     |  |                         |          
|------------------------------------------------------------------------------------------------------------------------------------ |  | ----------------------- | ---------
|                                                                                                                                     |  | Year Ended December 31, |          
|                                                                                                                                     |  | 2006                    |          
|                                                                                                                                     |  |                         |          
|                                                                                                                                     |  | (Amounts In Thousands)  |          
|Computation of weighted average number of basic and diluted shares:                                                                  |  |                         |          
|Common shares outstanding at the beginning of the year                                                                               |  |                         | 4,562,237
|Weighted average number of net shares issued (redeemed)                                                                              |  |                         | (6,215   
|                                                                                                                                     |  |                        
|Weighted average shares outstanding (basic)                                                                                          |  |                         | 4,556,022
|Weighted average of potential dilutive shares attributable to stock        options granted, computed under the treasury stock method |  |                         | 25,581   
|                                                                                                                                     |  |                        
|Weighted average number of shares (diluted)                                                                                          |  |                         | 4,581,603
|                                                                                                                                     |  |                        
|                                                                                                                                    
|Net income (In Thousands)                                                                                                            |  | $                       | 15,559   
|                                                                                                                                     |  |                        
|                                                                                                                                    
|Earnings per share:                                                                                                                  |  |                         |          
|Basic                                                                                                                                |  | $                       | 3.42     
|                                                                                                                                     |  |                        
|Diluted                                                                                                                              |  | $                       | 3.39     
|                                                                                                                                     |  |                        

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Stock awards and options: For the year ended December 31, 2006, compensation expense for stock issued through the stock
award plan is accounted for using the fair value method prescribed by Statement of Financial Accounting
Standards No. 123 (revised 2004), Share-Based Payment (FAS 123R). Under this method,
compensation expense is measured and recognized for all stock-based awards made to employees and
directors based on the fair value of each option as of the date of the grant.
For the years ended December 31, 2005 and 2004, compensation expense for stock issued through the stock
award plan was accounted for using the intrinsic value based method of accounting prescribed by APB
Opinion No. 25, Accounting for Stock Issues to Employees. Under this method, compensation
was measured as the difference between the estimated fair value of the stock at the date of award
less the amount required to be paid for the stock. The difference, if any, was amortized straight
line to expense over the vesting period of five years of service. No share-based employee compensation
cost was recognized in 2005 and 2004 because all options granted under the plan had an exercise price
equal to the market value of the underlying common stock on the date of grant. See Note 8 to the
Financial Statements for a tabular presentation of the reconciliation between net income, basic earnings
per share and diluted earnings per share as reported in the financial statements and as the information
would have been reported (pro forma) if the Company has chosen to implement the fair value based
method for all options.
Common stock held by ESOP: The Companys maximum cash obligation related to these shares is classified outside stockholders
equity because the shares are not readily traded and could be put to the Company for cash.

|Page 63 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 1. Nature of Activities and Significant Accounting Policies (Continued)
Fair value of financial instruments: In cases where quoted market prices are not available, fair values of financial instruments
are based on estimates using present value or other valuation techniques. Those techniques are significantly
affected by the assumptions used, including the discount rate and estimates of future cash flows.
In that regard, the derived fair value estimates cannot be substantiated by comparison to independent
markets and, in many cases, could not be realized in immediate settlement of the instrument. Certain
financial instruments and all nonfinancial instruments are excluded from fair value disclosure. Accordingly,
the aggregate fair value amounts presented in Note 12 to the Financial Statements do not represent
the underlying value of the Company.
The following methods and assumptions were used by the Company in estimating the fair value of its
financial instruments:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

| | Off-balance sheet instruments: Fair values for outstanding letters of credit are based on fees currently charged to enter into
  similar agreements, taking into account the remaining terms of the agreements and the counterparties credit standing. The fair value of the outstanding letters of credit is not significant. Unfunded
  loan commitments are not valued since the loans are generally priced at market at the time of funding.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Cash and due from banks and federal funds sold: The carrying amounts reported in the consolidated balance sheets for cash and short-term instruments
  approximate their fair values.                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Investment securities: Fair values for investment securities are based on quoted market prices, where available. If
  quoted market prices are not available, fair values are based on quoted market prices of comparable
  instruments.                                                                                                                                                                                                         
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Loans receivable:  For variable-rate loans that reprice frequently and with no significant change in credit
  risk, fair values are based on carrying values. The fair values for other loans are determined using
  estimated future cash flows, discounted at the interest rates currently being offered for loans with
  similar terms to borrowers with similar credit quality.                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Accrued interest receivable:  The fair value of accrued interest receivable equals the amount receivable due to the current
  nature of the amounts receivable.                                                                                                                                                                                                                                                                                  
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Deposit liabilities: The fair values of deposits equal their carrying amounts, which represent the amount payable
  on demand.                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Short-term borrowings: The carrying amounts of federal funds sold and securities sold under agreements to repurchase
  approximate their fair values.                                                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Long-term borrowings: The fair values of the Banks long-term borrowings (other than deposits) are estimated
  using discounted cash flow analyses, based on the Banks current incremental borrowing rates
  for similar types of borrowing arrangements.                                                                                                                                                                                       
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Accrued interest payable: The fair value of accrued interest payable equals the amount payable due to the current nature
  of the amounts payable.                                                                                                                                                                                                                                                                                               

|                                                                                                               
|---------------------------------------------------------------------------------------------------------------
|Reclassifications:  Certain prior year amounts may be reclassified to conform to the current year presentation.

|Page 64 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 2. Investment Securities
Investment Securities Available For Sale:
Investment securities have been classified in the consolidated balance sheets according to managements
intent. The Company had no securities designated as trading in its portfolio at December 31, 2006
or 2005. The carrying amount of available-for-sale securities and their approximate fair values were
as follows December 31 (in thousands):
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

|                                           |  |  |                      |        
|------------------------------------------ |  |  | -------------------- | -------
|                                           |  |  | Amortized
      Cost |        
|                                           |  | 
|                                          
|December 31, 2006:                         |  |  |                      |        
|U. S. Government agencies and corporations |  |  | $                    | 95,554 
|State and political subdivisions           |  |  |                      | 84,552 
|                                           |  | 
|Total                                      |  |  | $                    | 180,106
|                                           |  | 
|                                          
|December 31, 2005:                         |  |  |                      |        
|U. S. Government agencies and corporations |  |  | $                    | 119,808
|State and political subdivisions           |  |  |                      | 79,865 
|                                           |  | 
|Total                                      |  |  | $                    | 199,673
|                                           |  | 

|                                                                                                                                                                                              
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The amortized cost and estimated fair market value of available-for-sale securities classified according to their contractual maturities at December 31, 2006, were as follows (in thousands):
|                                                                                                                                                                                              

| |                                        | 
| | -------------------------------------- | 
| | Amortized
      Cost                   | 
| |                                        | 
|
| | Due in one year or less                | 
| | Due after one year through five years  | 
| | Due after five years through ten years | 
| | Due over ten years                     | 
| |                                        | 
| | Total                                  | 
| |                                        | 

|                                                                                                                                                                                                                           
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|As of December 31, 2006, investment securities with a carrying value of $59,063,000 were pledged to collateralize public and trust deposits, short-term borrowings and for other purposes, as required or permitted by law.

