HILLS BANCORPORATION FORM 10-K DECEMBER 31, 2003  UNITED
STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
FORM 10-K
|X|
  ANNUAL REPORT PURSUANT TO SECTION
  13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended December
  31, 2003.
  Commission
  File Number 0-12668.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) 679-2291Securities Registered pursuant to Section 12 (b) of
  the Act: NoneSecurities Registered pursuant to Section 12 (g) of
  the Act:No par value common
  stockTitle of ClassIndicate 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 |X|     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.  [X]
Indicate by check mark
whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the
Act)
Yes |X|     No
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 March 22, 2004 (based upon
reports of beneficial ownership that approximately 81% 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 $101 per share) was $124,079,000.
The number of shares
outstanding of the Registrants common stock as of March 22, 2004 is 1,516,678
shares of no par value common stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy
Statement dated March 22, 2004 for the Annual Meeting of the Shareholders of
the Registrant to be held April 19, 2004 (the Proxy Statement) are
incorporated by reference in Part III of this Form 10-K.
EXHIBIT INDEX
The exhibits index is on
Page 82.
Page 1 of 92

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, 2002, Hills Bank
Kalona was merged into Hills Bank and Trust.
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 that, 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.  The Company had no employees as of December 31, 2003 and the Bank
had 309 regular and 102 part-time employees.
Page 2 of 92

Item 1. Business (Continued)
Johnson 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 86,000. 
Johnson County, Iowa has a population of approximately 114,000.  The University of Iowa in Iowa City has
approximately 30,000 students and 24,500 full and part-time employees,
including employees of The University of Iowa Hospitals and Clinics. Other principal
employers in Johnson County include the following:
Employer
  
  Type
  of Business
  
  EmployeesIowa City Community School District
  
  Education
  
  1,250Hy-Vee Food Stores
  
  Grocery Stores
  
  1,200Veterans Administration Medical Center
  
  Health Care
  
  1,200Mercy Hospital
  
  Health Care
  
  1,150National Computer Systems
  
  Information Service - Computers
  
  950American College Testing Program
  
  Educational Testing Service
  
  850United Technologies
  
  Automotive Products Manufacturing
  
  850Rockwell Collins
  
  Electronic Manufacturing
  
  800Oral B Laboratories
  
  Consumer Products
  
  800Proctor & Gamble
  
  Consumer Products
  
  600City of Iowa City
  
  City Government
  
  600Page 3 of 92

Item 1. Business (Continued)
Linn County
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 3,800.  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 27,000 from Marion 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 195,000.The largest
employer in the Cedar Rapids area is Rockwell Collins, manufacturer of
communications instruments, with about 6,300 employees. Other large employers
in the Cedar Rapids area and their approximate number of employees are as
follows:
Employer
  
  Type
  of Business
  
  EmployeesCedar Rapids, College, Linn-Mar, Marion and Grant
  Wood School Districts
  
  Education
  
  4,050Maytag Appliances, Amana Iowa
  
  Appliance Manufacturing
  
  2,950AEGON USA, Inc.
  
  Insurance
  
  2,500IES Utilities
  
  Electric Utility
  
  2,300St. Lukes Hospital
  
  Health Care
  
  2,250Hy-Vee Food Stores
  
  Grocery Stores
  
  1,950McLeod*USA
  
  Telecommunications
  
  1,950Mercy Medical Center
  
  Health Care
  
  1,700MCI Communications, Inc
  
  Long Distance Service
  
  1,600City of Cedar Rapids
  
  City Government
  
  1,300Quaker Oats Company
  
  Cereals and Chemicals
  
  1,250APAC Teleservices
  
  Telemarketing
  
  1,200Kirkwood Community College
  
  Education
  
  1,150Washington County
The Bank has an office
located in Kalona, Iowa, which is in Washington County.  Kalona is located approximately 20 miles
south of Iowa City.  Kalona has a
population of approximately 2,300.  The
population of Washington County is approximately 21,000.  Kalona is primarily an agricultural
community, but it is located within easy driving distance for employment in
Iowa City, Coralville and North Liberty (combined population 85,000) and
Washington, Iowa (population 7,000).
Page 4 of 92

Item 1. Business (Continued)
COMPETITION
The financial services
industry is highly competitive.  The
Bank must compete with financial services providers, such as banks, savings and
loan associations, credit unions, finance companies, mortgage banking
companies, insurance companies and money market and mutual fund companies.  It also faces increased competition from
non-banking institutions such as brokerage houses and insurance companies, as
well as from financial services subsidiaries of commercial and manufacturing
companies.  Many of these competitors
enjoy the benefits of fewer regulatory constraints and lower cost structures.
Effective March 13, 2000,
securities firms and insurance companies that elect to become financial holding
companies may acquire banks and other financial institutions.  This may significantly change the
competitive environment in which the Company conducts business.  The financial services industry is also
likely to become more competitive as further technological advances enable more
companies to provide financial services. 
These technological advances may diminish the importance of depository
institutions and other financial intermediaries in the transfer of funds
between parties.
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, 2003 is as follows:
Johnson County
  
  Linn CountyOffices
  
  Deposits
  (in millions)
  
  Offices
  
  Deposits
  (in millions)Hills Bank and Trust
  Company
  
  
  6
  
  
  
  $
  672
  
  
  
  5
  
  
  
  $
  119Branches of largest
  competing regional bank
  
  
  5
  
  
  
  
  214
  
  
  
  10
  
  
  
  
  776Largest competing
  independent bank
  
  
  6
  
  
  
  
  374
  
  
  
  9
  
  
  
  
  353Largest competing credit
  union
  
  
  5
  
  
  
  
  242
  
  
  
  6
  
  
  