|Page 65 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 2. Investment Securities (Continued)
    Sales proceeds and gross realized gains and losses on available-for-sale securities were as follows for the years ended December 31 (in thousands):
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                

| |                       |  | 
| | --------------------- |  | 
| |                       |  | 
| |                       |  | 
| | Sales proceeds        |  | 
| | Gross realized gains  |  | 
| | Gross realized losses |  | 

|                                                                                                                                                                                                                                                                             
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The following table shows the Companys investments gross unrealized losses and fair value,
aggregated by investment category and length of time that individual securities have been in a continuous
unrealized loss position at December 31, 2006 and 2005 (in thousands):
|                                                                                                                                                                                                                                                                             

|                                                 |  |                     |  |                   |        |                       |   |     |   |  |      |  
|------------------------------------------------ |  | ------------------- |  | ----------------- | ------ | --------------------- | - | --- | - |  | ---- | -
|                                                 |  | Less than 12 months |  | 12 months or more |        | Total                 |  
|                                                 |  |                     |  |                   |        |                       |  
|2006 
      Description 
      of Securities     |  | #                   |  | Fair Value        |        | Unrealized
      Loss |   |     | % |  |      | #
|                                                 |  |                     |  |                   |        |                       |  
|                                                 |  |                     |  |                   |        |                       |   |     |   |  |      |  
|U.S. Government
   agencies and 
   corporations |  | 1                   |  | $                 | 3,529  |                       | $ | (10 | ) |  | 0.28 | %
|                                                 |  |                     |  |                   |        |                       |   |     |   |  |      |  
|                                                 |  |                     |  |                   |        |                       |   |     |   |  |      |  
|State andmunicipal 
    bonds                    |  | 52                  |  |                   | 9,431  |                       |   | (36 | ) |  | 0.38 | %
|                                                 |  |                     |  |                   |        |                       |  
|                                                 |  |                     |  |                   |        |                       |   |     |   |  |      |  
|                                                 |  |                     |  |                   |        |                       |   |     |   |  |      |  
|Total temporarily
   impaired
   securities      |  | 53                  |  | $                 | 12,960 |                       | $ | (46 | ) |  | 0.35 | %
|                                                 |  |                     |  |                   |        |                       |  
|                                                 |  |                     |  |                   |        |                       |   |     |   |  |      |  

|                                                 |  |                     |  |                   |        |                       |   |        |   |  |      |  
|------------------------------------------------ |  | ------------------- |  | ----------------- | ------ | --------------------- | - | ------ | - |  | ---- | -
|                                                 |  |                     |  |                   |        |                       |  
|                                                 |  | Less than 12 months |  | 12 months or more |        | Total                 |  
|                                                 |  |                     |  |                   |        |                       |  
|2005
      Description 
      of Securities      |  | #                   |  | Fair Value        |        | Unrealized
      Loss |   |        | % |  |      | #
|                                                 |  |                     |  |                   |        |                       |  
|                                                 |  |                     |  |                   |        |                       |   |        |   |  |      |  
|U.S. Government
   agencies and 
   corporations |  | 25                  |  | $                 | 51,103 |                       | $ | (842   | ) |  | 1.65 | %
|                                                 |  |                     |  |                   |        |                       |   |        |   |  |      |  
|State and 
   municipal
   bonds                 |  | 171                 |  |                   | 35,645 |                       |   | (591   | ) |  | 1.66 | %
|                                                 |  |                     |  |                   |        |                       |  
|                                                 |  |                     |  |                   |        |                       |   |        |   |  |      |  
|Total temporarily 
   impaired 
   securities    |  | 196                 |  | $                 | 86,748 |                       | $ | (1,433 | ) |  | 1.65 | %
|                                                 |  |                     |  |                   |        |                       |  

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|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. The nature of the investments with gross unrealized losses as of December 31, 2006 was as follows: U.S. government agency securities (39 positions issued and guaranteed by FNMA, FHLB, or FHLMC); and state and municipal bonds (74 issues are local issues, nonrated and 187 issues are A1 or better rated, general obligation bonds). Therefore, none of the impairments 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 cause of the impairments is due to changes in interest rates. The Company has not recognized any unrealized loss in income because management has the intent and ability to hold the securities for the
  foreseeable future.

|Page 66 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 2. Investment Securities (Continued)
    Investment Securities Held to Maturity:
|----------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                    

|                                 |  |  |                      |                       
|-------------------------------- |  |  | -------------------- | ----------------------
|                                 |  |  | Amortized
      Cost |                       
|                                 |  |  |                      |                       
|                                 |  |  |                      | (Amounts In Thousands)
|December 31, 2006:               |  |  |                      |                       
|State and political subdivisions |  |  | $                    | 170                   
|                                 |  | 
|                                
|December 31, 2005:               |  |  |                      |                       
|State and political subdivisions |  |  | $                    | 215                   
|                                 |  | 

|                                                                                                                                                                                               
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The amortization cost and estimated fair market value of securities held to maturity classified according
to their contractual maturities at December 31, 2006, were as follows (in thousands):
|                                                                                                                                                                                               

| |                                        | 
| | -------------------------------------- | 
| | Amortized
      Cost                   | 
| |                                        | 
| | Due in one year or less                | 
| | Due after one year through five years  | 
| | Due after five years through ten years | 
| |                                        | 
| | Total                                  | 
| |                                        | 

|                                                         
|---------------------------------------------------------
|Note 3. Loans
    The composition of loans is as follows:
|                                                         

| |                                |  |     
| | ------------------------------ |  | ----
| |                                |  |     
| |                                |  |     
| | 2006                           |  | 2005
| |                                |  |     
| |                                |  |     
| |                                | 
| | Agricultural                   |  |     
| | Commercial and financial       |  |     
| | Real estate:                   |  |     
| | Construction                   |  |     
| | Mortgage                       |  |     
| | Loans to individuals           |  |     
| |                                |  |     
| |                                |  |     
| | Less allowance for loan losses |  |     
| |                                |  |     
| |                                |  |     
| |                                |  |     

|Page 67 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 3. Loans (Continued)
    Changes in the allowance for loan losses are as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                     

|                             |  |  |                        
|---------------------------- |  |  | -----------------------
|                             |  |  | Year Ended December 31,
|                             |  |  | 2006                   
|                             |  |  |                        
|                             |  |  | (Amounts In Thousands) 
|                            
|Balance, beginning           |  |  | $                      
|Provision charged to expense |  |  |                        
|Recoveries                   |  |  |                        
|Loans charged off            |  |  |                        
|                             |  | 
|Balance, ending              |  |  | $                      
|                             |  | 

|                                                                                                                                    
|------------------------------------------------------------------------------------------------------------------------------------
|Information about non-performing and nonaccrual loans as of and for the years ended December 31, 2006,
2005 and 2004 are as follows:
|                                                                                                                                    

|                                                                              |  |  |                       
|----------------------------------------------------------------------------- |  |  | ----------------------
|                                                                              |  |  | 2006                  
|                                                                              |  |  |                       
|                                                                              |  |  | (Amounts In Thousands)
|                                                                             
|Loans receivable for which there is a related allowance 
     for loan losses |  |  | $                     
|Loans receivable for which there is no related allowance 
    for loan losses |  |  |                       
|                                                                              |  | 
|**Total**                                                                     |  |  | $                     
|                                                                              |  | 
|                                                                             
|Related allowance for credit losses on non-performing loans                   |  |  | $                     
|Average balance of non-performing loans                                       |  |  |                       
|Nonaccrual loans (included as non-performing loans)                           |  |  |                       
|Loans past due ninety days or more and still accruing                         |  |  |                       
|Interest income recognized on non-performing loans                            |  |  |                       

|                                                                                                                                    
|------------------------------------------------------------------------------------------------------------------------------------
|Note 4.Property and Equipment
    The major classes of property and equipment and the total accumulated depreciation are as follows:

|                              |  |  |                       
|----------------------------- |  |  | ----------------------
|                              |  |  |                       
|                              |  |  | December 31,          
|                              |  |  |                       
|                              |  |  | 2006                  
|                              |  |  |                       
|                              |  |  | (Amounts In Thousands)
|                             
|Land                          |  |  | $                     
|Buildings and improvements    |  |  |                       
|Furniture and equipment       |  |  |                       
|                              |  | 
|                              |  |  |                       
|Less accumulated depreciation |  |  |                       
|                              |  | 
|Net                           |  |  | $                     
|                              |  | 

|Page 68 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 5. Interest-Bearing Deposits
    A summary of these deposits is as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                               

|                        |  | 
|----------------------- |  | 
|                        |  | 
|                        |  | 
|                        |  | 
|                        |  | 
|                        |  | 
|                       
|NOW and other demand    |  | 
|Savings                 |  | 
|Time, $100,000 and over |  | 
|Other time              |  | 
|                        |  | 
|                        |  | 
|                        |  | 

|                                         
|-----------------------------------------
|Time deposits have a maturity as follows:
|                                         

| |                                          | 
| | ---------------------------------------- | 
| |                                          | 
| |                                          | 
| |                                          | 
| |                                          | 
| | Due in one year or less                  | 
| | Due after one year through two years     | 
| | Due after two years through three years  | 
| | Due after three years through four years | 
| | Due over four years                      | 
| |                                          | 
| |                                          | 
| |                                          | 

|                                                                                                                                                                   
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note 6. Short-Term Borrowings
    The following table sets forth selected information for short-term borrowings (borrowings with a maturity of less than one year):
|                                                                                                                                                                   

|                                                                                                                                   |  | 
|---------------------------------------------------------------------------------------------------------------------------------- |  | 
|                                                                                                                                   |  | 
|                                                                                                                                   |  | 
|                                                                                                                                   |  | 
|                                                                                                                                   |  | 
|Federal funds purchased, secured by U.S. Government agencies                                                                       |  | 
|                                                                                                                                   |  | 
|Repurchase agreements with customers, renewable daily, interest 
      payable monthly, secured by U.S. Government agencies        |  | 
|Repurchase agreements with customers, interest fixed, maturities of 
      less than one year, secured by U.S. Government agencies |  | 
|                                                                                                                                   |  | 
|                                                                                                                                   |  | 
|                                                                                                                                   |  | 

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The weighted average interest rate on short-term borrowings outstanding as of December 31, 2006 and
2005 was 4.40% and 3.45%, respectively.
Customer repurchase agreements are used by the Bank to acquire funds from customers where the customer
is required or desires to have their funds supported by collateral consisting of government, government
agency or other types of securities. The repurchase agreement is a commitment to sell these securities
to a customer at a certain price and repurchase them at a future date at that same price plus interest
accrued at an agreed upon rate. The Bank uses customer repurchase agreements in its liquidity plan
as well as an accommodation to customers. At December 31, 2006, $48.4 million of securities sold
under repurchase agreements with a weighted average interest rate of 4.17%, maturing in 2007, were
collateralized by U.S. Government agencies having an estimated fair value of $56.6 million and an
amortized cost of $57.6 million.

|Page 69 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 7.   Federal Home Loan Bank Borrowings
    As of December 31, 2006 and 2005, the borrowings were as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                

| |                                                    | 
| | -------------------------------------------------- | 
| |                                                    | 
| |                                                    | 
| | (Effective interest rates as of December 31, 2006) | 
| |                                                    | 
| | Due 2006                                           | 
| | Due 2007, 4.48%                                    | 
| | Due 2008, 5.25% to 6.00%                           | 
| | Due 2009, 5.66% to 6.22%                           | 
| | Due 2010, 5.77% to 6.61%                           | 
| | Due 2015, 3.70% to 4.56%                           | 
| | Due 2016, 4.46% to 4.69%                           | 
| |                                                    | 
| |                                                    | 
| |                                                    | 

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|$215 million of the borrowings were callable as of December 31, 2006, with $110 million callable in
the first quarter of 2007. The advances are unlikely to be called unless rates would move significantly
upwards.
The advances from the FHLB are collateralized by the Companys investment in FHLB stock of $12,757,000
and $12,000,000 at December 31, 2006 and 2005, respectively. Additional collateral is provided by
the Companys 1-4 family mortgage loans totaling $282,455,000 at December 31, 2006 and $267,794,000
at December 31, 2005.
Note 8.   Employee Benefit Plans
The Company has an Employee Stock Ownership Plan (the ESOP) to which it makes discretionary
cash contributions. The Companys contribution to the ESOP totaled $123,000, $115,000 and $1,038,000
for the years ended December 31, 2006, 2005 and 2004, respectively.
In the event a terminated plan participant desires to sell his or her shares of the Company stock,
or for certain employees who elect to diversify their account balances, the Company may be required
to purchase the shares from the participant at their fair value. To the extent that shares of common
stock held by the ESOP are not readily tradeable, a sponsor must reflect the maximum cash obligation
related to those securities outside of stockholders equity as a liability. Effective June 30,
2005, as a result of the Companys program to repurchase up to a total of 750,000 shares of
the Companys common stock, the Company began obtaining a quarterly independent appraisal of
the shares of stock. Previously, the Company was obtaining an independent appraisal of the shares
of stock on an annual basis for the Companys ESOP. As of December 31, 2006 and 2005, the shares
held by the ESOP, fair value and maximum cash obligation were as follows:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

| |                         | 
| | ----------------------- | 
| | 2006                    | 
| |                         | 
|
| | Shares held by the ESOP | 
| |                         | 
| | Fair value per share    | 
| |                         | 
| | Maximum cash obligation | 
| |                         | 

|Page 70 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 8.    Employee Benefit Plans (Continued)
The Company has a profit-sharing plan with a 401(k) feature, which provides for discretionary annual
contributions in amounts to be determined by the Board of Directors. The profit-sharing contribution
totaled $983,000, $905,000, and $0 for the years ended December 31, 2006, 2005 and 2004, respectively.
The Companys made matching contributions under its 401(k) plan of $105,000 in 2006, $98,200
in 2005 and $95,500 in 2004.
The Company provides a deferred compensation program for executive officers. This program allows executive
officers to elect to defer a portion of their salaried compensation for payment by the Company at
a subsequent date. The executive officers can defer up to 30% of their base compensation and up to
100% of any bonus into the deferral plan. Any amount so deferred is credited to the executive officers
deferred compensation account and converted to units equivalent in value to the fair market value
of a share of stock in Hills Bancorporation. The stock units are book entry only and
do not represent an actual purchase of stock. The executive officers account is adjusted each
year for dividends paid and the change in the market value of Hills Bancorporation stock. The deferrals
and earnings grow tax deferred until withdrawn from the plan. Earnings credited to the individuals
accounts are recorded as compensation expense when earned. The deferred compensation liability is
recorded in other liabilities and totals $2.5 million and $2.3 million at December 31, 2006 and 2005,
respectively. Expense related to the deferred compensation plan was $256,000, $535,000 and $304,000
for 2006, 2005 and 2004, respectively.
The Company has a Stock Option and Incentive Plan for certain key employees and directors whereby shares
of commonstock have been reserved for awards in the form of stock options or restricted stock awards. Under
the plan, the aggregate number of options and shares granted cannot exceed 198,000 shares. A Stock
Option Committee may grant options at prices equal to the fair value of the stock at the date of
the grant. Options expire 10 years from the date of the grant. Directors may exercise options immediately
and officers rights under the plan vest over a five-year period from the date of the grant.
Prior to January 1, 2006, the Company accounted for the stock options under the recognition and measurement
principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees.
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised
2004), Share-Based Payment(FAS 123R), which requires the measurement and recognition of compensation expense for all stock-based
awards made to employees and Directors. The Company adopted FAS 123R using the modified prospective
transition method. The Consolidated Financial Statements as of and for year ended December 31, 2006
reflect the impact of FAS 123R and include $44,000 of share-based compensation expense. In accordance
with the modified prospective transition method, the Consolidated Financial Statements for prior
periods have not been restated.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Page 71 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 8.   Employee Benefit Plans (Continued)
    The results for the year ended December 31, 2006 are not directly comparable to the same periods in 2005 and 2004. Prior to the adoption of FAS 123R, the Company applied the existing accounting rules under APB Opinion No. 25, which provided that no compensation expense was charged for options granted at an exercise price equal to the market value of the underlying common stock on the date of the grant. If the fair value recognition provisions of FAS 123R had been applied to share-based compensation for the years ended December 31, 2005 and 2004, the Companys pro forma net income and earnings per share would have been as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

|                                                                                                                                                    |                         | 
|--------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------- | 
|                                                                                                                                                    | Year Ended December 31, | 
|                                                                                                                                                    |                         | 
|                                                                                                                                                    | 2005                    | 
|                                                                                                                                                    |                         | 
|Net income:                                                                                                                                         |                         | 
|As reported                                                                                                                                         |                         | 
|Deduct total share-based employee compensation expense determined
         under fair value based method for all awards, net of related tax effects |                         | 
|                                                                                                                                                    |                         | 
|Pro forma                                                                                                                                           |                         | 
|                                                                                                                                                    |                         | 
|                                                                                                                                                    |                        
|Basic earnings per share:                                                                                                                           |                         | 
|As reported                                                                                                                                         |                         | 
|Pro forma                                                                                                                                           |                         | 
|                                                                                                                                                    |                         | 
|Diluted earnings per share:                                                                                                                         |                         | 
|As reported                                                                                                                                         |                         | 
|Pro forma                                                                                                                                           |                         | 

|                                              
|----------------------------------------------
|A summary of the stock options are as follows:
|                                              

| |                            | 
| | -------------------------- | 
| |                            | 
| |                            | 
| | Balance, December 31, 2003 | 
| | Granted                    | 
| | Exercised                  | 
| |                            | 
| | Balance, December 31, 2004 | 
| | Granted                    | 
| | Exercised                  | 
| |                            | 
| | Balance, December 31, 2005 | 
| | Granted                    | 
| | Exercised                  | 
| |                            | 
| | Balance, December 31, 2006 | 
| |                            | 

|                                                                                                                           
|---------------------------------------------------------------------------------------------------------------------------
|The weighted-average fair value of options granted in 2006, 2005 and 2004 was none, none and $6.53 per share, respectively.

|Page 72 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 8.   Employee Benefit Plans (Continued)
    The fair value of each option is estimated as of the date of grant using a Black Scholes option pricing model. The expected lives of options granted incorporate historical employee exercise behavior. The risk-free rate for periods that coincide with the expected life of the options is based on the annual 10 year interest rate swap rate as published by the Federal Reserve Bank. Expected volatility is based on volatility levels of the Companys peers common stock as the Companys stock has limited trading activity. Expected dividend yield was based on historical dividend rates. Significant assumptions include:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

| |                         |  | 
| | ----------------------- |  | 
| |                         |  | 
| |                         |  | 
|
| | Risk-free interest rate |  | 
| | Expected option life    |  | 
| | Expected volatility     |  | 
| | Expected dividends      |  | 

|                                                                                                  
|--------------------------------------------------------------------------------------------------
|Other pertinent information related to the options outstanding at December 31, 2006 is as follows:
|                                                                                                  

|Exercise Price |       | Number Outstanding |        | Remaining Contractual Life |           | Number Exercisable |       
|-------------- | ----- | ------------------ | ------ | -------------------------- | --------- | ------------------ | ------
|               |      
|               |      
|$              | 13.67 |                    | 6,165  |                            | 3 Months  |                    | 6,165 
|               | 25.67 |                    | 26,150 |                            | 53 Months |                    | 26,150
|               | 25.00 |                    | 400    |                            | 48 Months |                    | 400   
|               | 29.33 |                    | 15,600 |                            | 72 Months |                    |      
|               | 33.67 |                    | 3,000  |                            | 84 Months |                    |      
|               | 34.50 |                    | 2,940  |                            | 88 Months |                    | 2,940 
|               | 36.25 |                    | 2,940  |                            | 93 Months |                    | 2,940 
|               |       |                    |        |                            |           |                    |       
|               |       |                    | 57,195 |                            |           |                    | 38,595
|               |       |                    |        |                            |           |                    |       

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|As of December 31, 2006, the outstanding options have a weighted-average exercise price of $26.79 per
share and a weighted average remaining contractual term of 4.88 years. The intrinsic value of all
options outstanding was $1,532,000 as of December 31, 2006.
As of December 31, 2006, there was $36,900 in unrecognized compensation cost for stock options granted
under the plan. This cost is expected to be recognized over a weighted-average period of 1.16 years.
As of December 31, 2006, the vested options totaled 38,595 shares with a weighted-average exercise
price of $25.22 per share and a weighted-average remaining contractual term of 4.26 years. The intrinsic
value for the vested options was $973,400. The intrinsic value for all options exercised during 2006
was $139,000. The fair value of the 31,200 options vested during 2006 was $248,000.
As of December 31, 2006, 116,981 shares were available for stock options and awards. The committee
is also authorized to grant awards of restricted common stock, and it authorized the issuance of
4,291 shares of common stock in 2006, 13,748 in 2005 and 222 in 2004 to certain employees. The vesting
period for these awards is five years and the Bank amortizes the expense on a straight line basis
during the vesting period. The expense relating to these awards for the years ended December 31,
2006, 2005 and 2004 was $149,000, $70,000 and $57,000, respectively.

|Page 73 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 9.   Income Taxes
    Income taxes for the years ended December 31, 2006, 2005 and 2004 are summarized as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                      

| |               | **2006**                   |           | **2005** |   | **2004** |   |  
| | ------------- | -------------------------- | --------- | -------- | - | -------- | - | -
| |               |                            |           |         
| |               | **(Amounts In Thousands)** |           |         
|
| | **Current:**  |                            |           |          |   |          |   |  
| | Federal       | **$**                      | **6,771** |          | $ | 6,335    |   | $
| | State         |                            | **1,276** |          |   | 1,219    |   |  
| | **Deferred:** |                            |           |          |   |          |   |  
| | Federal       |                            | **(968**  | **)**    |   | (756     | ) |  
| | State         |                            | **(146**  | **)**    |   | (114     | ) |  
| |               |                            |           |         
| |               | **$**                      | **6,933** |          | $ | 6,684    |   | $
| |               |                            |           |         