  
  340All other bank and credit
  union offices
  
  
  20
  
  
  
  
  331
  
  
  
  65
  
  
  
  
  1,969Total
  Market in County
  
  
  42
  
  
  
  
  1,833
  
  
  
  95
  
  
  
  
  3,557THE
ECONOMY
The Banks primary trade
territory is Johnson County, Iowa. Linn County, Iowa is becoming an
increasingly important market, and the Bank now has five offices open in Linn
County.  The Bank also has one office in
Kalona in Washington County, Iowa.  The
table that follows shows the employment information as of December 31, 2003,
regarding the labor force and unemployment levels in the three counties in
which the Bank has office locations along with data on the United States and
the State of Iowa.
Labor Force
  
  Unemployed
  
  Rate %United States
  
  146,878,000
  
  8,398,000
  
  5.72
  %State of Iowa
  
  1,633,200
  
  71,200
  
  4.36
  %Johnson County
  
  76,600
  
  2,600
  
  3.39
  %Linn County
  
  118,300
  
  5,100
  
  4.31
  %Washington County
  
  10,720
  
  440
  
  4.10
  %Page 5 of 92

Item 1. Business (Continued)
The unemployment rate for
the Banks trade territory is favorable and the rate has historically been
lower than 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.  Johnson and Linn County has
been one of the strongest economic areas in Iowa and has 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 2003 enrollment.
The
  University of Iowa
  
  
  29,745Iowa CityCoe
  College
  
  
  1,317Cedar RapidsCornell
  College
  
  
  1,117Mount VernonKirkwood
  Community College
  
  
  15,032Cedar Rapids, Iowa City and WashingtonMount
  Mercy College
  
  
  1,473Cedar RapidsThe State of Iowa
continues to collect decreasing tax revenues while spending continues to
increase, and the Iowa legislature has required the University of Iowa to
reduce spending in the last three fiscal years.  The University has reacted to its budget constraints without
significant lay-offs and has continued to review and reduce employment, when
necessary, through attrition.  However,
salary increases at the University have been minimal.
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 acre in Iowa in 2003 was $2,275 compared to $2,083 in
2002.  The range of average land prices
in Johnson, Linn and Washington counties is between $2,546 and $2,926 per
acre.  The increase was 8.5% from
2002.  The Banks total agricultural
loans comprise about 4.3% of the Banks total loans.
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
statues, 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, such as the
Company and its subsidiary Bank, 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.
Page 6 of 92

Item 1. Business (Continued)
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.
Significant Regulatory Developments
The Gramm-Leach-Bliley
Act, also known as the Financial Services Modernization Act (the Act), was
enacted on November 12, 1999. The Act allows eligible bank holding companies to
engage in a wider range of non-banking activities and grants them greater
authority to engage in securities and insurance activities.  Under the Act, an eligible bank holding
company that elects to become a financial holding company may engage in any
activity that the Federal Reserve, in consultation with the Secretary of the
Treasury, determines by regulation or order is financial in nature, incidental
to any such financial activity, or complementary to any such financial activity
and does not pose a substantial risk to the safety or soundness of depository
institutions or the financial system generally. A financial service corporation
can engage in a number of financial activities including insurance and
securities underwriting and other agency activities, merchant banking and
insurance company portfolio investment activities.  Activities that are ancillary to financial activities are also
allowed.  Additionally, the Act amends
the federal securities laws to incorporate functional regulation of bank
securities and activities and provides for the functional regulation of
insurance activities by establishing which insurance products banks and bank
subsidiaries may provide as principal. 
National banks are also authorized by the Act to engage, through
financial subsidiaries, in certain activities that are permissible for
financial holding companies (as described above) and certain activities that
the Secretary of the Treasury, in consultation with the Federal Reserve,
determines are financial in nature or incidental to any such financial
activity.
Various bank regulatory
agencies have issued regulations as mandated by the Act.  During June 2000, all of the federal bank
regulatory agencies jointly issued regulations implementing the privacy
provisions of the Act.  In addition, the
Federal Reserve issued interim regulations establishing procedures for bank
holding companies to elect to become financial holding companies and listing the
financial activities permissible for financial holding companies, as well as
describing the extent to which financial holding companies may engage in
securities and merchant banking activities. 
The Federal Reserve has issued an interim regulation regarding the
parameters under which state member banks may establish and maintain financial
subsidiaries. At this time, it is not possible to predict the impact the Act
and its implementing regulations may have on the Company. As of the date of
this filing, the Company has not applied for or received approval to operate as
a financial holding company. In addition, the Bank has not applied for or
received approval to establish financial subsidiaries.
In the area of privacy,
the Act requires clear disclosure by all financial institutions of their
privacy policies regarding the sharing of nonpublic information with both
affiliates and third parties.  Further,
the Act requires a notice to consumers and an opportunity to opt out of
sharing of nonpublic personal information with nonaffiliated third parties,
subject to certain limited exceptions. The Act also reforms laws that regulate
ATMs, Community Reinvestment Banks and Deposit Production Offices.
Specifically, the Act requires ATM operators who impose a fee for use of an ATM
by a non-customer to post a notice both on the machine and on the screen that a
fee will be charged and the amount of the fee, and further requires a notice
when ATM cards are issued that surcharges may be imposed by other parties when
transactions are initiated from ATMs not operated by the card issuer.  The Act also clarifies that nothing in the
act repeals any provision of the Continuity Reinvestment Act (CRA); however,
the Act requires full disclosure of all CRA agreements and reduces the
frequency of CRA exams for small banks and savings and loans (those with no
more than $250 million in assets).  The
Act allows community banks all the powers as a matter of right that large
institutions have accumulated on an ad hoc basis, including the ability to
underwrite municipal bonds in the future. 
Finally, the Act expands the prohibition of deposit production offices
contained in the Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994 (the Riegle-Neal Act) to include all branches of an out-of-state bank
holding company.
Page 7 of 92