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Temporary differences between the amounts reported in the financial statements and the tax basis of
assets and liabilities result in deferred taxes. No valuation allowance was required for deferred
tax assets. Based upon the Companys level of historical taxable income and anticipated future
taxable income over the periods in which the deferred tax assets are deductible, management believes
it is more likely than not that the Company will realize the benefits of these deductible differences.
Deferred tax assets and liabilities at December 31, 2006 and 2005 were as follows:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

| |                                            | **December 31,**           |       |         
| | ------------------------------------------ | -------------------------- | ----- | --------
| |                                            |                            |       |         
| |                                            | **2006**                   |       | **2005**
| |                                            |                            |       |         
| |                                            | **(Amounts In Thousands)** |       |         
| | Deferred income tax assets:                |                            |       |         
| | Allowance for loan losses                  | $                          | 6,827 |         
| | Deferred compensation                      |                            | 1,440 |         
| | Accrued expenses                           |                            | 281   |         
| | Unrealized losses on investment securities |                            | 784   |         
| | Other                                      |                            | 13    |         
| |                                            |                            |       |         
| | **Gross deferred tax assets**              |                            | 9,345 |         
| |                                            |                            |       |         
| | Deferred income tax liabilities:           |                            |       |         
| | Property and equipment                     |                            | 1,005 |         
| | FHLB dividends                             |                            | 132   |         
| | Prepaid expenses                           |                            | 277   |         
| | Goodwill                                   |                            | 318   |         
| |                                            |                            |       |         
| | **Gross deferred tax liabilities**         |                            | 1,732 |         
| |                                            |                            |       |         
| | **Net deferred income tax asset**          | $                          | 7,613 |         
| |                                            |                            |       |         
| |                                            |                            |      

|Page 74 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 9.   Income Taxes (Continued)
    The net change in the deferred income taxes for the years ended December 31, 2006, 2005 and 2004 is reflected in the financial statements as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                           

|                                                | **Year Ended December 31,** |       
|----------------------------------------------- | --------------------------- | ------
|                                                |                             |       
|                                                | **2006**                    |       
|                                                |                             |       
|                                                | **(Amounts In Thousands)**  |       
|                                                |                            
|Consolidated statements of income               | $                           | (1,114
|Consolidated statements of stockholders equity |                             | 320   
|                                                |                             |       
|                                                | $                           | (794  
|                                                |                             |       

|                                                                                                                                                                                                                                      
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Income tax expense for the years ended December 31, 2006, 2005 and 2004 are less than the amounts computed
by applying the maximum effective federal income tax rate to the income before income taxes because
of the following items:
|                                                                                                                                                                                                                                      

|                                                        | **2006**   |            | **2005**                            |  | **2004**   |      
|------------------------------------------------------- | ---------- | ---------- | ----------------------------------- |  | ---------- | -----
|                                                        |            |           
|                                                        | **Amount** |            | **% Of 
      Pretax
      Income** |  | **Amount** |      
|                                                        |            |           
|                                                        |           
|Expected tax expense                                    | **$**      | **7,872**  |                                     |  | **35.0**   | **%**
|Tax-exempt interest                                     |            | **(1,114** | **)**                               |  | **(5.0**   | **)**
|Interest expense
  limitation                           |            | **185**    |                                     |  | **0.8**    |      
|State income taxes,
  net of federal income tax benefit |            | **735**    |                                     |  | **3.3**    |      
|Income tax credits                                      |            | **(566**   | **)**                               |  | **(2.5**   | **)**
|Other                                                   |            | **(179**   | **)**                               |  | **(0.8**   | **)**
|                                                        |            |           
|                                                        | **$**      | **6,933**  |                                     |  | **30.8**   | **%**
|                                                        |            |           

|Page 75 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 10. Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and CashRestrictions
The Company and the Bank are subject to various regulatory capital requirements administered by the
federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain
mandatory and possibly additional discretionary actions by regulators that, if undertaken, could
have a direct material effect on the Companys financial results. Under capital adequacy guidelines
and the regulatory frameworks for prompt corrective action, the Company and the Bank must meet specific
capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet
items as calculated under regulatory accounting practices. Capital amounts and classifications of
the Company and the Bank are also subject to qualitative judgments by the regulators about components,
risk weightings and other factors.
Quantitative measures established by the regulations to ensure capital adequacy require the Company
and the Bank to maintain minimum amounts and ratios (set forth in the tables that follow) of total
and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier
1 capital (as defined) to average assets (as defined). Management believes that, as of December 31,
2006 and 2005, the Company and the Bank met all capital adequacy requirements to which they are subject.
As of December 31, 2006, the most recent notifications from the Federal Reserve System categorized
the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized
as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier
1 leverage ratios as set forth in the table that follows. There are no conditions or events since
that notification that management believes have changed the institutions category.
The actual amounts and capital ratios as of December 31, 2006 and 2005, with the minimum regulatory
requirements for the Company and Bank are presented below (amounts in thousands):
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

|                          | Actual |         | For Capital
      Adequacy
      Purposes |  | To Be Well
      Capitalized Under
      Prompt Corrective
      Action Provisions |  
|------------------------- | ------ | ------- | ----------------------------------------- |  | ---------------------------------------------------------------------------------- | -
|
|
|                          |        |        
|As of December 31, 2006:  |        |         |                                           |  |                                                                                    |  
|Company:                  |        |         |                                           |  |                                                                                    |  
|Total risk-based capital  | $      | 152,737 |                                           |  | 13.31                                                                              | %
|Tier 1 risk-based capital |        | 138,344 |                                           |  | 12.05                                                                              |  
|Leverage ratio            |        | 138,344 |                                           |  | 9.00                                                                               |  
|Bank:                     |        |         |                                           |  |                                                                                    |  
|Total risk-based capital  |        | 151,983 |                                           |  | 13.25                                                                              |  
|Tier 1 risk-based capital |        | 137,599 |                                           |  | 11.99                                                                              |  
|Leverage ratio            |        | 137,599 |                                           |  | 8.95                                                                               |  

|Page 76 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 10. Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and CashRestrictions   (Continued)
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                

|                          | Actual |         | For Capital
      Adequacy
      Purposes |  | To Be Well
      Capitalized Under
      Prompt Corrective
      Action Provisions |  
|------------------------- | ------ | ------- | ----------------------------------------- |  | ---------------------------------------------------------------------------------- | -
|                          |        |        
|
|                          |        |        
|As of December 31, 2005:  |        |         |                                           |  |                                                                                    |  
|Company:                  |        |         |                                           |  |                                                                                    |  
|Total risk-based capital  | $      | 142,321 |                                           |  | 13.80                                                                              | %
|Tier 1 risk-based capital |        | 129,396 |                                           |  | 12.54                                                                              |  
|Leverage ratio            |        | 129,396 |                                           |  | 9.04                                                                               |  
|Bank:                     |        |         |                                           |  |                                                                                    |  
|Total risk-based capital  |        | 138,523 |                                           |  | 13.44                                                                              |  
|Tier 1 risk-based capital |        | 125,605 |                                           |  | 12.18                                                                              |  
|Leverage ratio            |        | 125,605 |                                           |  | 8.78                                                                               |  

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by
the Bank. The Bank is subject to certain statutory and regulatory restrictions on the amount it may
pay in dividends. To maintain acceptable capital ratios in the Bank, certain of its retained earnings
are not available for the payment of dividends. To maintain a ratio of capital to assets of 8%, retained
earnings of $16,254,000 as of December 31, 2006 are available for the payment of dividends to the
Company.
The Bank is required to maintain reserve balances in cash or with the Federal Reserve Bank. Reserve
balances totaled $1,914,000 and $1,639,000 as of December 31, 2006 and 2005, respectively.

|Page 77 of 97
|-------------



|HILLS BANCORPORATION
      NOTES TO FINANCIAL STATEMENTS
      Note 11.   Related Party Transactions
      Certain directors of the Company and the Bank and companies with which the directors are affiliated and certain principal officers are customers of, and have banking transactions with, the Bank in the ordinary course of business. Such indebtedness has been incurred on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons.
    The following is an analysis of the changes in the loans to related parties during the years ended December 31, 2006 and 2005:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

| |                        | Year Ended December 31,    |            
| | ---------------------- | -------------------------- | -----------
| |                        |                            |            
|
| |                        |                            |            
| |                        | **(Amounts In Thousands)** |            
|
|
| | **Balance, beginning** | **$**                      | **38,951** 
| | Advances               |                            | **50,087** 
| | Collections            |                            | **(56,400**
| |                        |                            |            
| | **Balance, ending**    | **$**                      | **32,638** 
| |                        |                            |            

|                                                                                                                         
|-------------------------------------------------------------------------------------------------------------------------
|Deposits from related parties are accepted subject to the same interest rates and terms as those from
nonrelated parties.

|Page 78 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 12.   Fair Value of Financial Instruments
The carrying value and estimated fair values of the Companys financial instruments as of December 31,
2006 and 2005 are as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                      

|                                                                              | 2006  |               | 2005 |      
|----------------------------------------------------------------------------- | ----- | ------------- | ---- | -----
|
|
|
|
|
|Cash and due from banks                                                       | **$** | **23,397**    |      | **$**
|Investment securities                                                         |       | **190,984**   |      |      
|Loans                                                                         |       | **1,283,035** |      |      
|Accrued interest receivable                                                   |       | **10,292**    |      |      
|Deposits                                                                      |       | **1,107,409** |      |      
|Federal funds purchased and securities
   sold under agreements to repurchase |       | **59,063**    |      |      
|Borrowings from Federal Home Loan
   Bank                                     |       | **235,379**   |      |      
|Accrued interest payable                                                      |       | **3,500**     |      |      

|                               |       |             |  |       |       |  |   |        
|------------------------------ | ----- | ----------- |  | ----- | ----- |  | - | -------
|
|
|
|Off-balance sheet instruments: |       |             |  |       |       |  |   |        
|Loan commitments               | **$** | **200,786** |  | **$** | **** |  | $ | 189,936
|Letters of credit              |       | **10,107**  |  |       | **** |  |   | 12,374 

|Page 79 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 13.   Parent Company Only Financial Information
Following is condensed financial information of the Company (parent company only):
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                          
|CONDENSED BALANCE SHEETS
    December31, 2006 and 2005
    (Amounts In Thousands)                                                                                                         
|                                                                                                                                                                                          

|ASSETS                                              | 2006  |             | 2005  |  
|--------------------------------------------------- | ----- | ----------- | ----- | -
|
|                                                   
|Cash                                                | **$** | **983**     |       | $
|Investment in subsidiary bank                       |       | **138,834** |       |  
|Other assets                                        |       | **668**     |       |  
|                                                    |       |            
|**Total assets**                                    | **$** | **140,485** |       | $
|                                                    |       |            
|                                                   
|**LIABILITIES AND STOCKHOLDERS EQUITY**           
|                                                    |      
|                                                   
|Liabilities                                         | **$** | **906**     |       | $
|                                                    |       |            
|Redeemable common stock held by ESOP                |       | **20,940**  |       |  
|                                                    |       |            
|Stockholders equity:                              
|Capital stock                                       |       | **12,364**  |       |  
|Retained earnings                                   |       | **131,852** |       |  
|Accumulated other comprehensive income (loss)       |       | **(1,265**  | **)** |  
|Treasury stock at cost                              |       | **(3,372**  | **)** |  
|                                                    |       |            
|                                                    |       | **139,579** |       |  
|Less maximum cash obligation related to ESOP shares |       | **20,940**  |       |  
|                                                    |       |            
|******Total stockholders equity**                  |       | **118,639** |       |  
|                                                    |       |            
|******Total liabilities and stockholders equity**  | **$** | **140,485** |       | $
|                                                    |       |            

|Page 80 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 13.   Parent Company Only Financial Information (Continued)
|-------------------------------------------------------------------------------------------------------------------
|                                                                                                                   
|CONDENSED STATEMENTS OF INCOME 
     Years Ended December 31, 2006, 2005 and 2004
(Amounts In Thousands)           
|                                                                                                                   

|                                                                                                       | **2006** |        | **2005** |   | **2004** |  
|------------------------------------------------------------------------------------------------------ | -------- | ------ | -------- | - | -------- | -
|                                                                                                       |         
|                                                                                                       |         
|Interest on checking account and investment securities                                                 | $        | 160    |          | $ | 81       |  
|Dividends received from subsidiary                                                                     |          | 3,696  |          |   | 3,413    |  
|Other expenses                                                                                         |          | (265   | )        |   | (291     | )
|                                                                                                       |          |       
|**Income before income tax benefit and
                  equity in subsidiarys undistributed income** |          | 3,591  |          |   | 3,203    |  
|Income tax benefit                                                                                     |          | 37     |          |   | 71       |  
|                                                                                                       |          |       
|                                                                                                       |          | 3,628  |          |   | 3,274    |  
|Equity in subsidiarys undistributed income                                                            |          | 11,931 |          |   | 11,928   |  
|                                                                                                       |          |       
|**Net income**                                                                                         | $        | 15,559 |          | $ | 15,202   |  
|                                                                                                       |          |       

|Page 81 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 13.   Parent Company Only Financial Information (Continued)
|-------------------------------------------------------------------------------------------------------------------
|                                                                                                                   
|CONDENSED STATEMENTS OF CASH FLOWS 
Years Ended December 31, 2006, 2005 and 2004
(Amounts In Thousands)            
|                                                                                                                   

|                                                            | **2006** |             | **2005** |   | **2004** |  
|----------------------------------------------------------- | -------- | ----------- | -------- | - | -------- | -
|                                                            |         
|Cash flows from operating activities:                       |          |             |          |   |          |  
|Net income                                                  | **$**    | **15,559**  |          | $ | 15,202   |  
|Noncash items included in net income:                       |          |             |          |   |          |  
|Undistributed income of subsidiary                          |          | **(11,931** | **)**    |   | (11,928  | )
|Share-based compensation                                    |          | **44**      |          |   |         |  
|Income tax benefits related to share-based
    compensation |          | **67**      |          |   | 16       |  
|(Increase) decrease in other assets                         |          | **(115**    | **)**    |   | (85      | )
|Increase in liabilities                                     |          | **147**     |          |   | 223      |  
|                                                            |          |            
|**Net cash provided by operating activities**               |          | **3,771**   |          |   | 3,428    |  
|                                                            |          |            
|Cash flows from investing activities:                       |          |             |          |   |          |  
|Proceeds from maturities of investment securities           |          | ****       |          |   | 500      |  
|                                                            |          |            
|**Net cash provided by investing activities**               |          | ****       |          |   | 500      |  
|                                                            |          |            
|Cash flows from financing activities:                       |          |             |          |   |          |  
|Common stock issued, net                                    |          | **283**     |          |   | 590      |  
|Purchase of treasury stock                                  |          | **(3,309**  | **)**    |   | (63      | )
|Dividends paid                                              |          | **(3,696**  | **)**    |   | (3,412   | )
|                                                            |          |            
|**Net cash used in financing activities**                   |          | **(6,722**  | **)**    |   | (2,885   | )
|                                                            |          |            
|**(Decease) increase in cash**                              |          | **(2,951**  | **)**    |   | 1,043    |  
|Cash balance:                                               |          |             |          |   |          |  
|Beginning                                                   |          | **3,934**   |          |   | 2,891    |  
|                                                            |          |            
|Ending                                                      | **$**    | **983**     |          | $ | 3,934    |  
|                                                            |          |            
|                                                            |          |             |         