Item 1. Business (Continued)
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). 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.
Source
of Strength Policy.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.
Similarly, under the cross-guarantee provisions of the Federal Deposit
Insurance Act, in the event of a loss suffered or anticipated by the FDIC 
either as a result of default of a banking or thrift subsidiary of a
bank/financial holding company such as the Company or related to FDIC
assistance provided to a subsidiary in danger of default  the other banking
subsidiaries of such bank/financial holding company may be assessed for the
FDICs loss, subject to certain exceptions.
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.
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.
Page 8 of 92

Item 1. Business
(Continued)
Regulatory
Capital Requirements
Regulatory guidelines
define capital and spell out the minimum acceptable capital levels for
banks.  The purpose of these guidelines
is to increase depositor protection and to reduce deposit insurance fund
losses.  Currently, the three federal
banking agencies use a risk-based approach to gauge bank capital. Under this
approach, the agencies define what is to be included in bank capital and
establish the minimum capital a bank must have primarily to protect it from the
risk inherent in its asset holdings.
Risk-based capital
guidelines divide capital into core and supplemental capital.  Core or Tier I capital is similar to what is
normally thought of as capital in other businesses. It consists primarily of
common and certain preferred stock, surplus and undivided profits.  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.  Supplemental or Tier 2
capital consists, within certain specified limits, of such things as the
allowance for loan losses, hybrid capital instruments and subordinated debt.
These supplemental items are often forms of debt that are subordinate to claims
of depositors and the FDIC.  As such,
they provide depositor protection and are included in bank capital.  The sum of Tier 1 and Tier 2 capital, less
certain deductions, represents a banks total capital. In the capital
guidelines, Tier 1 capital must constitute at least 50% of a banks total
capital.  Thus, the use of Tier 2
capital is limited by the hard equity in a banks capital structure.
As part of their capital
adequacy assessment, the regulatory agencies convert a banks assets, including
off-balance sheet items, to risk-equivalent assets. The purpose of this
conversion is to quantify the relative risk, primarily credit risk, in these
assets and to determine the minimum capital necessary to compensate for this
risk. For example, assets that pose little risk, such as cash held at the
banks offices and U. S. government securities, are weighted zero, meaning that
no capital support is required for these assets.  Assets that pose greater risk are weighted at 20%, 50% or 100% of
their dollar value, indicating the level of capital support they require.  Except for banks with large off-balance
sheet asset positions, risk weighting will nearly always lower total assets requiring
capital support.  However, even if a
bank held nothing but cash and U.S. securities, it would still be required to
maintain capital support for these assets. The reason is that banks face more
than credit risk (e.g., market risk), and these other risks require that banks
maintain minimum levels of capital to protect the banks and their depositors.
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, 2003,
the Company had regulatory capital in excess of the Federal Reserves minimum
and well-capitalized definition requirements, with a leverage ratio of 8.87%,
with total Tier 1 risk-based capital ratio of 13.31% and a total risk-based
capital ratio of 14.56%.
Page 9 of 92

Item 1. Business
(Continued)
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.
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.
The FDIC may terminate
the deposit insurance of any insured depository institution if the FDIC
determines, after a hearing, that the institution (i) has engaged in or is
engaging in unsafe or unsound practices, (ii) is in an unsafe or unsound
condition to continue operations or (iii) has violated any applicable law,
regulation, order, or any condition imposed in writing by, or written agreement
with, the FDIC.  The FDIC may also
suspend deposit insurance temporarily during the hearing process for a
permanent termination of insurance if the institution has no tangible
capital.  Management of the Company is
not aware of any activity or condition that could result in termination of the
deposit insurance of the Bank.
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 normally must have a primary
capital to total assets ratio of six and one-half percent (6 1⁄2 %). In certain
instances, the Superintendent may mandate higher capital, but the
Superintendent has not imposed such a requirement on the Bank.  The Superintendent defines the term primary
capital to mean the sum of stockholders equity and the allowance for loan
losses less any intangible assets.  In
determining the primary capital ratio, the Superintendent uses the total assets
as of the date of computation.  At
December 31, 2003, the primary capital to total assets ratio of the Bank
exceeded the ratio required by the Superintendent.
Page 10 of 92

Item 1. Business (Continued)
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.
Depending upon the capital
category to which an institution is assigned, the regulators corrective powers
include: requiring the institution to submit a capital restoration plan;
limiting the institutions asset growth and restricting its activities;
requiring the institution to issue additional capital stock (including
additional voting stock) or to be acquired; restricting transactions between
the institution and its affiliates; restricting the interest rate the
institution may pay on deposits; ordering a new election of directors of the
institution; requiring that senior executive officers or directors be
dismissed; prohibiting the institution from accepting deposits from
correspondent banks; requiring the institution to divest certain subsidiaries;
prohibiting the payment of principal or interest on subordinated debt; and
ultimately, appointing a receiver for the institution.  As of December 31, 2003, the Bank was well
capitalized, as defined by FDIC regulations.
Community Investment and Consumer Protection Laws.  The Community Reinvestment Act requires
insured institutions to define the communities that they serve, identify the
credit needs of those communities and adopt and implement a Community
Reinvestment Act Statement pursuant to which they offer credit products and
take other actions that respond to the credit needs of the community. The
responsible federal banking regulator must conduct regular Community
Reinvestment Act examinations of insured financial institutions and assign to
them a Community Reinvestment Act rating of outstanding, satisfactory,
needs improvement and unsatisfactory. In 2003, the Community Reinvestment
Act rating of the Companys banking subsidiary was either outstanding or
satisfactory.
In
addition to the Community Reinvestment Act, other federal and state laws
regulate various lending and consumer aspects of the banking business.
Governmental Agencies, including the Department of Housing and Urban
Development, the Federal Trade Commission and the Department of Justice, have become concerned
that in some cases prospective borrowers experience unlawful discrimination in
their efforts to obtain loans
from depository and other lending institutions. These agencies have brought
litigation against some depository institutions alleging discrimination against
borrowers. Many of these suits
have been settled, in some cases for material sums, short of a full trial.
Recently,
these governmental agencies have clarified what they consider to be lending
discrimination and have specified various factors that they will use to
determine the existence of lending discrimination under the Equal Credit
Opportunity Act and the Fair Housing Act. These factors include evidence that a
lender discriminated on a prohibited basis, evidence that a lender treated
applicants differently based on prohibited factors in the absence of evidence
that the treatment was the result of prejudice
or a conscious intention to discriminate, and evidence that a lender applied an
otherwise neutral non-discriminatory policy uniformly to all applicants, but
the practice had a discriminatory effect, unless the practice could be
justified as a business necessity.
Page 11 of 92

Item 1. Business
(Continued)
Banks and other
depository institutions also are subject to numerous consumer-oriented laws and
regulations. These laws, which 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,
require compliance by depository institutions with various disclosure
requirements and requirements regulating the availability of funds after
deposit or the making of certain
loan, to customers.
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 2003 the assessment total was $90,215.
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, 2003.  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.
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 12 of 92

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 recent legislation that became effective on February 21,
2001 (the 2001 Amendment).  The 2001
Amendment allows 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 repeals all limitations on bank office location and effectively
allows statewide branching.  After that
date, banks will be 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.
Miscellaneous.The Bank is subject to certain restrictions on loans to the Company or
its non-bank subsidiaries, on investments in the stock or securities thereof,
on the taking of such stock or securities as collateral for loans to any
borrower, and on the issuance of a guarantee or letter of credit on behalf of
the Company or its non-banking subsidiaries. The Bank is also subject to certain
restrictions on most types of transactions with the Company or its non-bank
subsidiaries, requiring that the terms of such transactions be substantially
equivalent to terms of similar transactions with non-affiliated firms.
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.
Regulatory
Enforcement Authority.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 against banking organizations and institutions-affiliated
parties, as defined. In general, these enforcement actions may be initiated for
violations of laws and regulations and unsafe or unsound practices. Other
actions or inactions may provide the basis for enforcement action, including
misleading or untimely reports filed with regulatory authorities.
Page 13 of 92

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)

Year Ended
  December 31st2003
  
  2002
  
  2001(Amounts
  In Thousands)ASSETSCash and due from banks
  
  $
  25,186
  
  $
  27,815
  
  $
  24,493Taxable securities
  
  
  150,149
  
  
  143,422
  
  
  132,227Nontaxable securities
  
  
  63,689
  
  
  56,369
  
  
  42,783Federal funds sold
  
  
  41,269
  
  
  34,827
  
  
  29,551Loans, net
  
  
  829,710
  
  
  733,822
  
  
  646,196Property and equipment, net
  
  
  22,148
  
  
  21,598
  
  
  18,889Other assets
  
  
  23,159
  
  
  21,650
  
  
  19,575$
  1,155,310
  
  $
  1,039,503
  
  $
  913,714LIABILITIES AND
  STOCKHOLDERS EQUITYNoninterest-bearing demand deposits
  
  $
  108,414
  
  $
  92,145
  
  $
  78,687Interest-bearing demand deposits
  
  
  122,918
  
  
  96,054
  
  
  76,366Savings deposits
  
  
  214,088
  
  
  194,230
  
  
  169,561Time deposits
  
  
  399,747
  
  
  381,973
  
  
  357,882Securities sold under agreements to repurchase
  
  
  29,323
  
  
  21,240
  
  
  17,444FHLB borrowings
  
  
  167,595
  
  
  153,543
  
  
  123,211Other liabilities
  
  
  6,448
  
  
  6,173
  
  
  5,924Redeemable common stock
  held byEmployee Stock Ownership Plan
  
  
  13,908
  
  
  12,572
  
  
  11,872Stockholders equity
  
  
  92,869
  
  
  81,573
  
  
  72,767$
  1,155,310
  
  $
  1,039,503
  
  $
  913,714Page 14 of 92

INTEREST INCOME AND
EXPENSE
Year Ended
  December 31,2003
  
  2002
  
  2001(Amounts
  In Thousands)Income:Loans (1)
  
  $
  54,434
  
  $
  54,491
  
  $
  53,121Taxable securities
  
  
  6,268
  
  
  7,412
  
  
  7,670Nontaxable securities (1)
  
  
  3,590
  
  
  3,433
  
  
  2,924Federal funds sold
  
  
  382
  
  
  520
  
  
  1,132Total interest income
  
  
  64,674
  
  
  65,856
  
  
  64,847Expense:Interest-bearing demand deposits
  
  
  1,011
  
  
  1,094
  
  
  1,412Savings deposits
  
  
  1,950
  
  
  2,900
  
  
  4,611Time deposits
  
  
  13,959
  
  
  18,300
  
  
  20,611Securities sold under agreements to repurchase
  
  
  394
  
  
  375
  
  
  617FHLB borrowings
  
  
  9,091
  
  
  8,472
  
  
  7,184Total interest expense
  
  
  26,405
  
  
  31,141
  
  
  34,435Net interest income
  
  $
  38,269
  
  $
  34,715
  
  $
  30,412(1) Presented on a tax equivalent basis using a rate of 34% for the three years presented.Page 15 of 92