|Page 82 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 14.   Commitments and Contingencies
Concentrations of credit risk: The Banks loans, commitments to extend credit, unused lines of credit and outstanding
letters of credit have been granted to customers within the Banks market area. Investments
in securities issued by state and political subdivisions within the state of Iowa totaled approximately
$22,250,000. The concentrations of credit by type of loan are set forth in Note 3 to the Financial
Statements. Outstanding letters of credit were granted primarily to commercial borrowers. Although
the Bank has a diversified loan portfolio, a substantial portion of its debtors ability to
honor their contracts is dependent upon the economic conditions in Johnson County and Linn County, Iowa.
Contingencies:  In the normal course of business, the Company and Bank are involved in various legal proceedings.
In the opinion of management, any liability resulting from such proceedings would not have a material
adverse effect on the accompanying financial statements.
Financial instruments with off-balance sheet risk: The Bank is a party to financial instruments with off-balance sheet risk in the normal course
of business to meet the financing needs of its customers. These financial instruments include commitments
to extend credit, credit card participations and standby letters of credit. These instruments involve,
to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated
balance sheets.
The Banks exposure to credit loss in the event of nonperformance by the other party to the financial
instrument for commitments to extend credit, credit card participations and standby letters of credit
is represented by the contractual amount of those instruments. The Bank uses the same credit policies
in making commitments and conditional obligations as it does for on-balance sheet instruments. A
summary of the Banks commitments at December 31, 2006 and 2005 is as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

| |                                                              | **2006**                   |            | **2005** |   |       
| | ------------------------------------------------------------ | -------------------------- | ---------- | -------- | - | ------
| |                                                              |                            |            |         
| |                                                              | **(Amounts In Thousands)** |            |         
| | Firm loan commitments and unused portion of lines of credit: |                            |            |          |   |       
| | Home equity loans                                            | **$**                      | **18,796** |          | $ | 17,191
| | Credit card participations                                   |                            | **28,091** |          |   | 24,934
| | Commercial, real estate and home construction                |                            | **83,699** |          |   | 86,301
| | Commercial lines                                             |                            | **70,200** |          |   | 61,510
| | Outstanding letters of credit                                |                            | **10,107** |          |   | 12,374
| |                                                              |                            |           

|Page 83 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 14.    Commitments and Contingencies (Continued)
Commitments to extend credit are agreements to lend to a customer as long as there is no violation
of any condition established in the contract. Since many of the commitments are expected to expire
without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
The Bank evaluates each customers credit worthiness on a case-by-case basis. The amount of
collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on managements
credit evaluation of the party. Collateral held varies, but may include accounts receivable, crops,
livestock, inventory, property and equipment, residential real estate and income-producing commercial
properties. Credit card participations are the unused portion of the holders credit limits.
Such amounts represent the maximum amount of additional unsecured borrowings.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance
of a customer to a third party. Those guarantees are primarily issued to support public and private
borrowing arrangements and, generally, have terms of one year, or less. The credit risk involved
in issuing letters of credit is essentially the same as that involved in extending loans to customers.
The Bank holds collateral, which may include accounts receivable, inventory, property, equipment,
and income-producing properties, supporting those commitments if deemed necessary. In the event the
customer does not perform in accordance with the terms of the agreement with the third party, the
Bank would be required to fund the commitment. The maximum potential amount of future payments the
Bank could be required to make is represented by the contractual amount shown in the summary above.
If the commitment is funded the Bank would be entitled to seek recovery from the customer. At December
31, 2006 and 2005 no amounts have been recorded as liabilities for the Banks potential obligations
under these guarantees.
Lease commitments: The Company leases certain facilities under operating leases. The minimum future
rental commitments as of December 31, 2006 for all noncancelable leases relating to Bank premises
were as follows:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

| | Year ending December 31: |            | (Amounts In Thousands) |  
| | ------------------------ | ---------- | ---------------------- | -
| |                          |            |                        |  
| |                          | 2007       |                        | $
| |                          | 2008       |                        |  
| |                          | 2009       |                        |  
| |                          | 2010       |                        |  
| |                          | 2011       |                        |  
| |                          | Thereafter |                        |  
| |                          |            |                        |  
| |                          |            |                        | $
| |                          |            |                        |  

|Page 84 of 97
|-------------



|HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS
Note 15.  Quarterly Results of Operations (unaudited, amounts in thousands, except per share amounts)
|--------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                        

|                           | Quarter Ended |       
|-------------------------- | ------------- | ------
|
|
|
|2006                       |               |       
|Interest income            | $             | 20,229
|Interest expense           |               | 9,164 
|
|Net interest income        | $             | 11,065
|Provision for loan losse   |               | 655   
|Other income               |               | 3,455 
|Other expense              |               | 8,122 
|
|Income before income taxes | $             | 5,743 
|Income taxes               |               | 1,794 
|
|Net income                 | $             | 3,949 
|                           |               |       
|
|                          
|Basic earnings per share   | $             | 0.87  
|Diluted earnings per share |               | 0.86  
|                          
|2005                       |               |       
|Interest income            | $             | 17,092
|Interest expense           |               | 6,371 
|
|Net interest income        | $             | 10,721
|Provision for loan losses  |               | 10    
|Other income               |               | 3,055 
|Other expense              |               | 7,717 
|
|Income before income taxes | $             | 6,049 
|Income taxes               |               | 1,906 
|
|Net income                 | $             | 4,143 
|                           |               |       
|
|                          
|Basic earnings per share   | $             | 0.91  
|Diluted earnings per share |               | 0.91  