Item 1. Business (Continued)
INTEREST RATES AND
INTEREST DIFFERENTIAL
Year Ended
  December 31,2003
  
  2002
  
  2001Average yields:Loans (1)
  
  
  6.55
  %
  
  7.41
  %
  
  8.20
  %Loans (tax equivalent basis)
  
  
  6.56
  
  
  7.43
  
  
  8.22Taxable securities
  
  
  4.17
  
  
  5.17
  
  
  5.80Nontaxable securities
  
  
  3.72
  
  
  4.02
  
  
  4.51Nontaxable securities (tax equivalent basis)
  
  
  5.64
  
  
  6.09
  
  
  6.83Federal funds sold
  
  
  0.93
  
  
  1.49
  
  
  3.85Interest-bearing demand deposits
  
  
  0.82
  
  
  1.14
  
  
  1.85Savings deposits
  
  
  0.91
  
  
  1.49
  
  
  2.72Time deposits
  
  
  3.49
  
  
  4.79
  
  
  5.76Securities sold under agreements to repurchase
  
  
  1.34
  
  
  1.79
  
  
  3.53FHLB borrowings
  
  
  5.42
  
  
  5.52
  
  
  5.83Yield on average interest-earning assets
  
  
  5.96
  
  
  6.80
  
  
  7.62Rate on average interest-bearing liabilities
  
  
  2.83
  
  
  3.68
  
  
  4.63Net interest spread (2)
  
  
  3.13
  
  
  3.12
  
  
  2.99Net interest margin (3)
  
  
  3.53
  
  
  3.58
  
  
  3.58(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
  and state tax rate of 34% and 5%, respectively, 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 16 of 92

Item 1. Business
(Continued)
CHANGES IN INTEREST
INCOME AND EXPENSE
Changes DueTo Volume
  
  Changes DueTo Rates
  
  TotalChanges(Amounts In Thousands)Year ended December 31,
  2003:Change in interest income:Loans
  
  
  $
  6,704
  
  
  
  $
  (6,761
  )
  
  
  $
  (57
  )Taxable securities
  
  
  
  337
  
  
  
  
  (1,481
  )
  
  
  
  (1,144
  )Nontaxable securities
  
  
  
  423
  
  
  
  
  (266
  )
  
  
  
  157Federal funds sold
  
  
  
  83
  
  
  
  
  (221
  )
  
  
  
  (138
  )7,547
  
  
  
  
  (8,729
  )
  
  
  
  (1,182
  )Change in interest expense:Interest-bearing demand deposits
  
  
  
  265
  
  
  
  
  (348
  )
  
  
  
  (83
  )Savings deposits
  
  
  
  271
  
  
  
  
  (1,221
  )
  
  
  
  (950
  )Time deposits
  
  
  
  818
  
  
  
  
  (5,159
  )
  
  
  
  (4,341
  )Securities sold under agreements to repurchase
  
  
  
  127
  
  
  
  
  (154
  )
  
  
  
  (27
  )FHLB borrowings
  
  
  
  773
  
  
  
  
  (108
  )
  
  
  
  6652,254
  
  
  
  
  (6,990
  )
  
  
  
  (4,736
  )Change in net interest income
  
  
  $
  5,293
  
  
  
  $
  (1,739
  )
  
  
  $
  3,554Year ended December 31,
  2002:Change in interest income:Loans
  
  
  $
  6,777
  
  
  
  $
  (5,407
  )
  
  
  $
  1,370Taxable securities
  
  
  
  617
  
  
  
  
  (875
  )
  
  
  
  (258
  )Nontaxable securities
  
  
  
  852
  
  
  
  
  (343
  )
  
  
  
  509Federal funds sold
  
  
  
  177
  
  
  
  
  (789
  )
  
  
  
  (612
  )8,423
  
  
  
  
  (7,414
  )
  
  
  
  1,009Change in interest expense:Interest-bearing demand deposits
  
  
  
  308
  
  
  
  
  (626
  )
  
  
  
  (318
  )Savings deposits
  
  
  
  598
  
  
  
  
  (2,309
  )
  
  
  
  (1,711
  )Time deposits
  
  
  
  1,321
  
  
  
  
  (3,638
  )
  
  
  
  (2,317
  )Securities sold under agreements to repurchase
  
  
  
  114
  
  
  
  
  (350
  )
  
  
  
  (236
  )FHLB borrowings
  
  
  
  1,687
  
  
  
  
  (399
  )
  
  
  
  1,2884,028
  
  
  
  
  (7,322
  )
  
  
  
  (3,294
  )Change in net interest income
  
  
  $
  4,395
  
  
  
  $
  (92
  )
  
  
  $
  4,303Rate 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 17 of 92

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
  31,2003
  
  2002
  
  2001
  
  2000
  
  1999(Amounts
  In Thousands)Agricultural
  
  $
  38,153
  
  $
  37,937
  
  $
  34,304
  
  $
  28,560
  
  $
  27,302Commercial and financial
  
  
  47,938
  
  
  46,828
  
  
  44,363
  
  
  37,832
  
  
  36,848Real estate, construction
  
  
  66,644
  
  
  47,201
  
  
  40,430
  
  
  38,184
  
  
  40,879Real estate, mortgage
  
  
  696,453
  
  
  621,226
  
  
  533,257
  
  
  497,744
  
  
  435,639Loans to individuals
  
  
  31,591
  
  
  32,906
  
  
  34,713
  
  
  33,715
  
  
  31,030Total
  
  $
  880,779
  
  $
  786,098
  
  $
  687,067
  
  $
  636,035
  
  $
  571,698There 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, 2003:
AmountOf Loans
  
  One Year 
  Or Less (1)
  
  One To 
  Five Years
  
  Over Five 
  Years(Amounts
  In Thousands)Commercial
  
  $
  86,091
  
  $
  43,425
  
  $
  35,656
  
  $
  7,010Real Estate
  
  
  763,097
  
  
  91,925
  
  
  250,054
  
  
  421,118Other
  
  
  31,591
  
  
  11,609
  
  
  19,492
  
  
  490Totals
  
  $
  880,779
  
  $
  146,959
  
  $
  305,202
  
  $
  428,618The types of interest rates applicable to these principal payments are shown below:
Fixed rate
  
  $
  398,683
  
  $
  94,619
  
  $
  259,564
  
  $
  44,500Variable rate
  
  
  482,096
  
  
  52,340
  
  
  45,638
  
  
  384,118$
  880,779
  
  $
  146,959
  
  $
  305,202
  
  $
  428,618(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 18 of 92

Item 1. Business (Continued)
NONACCRUAL, PAST DUE AND
RESTRUCTURED LOANS
The following table
summarizes the Companys non-accrual, past due, restructured and impaired loans
as of December 31 for each of the years presented:
2003
  
  2002
  
  2001
  
  2000
  
  1999(Amounts In
  Thousands)Nonaccrual loans
  
  $
  3,944
  
  $
  1,538
  
  $
  1,001
  
  $
  618
  
  $
  Accruing loans past due 90
  days or more
  
  
  2,296
  
  
  2,516
  
  
  2,921
  
  
  2,143
  
  
  1,320Restructured loans
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  Impaired loans (includes
  non-accrual loans)
  
  
  18,177
  
  
  16,261
  
  
  11,288
  
  
  11,068
  
  
  9,265The Company does not have
a significant amount of loans that are past due less than 90 days on which
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 interest
is not reasonably assured.  The
non-accrual loans for swine production loans were $2.4 million at December 31,
2003 compared to none at December 31, 2002. 
The non-accrual loans are considered to be impaired loans for purposes
of reviewing the adequacy of the loan loss reserve at year-end.   Interest income was not materially affected
by this classification.
The Company has no
individual borrower or borrowers engaged in the same or similar industry
exceeding 10% of total loans.  The
Company has no other interest-bearing assets, other than loans, that meet the
non-accrual, past due, restructured or potential problem loan criteria.
Impaired loans increased
by $1,916,000 as of December 31, 2003 from December 31, 2002. The increase was
primarily related to swine production loans which increased $1.4 million from
December 31, 2002 to December 31, 2003.
Specific allowance for
losses on non-accrual and impaired loans are established if the loan balances
exceed the net present value of the future cash flows or the fair value of the
collateral if the loan is collateral dependent.
Page 19 of 92

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 31,2003
  
  2002
  
  2001
  
  2000
  
  1999(Amounts
  In Thousands)Allowance for loan losses
  at beginning of year
  
  $
  12,125
  
  $
  9,950
  
  $
  10,428
  
  $
  9,750
  
  $
  8,856Charge-offs:Agriculture
  
  
  26
  
  
  33
  
  
  35
  
  
  26
  
  
  60Commercial and financial
  
  
  266
  
  
  562
  
  
  1,225
  
  
  522
  
  
  181Real estate, mortgage
  
  
  478
  
  
  390
  
  
  557
  
  
  254
  
  
  104Loans to individuals
  
  
  874
  
  
  803
  
  
  724
  
  
  372
  
  
  4181,644
  
  
  1,788
  
  
  2,541
  
  
  1,174
  
  
  763Recoveries:Agriculture
  
  
  88
  
  
  116
  
  
  72
  
  
  153
  
  
  157Commercial and financial
  
  
  661
  
  
  371
  
  
  289
  
  
  276
  
  
  260Real estate, mortgage
  
  
  318
  
  
  402
  
  
  362
  
  
  118
  
  
  30Loans to individuals
  
  
  613
  
  
  625
  
  
  416
  
  
  357
  
  
  3101,680
  
  
  1,514
  
  
  1,139
  
  
  904
  
  
  757Net charge-offs
  (recoveries)
  
  
  (36
  )
  
  274
  
  
  1,402
  
  
  270
  
  
  6Provision for loan losses
  (1)
  
  
  424
  
  
  2,449
  
  
  924
  
  
  948
  
  
  900Allowance for loan losses
  at end of year
  
  $
  12,585
  
  $
  12,125
  
  $
  9,950
  
  $
  10,428
  
  $
  9,750Ratio of net charge-offs
  (recoveries) during year to average loans outstanding
  
  
  0.00
  %
  
  0.04
  %
  
  0.22
  %
  
  0.04
  %
  
  0.00
  %(1)
  For financial reporting purposes, management
  regularly reviews the loan portfolio and determines a provision for loan
  losses based upon the impact of economic conditions on the borrowers ability
  to repay, 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 20 of 92

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 believes are of higher credit risk (agricultural loans and
constructed model real estate homes as of December 31, 2003, 2002, 2001, 2000
and 1999).  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, 2003, 2002, 2001,
2000, and 1999:
2003
  
  2002Amount
  
  % of
  Total Allowance
  
  % Of Loans
  To Total Loans
  
  Amount
  
  % of
  Total Allowance
  
  % Of Loans
  To Total Loans(In
  Thousands)
  
  
  
  
  
  
  (In
  Thousands)Agriculture
  
  
  $
  2,470
  
  
  
  19.63
  %
  
  
  4.33
  %
  
  
  $
  2,219
  
  
  
  18.30
  %
  
  
  4.78
  %Commercial
  
  
  
  1,421
  
  
  
  11.29
  
  
  