|Page 85 of 97
|-------------



|PART II
Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A. Controls and Procedures
Disclosure 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 operation
of the Companys disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e)
under the Securities Exchange Act of 1934). Based upon that evaluation, the Chief Executive Officer
and Chief Financial Officer concluded that the Companys disclosure controls and procedures
are effective.
Managements Report on Internal Control Over Financial Reporting
The Companys management is responsible for establishing and maintaining an adequate system of
internal control over financial reporting (as defined in Rule 13a-15(f) and Rule 15d-15(f) under
the Securities Exchange Act of 1934). Internal control over financial reporting of the Company includes
those policies and procedures that: (1) pertain to the maintanence of records that, in reasonable
detail, accurately and fairly reflect the transactions of the Company; (2) provide reasonable assurance
that transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the Company
are being made only in accordance with authorizations of management and directors of the Company;
and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition,
use or disposition of the Companys assets that could have a material effect on the Companys
financial statements. Important features of the Companys system of internal control over financial
reporting include the adoption and implementation of written policies and procedures, careful selection
and training of financial management personnel, a continuing management commitment to the integrity
of the system and through examinations by an internal audit function that coordinates its activities
with the Companys Independent Registered Public Accounting Firm.
All internal control systems, no matter how well designed, have inherent limitations, including the
possibility of human error and the circumvention of overriding controls. Accordingly, even effective
internal control can provide only reasonable assurance with respect to financial statement preparation.
Further, because of changes in conditions, the effectiveness of internal control may vary over time.
The Companys management conducted an evaluation of the effectiveness of the Companys internal
controls over financial reporting as of December 31, 2006. Managements assessment is based
on the criteria described in Internal Control  Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, the Companys
management concluded that the Company maintained effective internal control over financial reporting
as of December 31, 2006.
There was no change in the Companys internal control over financial reporting during the most
recently completed fiscal quarter that has materially affected, or is reasonably likely to materially
affect, the Companys internal control over financial reporting.
The Companys independent registered public accounting firm, that audited the consolidated financial
statements included in this annual report, has issued an attestation report on the Companys
internal control over financial reporting as of December 31, 2006 and managements assessment
of the internal control over financial reporting. This report appears on the following page.
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        666 Grand Avenue
    Des Moines, IA 50309
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Report of Independent Registered Public Accounting Firm
To the Board of Directors and StockholdersHills Bancorporation:
We have audited managements assessment, included in the accompanying Managements Report on Internal Control Over Financial Reporting, that Hills Bancorporation (the Company) maintained effective internal control over financial reporting
as of December 31, 2006, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Hills Bancorporations
management is responsible for maintaining effective internal control over financial reporting and
for its assessment of the effectiveness of internal control over financial reporting. Our responsibility
is to express an opinion on managements assessment and an opinion on the effectiveness of the
Companys internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal control over financial
reporting, evaluating managements assessment, testing and evaluating the design and operating
effectiveness of internal control, and performing such other procedures as we considered necessary
in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys internal control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with generally accepted accounting principles. A companys
internal control over financial reporting includes those policies and procedures that (1) pertain
to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions
and dispositions of the assets of the company; (2) provide reasonable assurance that transactions
are recorded as necessary to permit preparation of financial statements in accordance with generally
accepted accounting principles, and that receipts and expenditures of the company are being made
only in accordance with authorizations of management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or
disposition of the companys assets that could have a material effect on the financial statements.
Because of inherent limitations, internal control over financial reporting may not prevent or detect
misstatements. Also, projections of any evaluation to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, managements assessment that Hills Bancorporation maintained internal control
over financial reporting as of December 31, 2006, is fairly stated, in all material respects,
based on criteria established in Internal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our
opinion, Hills Bancorporation maintained, in all material respects, effective internal control over
financial reporting as of December 31, 2006, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board
(United States), the consolidated balance sheets of Hills Bancorporation and subsidiaries as of December 31,
2006 and 2005, and the related consolidated statements of income, comprehensive income, stockholders
equity, and cash flows for each of the years in the three-year period ended December 31, 2006,
and our report dated March 9, 2007 expressed an unqualified opinion on those consolidated financial
statements.

Des Moines, IowaMarch 9, 2007

|Page 87 of 97
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|Item 9B. Other Information
Not applicable
PART III
Item 10.   Directors, Executive Officers and Corporate Governance
The information required by Item 10 of Part III is presented under the items entitled Certain
Information Regarding Directors and Executive Officers and Section 16(a) Beneficial Ownership
Reporting Compliance in the Companys Definitive Proxy Statement dated March 19, 2007
for the Annual Meeting of Stockholders on April 16, 2007. Such information is incorporated herein
by reference.
The Company has a Code of Ethics in place for the Chief Executive Officer and Chief Financial Officer.
A copy of the Companys Code of Ethics will be provided free of charge, upon written request
to:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

| | James G. Pratt
  Treasurer
  Hills Bancorporation
  131 Main Street
  Hills, Iowa  52235
| | ----------------------------------------------------------------------------------------

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Item 11.   Executive Compensation
The information required by Item 11 of the Part III is presented under the item entitled Executive
Compensation and Benefits in the Companys Definitive Proxy Statement for the Annual Meeting
of Stockholders on April 16, 2007. Such information is incorporated herein by reference.
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters
The information required by Item 12 of Part III is presented under the item entitled Security
Ownership of Principal Stockholders and Management and Report on Executive Compensation,
in the Companys Definitive Proxy Statement for the Annual Meeting of Stockholders on April
16, 2007. Such information is incorporated herein by reference.
Item 13.   Certain Relationships and Related Transactions, and Director Independence
The information required by Item 13 of Part III is presented under the item entitled Loans to
and Certain Other Transactions with Executive Officers and Directors in the Companys
Definitive Proxy Statement for the Annual Meeting of Stockholders on April 16, 2007. Such information
is incorporated herein by reference.
Item 14.   Principal Accountanting Fees and Services
Information required by this item is contained in the Registrants Proxy Statement dated March
19, 2007, under the heading Independent Auditors  Audit and Other Fees, which section
is incorporated herein by this reference.

|Page 88 of 97
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|PART IV
Item 15.   Exhibits, Financial Statement and Schedules
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|Form 10-K
      Reference
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|Page 89 of 97
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|SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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: March 9, 2007 | By: /s/ Dwight O. Seegmiller                                         
|                   
|                    | Dwight O. Seegmiller, Director, President and Chief Executive Officer
|                    |                                                                      
|Date: March 9, 2007 | By: /s/ James G. Pratt                                               
|                   
|                    | James G. Pratt, Secretary, Treasurer and Chief Accounting Officer    

|                                                                                                                                                                                                             
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
|                                                                                                                                                                                                             

|                    | DIRECTORS OF THE REGISTRANT 
|------------------- | ----------------------------
|                    |                             
|Date: March 9, 2007 | By: /s/ Willis M. Bywater   
|                   
|                    | Willis M. Bywater, Director 
|                    |                             
|Date: March 9, 2007 | By: /s/ Thomas J. Gill      
|                   
|                    | Thomas J. Gill, Director    
|                    |                             
|Date: March 9, 2007 | By: /s/ Donald H. Gringer   
|                   
|                    | Donald H. Gringer, Director 
|                    |                             
|Date: March 9, 2007 | By: /s/ Michael E. Hodge    
|                   
|                    | Michael E. Hodge, Director  
|                    |                             
|Date: March 9, 2007 | By: /s/ James A. Nowak      
|                   
|                    | James A. Nowak, Director    
|                    |                             
|Date: March 9, 2007 | By: /s/ Richard W. Oberman  
|                   
|                    | Richard W. Oberman, Director
|                    |                             
|Date: March 9, 2007 | By: /s/ Theodore H. Pacha   
|                   
|                    | Theodore H. Pacha, Director 
|                    |                             
|Date: March 9, 2007 | By: /s/ Ann M. Rhodes       
|                   
|                    | Ann M. Rhodes, Director     
|                    |                             
|Date: March 9, 2007 | By: /s/ Ronald E. Stutsman  
|                   
|                    | Ronald E. Stutsman, Director
|                    |                             
|Date: March 9, 2007 | By: /s/ Sheldon E. Yoder    
|                   
|                    | Sheldon E. Yoder, Director  

|Page 90 of 97
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|HILLS BANCORPORATIONANNUAL REPORT OF FORM 10-K FOR THEFISCAL YEAR ENDED DECEMBER 31, 2006
|-----------------------------------------------------------------------------------------
|                                                                                         

|Exhibit
      Number | Description                                                        | Page Number
      In The Sequential
      Numbering System
      For 2006 Form 10-K |      
|-------------------- | ------------------------------------------------------------------ | ----------------------------------------------------------------------------------- | -----
|                    
|11                   | Statement Re Computation of Basic and Diluted Earnings Per Share   |                                                                                     | 92   
|                     |                                                                    |                                                                                     |      
|21                   | Subsidiary of the Registrant                                       |                                                                                     | 93   
|                     |                                                                    |                                                                                     |      
|23                   | Consent of Independent Registered Public Accounting Firm, KPMG LLP |                                                                                     | 94   
|                     |                                                                    |                                                                                     |      
|31                   | Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 |                                                                                     | 95-96
|                     |                                                                    |                                                                                     |      
|32                   | Certifications under Section 906 of the Sarbanes-Oxley Act of 2002 |                                                                                     | 97   
|                    

|Page 91 of 97
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