  5.44
  
  
  
  
  1,374
  
  
  
  11.33
  
  
  
  5.91Real estate, construction
  
  
  
  1,076
  
  
  
  8.55
  
  
  
  7.57
  
  
  
  
  975
  
  
  
  8.04
  
  
  
  5.95Real estate
  
  
  
  6,775
  
  
  
  53.83
  
  
  
  79.07
  
  
  
  
  6,638
  
  
  
  54.75
  
  
  
  79.21Consumer
  
  
  
  843
  
  
  
  6.70
  
  
  
  3.59
  
  
  
  
  919
  
  
  
  7.58
  
  
  
  4.15$
  12,585
  
  
  
  100.00
  %
  
  
  100.00
  %
  
  
  $
  12,125
  
  
  
  100.00
  %
  
  
  100.00
  %2001
  
  2000Agriculture
  
  
  $
  1,032
  
  
  
  10.37
  %
  
  
  4.95
  %
  
  
  $
  1,576
  
  
  
  15.11
  %
  
  
  4.48
  %Commercial
  
  
  
  1,714
  
  
  
  17.23
  
  
  
  6.40
  
  
  
  
  1,281
  
  
  
  12.28
  
  
  
  5.95Real estate, construction
  
  
  
  770
  
  
  
  7.74
  
  
  
  5.84
  
  
  
  
  1,544
  
  
  
  14.81
  
  
  
  5.99Real estate
  
  
  
  5,722
  
  
  
  57.50
  
  
  
  77.80
  
  
  
  
  5,338
  
  
  
  51.19
  
  
  
  78.29Consumer
  
  
  
  712
  
  
  
  7.16
  
  
  
  5.01
  
  
  
  
  689
  
  
  
  6.61
  
  
  
  5.29$
  9,950
  
  
  
  100.00
  %
  
  
  100.00
  %
  
  
  $
  10,428
  
  
  
  100.00
  %
  
  
  100.00
  %1999Agriculture
  
  
  $
  1,025
  
  
  
  10.51
  %
  
  
  4.75
  %Commercial
  
  
  
  1,366
  
  
  
  14.01
  
  
  
  6.41Real estate, construction
  
  
  
  925
  
  
  
  9.49
  
  
  
  7.11Real estate
  
  
  
  5,698
  
  
  
  58.44
  
  
  
  76.33Consumer
  
  
  
  736
  
  
  
  7.55
  
  
  
  5.40$
  9,750
  
  
  
  100.00
  %
  
  
  100.00
  %The allocation of the
allowance for loan losses shows an increase of $251,000 to agriculture loans
and specifically this was due to loans for swine production.  This area of agriculture continues to have
overall concerns due to the possible large fluctuations in the hog prices.  The prices in 2003 averaged approximately
$36.00 per hundred weight compared to $34.20 in 2002.  The change in price that can happen is reflected in the average
price in 2001 which was $46.30.  The
average breakeven in the industry is approximately $40.00 per hundred weight,
so exposure on these types of loans continues to exist.  The other changes in the allocation are primarily
related to volume changes of loans outstanding and no material deterioration of
credit quality.
Page 21 of 92

Item 1. Business (Continued)
INVESTMENT SECURITIES
The following tables show
the carrying value of the investment securities which are principally held by
the Bank as of December 31, 2003, 2002 and 2000 and the maturities and weighted
average yield of the investment securities as of December 31, 2003:
December
  31,2003
  
  2002
  
  2001(Amounts
  In Thousands)Carrying value:U. S. Treasury securities
  
  $
  6,138
  
  $
  6,365
  
  $
  12,073Obligations of other U. S. Government agencies and
  corporations
  
  
  152,710
  
  
  134,936
  
  
  123,165Obligations of state and political subdivisions
  
  
  68,535
  
  
  64,528
  
  
  46,913$
  227,383
  
  $
  205,829
  
  $
  182,151December
  31, 2003Carrying
  Value
  
  Weighted
  Average
  Yield(Amounts
  In Thousands)Type and maturity
  grouping:U. S. Treasury maturities: within 1 year
  
  
  $
  6,138
  
  
  
  4.85
  %Obligations of other U. S. Government agencies and
  corporations, maturities:Within 1 year
  
  
  
  29,888
  
  
  
  5.53
  %From 1 to 5 years
  
  
  
  122,822
  
  
  
  3.24152,710Obligations of state and political subdivisions,
  maturities:Within 1 year
  
  
  
  8,529
  
  
  
  4.30
  %From 1 to 5 years
  
  
  
  39,895
  
  
  
  5.82From 5 to 10 years
  
  
  
  19,667
  
  
  
  5.24Over 10 years
  
  
  
  444
  
  
  
  5.1368,535Total
  
  
  $
  227,383Page 22 of 92

Item 1. Business (Continued)
INVESTMENT SECURITIES
As of December 31, 2003,
there were no investment securities, exceeding 10% of stockholders equity,
other than securities of the U. S. Government and 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 34% and a state tax rate of 5%.
DEPOSITS
The following tables show
the amount of average deposits and rates paid on such deposits for the years
ended December 31, 2003, 2002 and 2001 and the composition of the
certificates of deposit issued in denominations in excess of $100,000 as of
December 31, 2003:
December
  31,2003
  
  Rate
  
  2002
  
  Rate
  
  2001
  
  RateAverage
  noninterest-bearing deposits
  
  $
  108,414
  
  
  0.00
  %
  $
  92,145
  
  
  0.00
  %
  $
  78,687
  
  
  0.00
  %Average interest-bearing
  demand deposits
  
  
  122,918
  
  
  0.82
  
  
  96,054
  
  
  1.14
  
  
  76,366
  
  
  1.85Average savings deposits
  
  
  214,088
  
  
  0.91
  
  
  194,230
  
  
  1.49
  
  
  169,561
  
  
  2.72Average time deposits
  
  
  399,747
  
  
  3.49
  
  
  381,973
  
  
  4.79
  
  
  357,882
  
  
  5.76$
  845,167
  
  
  
  
  $
  764,402
  
  
  
  
  $
  682,496Amount
  
  RateTime certificates issued
  in amounts of $100,000 or more as of December 31, 2003 with maturity in:3 months or less
  
  $
  13,728
  
  
  2.84
  %3 through 6 months
  
  
  12,649
  
  
  2.696 through 12 months
  
  
  8,735
  
  
  2.57Over 12 months
  
  
  26,854
  
  
  3.84$
  61,966There were no deposits in
foreign banking offices.
Page 23 of 92

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, 2003, 2002 and 2001:
2003
  
  2002
  
  2001Return on average assets
  
  
  1.24
  %
  
  1.10
  %
  
  1.11
  %Return on average
  stockholders equity
  
  
  15.36
  
  
  14.05
  
  
  13.94Dividend payout ratio
  
  
  19.99
  
  
  22.87
  
  
  23.58Average stockholders
  equity to average assets ratio
  
  
  8.04
  
  
  7.85
  
  
  7.96SHORT-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 securities sold under agreements to repurchase during 2003, 2002 and
2001:
2003
  
  2002
  
  2001(Amounts In Thousands)Outstanding balance as of
  December 31
  
  $
  29,926
  
  $
  20,798
  
  $
  22,409Weighted average interest
  rate at year end
  
  
  1.00
  %
  
  1.52
  %
  
  2.36
  %Maximum month-end balance
  
  
  37,205
  
  
  28,882
  
  
  22,711Average month-end balance
  
  
  29,323
  
  
  21,240
  
  
  17,444Weighted average interest
  rate for the year
  
  
  1.34
  %
  
  1.79
  %
  
  3.53
  %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 2003, 2002 and 2001:
2003
  
  2002
  
  2001(Amounts In Thousands)Outstanding balance as of
  December 31
  
  $
  167,574
  
  $
  167,606
  
  $
  137,637Weighted average interest
  rate at year end
  
  
  5.34
  %
  
  5.35
  %
  
  5.57
  %Maximum month-end balance
  
  
  167,606
  
  
  167,637
  
  
  137,637Average month-end balance
  
  
  167,595
  
  
  153,543
  
  
  123,211Weighted average interest
  rate for the year
  
  
  5.42
  %
  
  5.52
  %
  
  5.83
  %Page 24 of 92

PART I
Item 2. Properties
The Companys office and
the main bank 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.  A majority of these operations previously
were located in the Banks Coralville office. As a result of the consolidation,
sixty-five full-time and part-time employees were relocated.
The other offices of
Hills Bank and Trust 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 automatic teller machine.  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 automatic teller machine 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 automatic teller machine.4.
  The Bank leases an office at 132 East Washington
  Street in downtown Iowa City with approximately 2,500 square feet.  The office has two 24-hour automatic
  teller machines and two private offices in addition to a tellers and customer
  service area.  The lease expires in
  2006.5.
  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.  The new office replaced a leased office
  that had 1,100 square feet.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 automatic teller machine.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 automatic teller machine.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 2007.Page 25 of 92

Item 2. Properties (Continued)
9.
  The Kalona office is a 6,400 square foot building
  that contains a walk-up 24-hour automatic teller machine and one drive-up
  lane.  This is an older building that
  was remodeled in late 1998.10.
  In March of 2002, Hills 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.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 materials
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, 2003.
Page 26 of 92

PART II

Item 5.
  Market for the Registrants Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity SecuritiesThere 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.  A bid and ask price is quoted in an Iowa City local paper and the
quotes are provided by a local broker. 
The Companys stock is not actively traded.  As of March 15, 2004, the Company had 1,416 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 OfTransactions
  
  High
  Selling
  Price
  
  Low
  Selling
  Price2003
  
  
  7,487
  
  
  26
  
  $
  101.00
  
  $
  88.002002
  
  
  16,917
  
  
  22
  
  
  88.00
  
  
  82.002001
  
  
  9,273
  
  
  28
  
  
  82.00
  
  
  77.00The Company paid
aggregate annual cash dividends in 2003, 2002 and 2001 of $2,853,000,
$2,622,000 and $2,392,000, respectively, or $1.90 per share in 2003, $1.75 per
share in 2002 and $1.60 per share in 2001. 
In January 2004, the Company declared and paid a dividend of $2.10 per
share totaling $3,185,000.  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.
As of December 31, 2003,
stock option information is as follows:
Number of shares that
  would be issued if all options were exercised
  
  
  19,291Weighted average price of
  options outstanding
  
  $
  77.27Number of additional
  shares that could be granted
  
  
  45,976There are no stock option
plans that have not been approved by the stockholders.
Page 27 of 92

Item 6. Selected Financial Data
CONSOLIDATED FIVE-YEAR
STATISTICAL SUMMARY
2003
  
  2002
  
  2001
  
  2000
  
  1999YEAR-END TOTALS (Amounts in Thousands)Total
  assets
  
  $
  1,183,223
  
  $
  1,098,547
  
  $
  976,105
  
  $
  875,750
  
  $
  773,966Investment
  securities
  
  
  236,157
  
  
  214,211
  
  
  189,960
  
  
  161,066
  
  
  156,198Federal
  funds sold
  
  
  13,233
  
  
  32,514
  
  
  29,428
  
  
  28,065
  
  
  206Loans
  held for sale
  
  
  1,960
  
  
  6,884
  
  
  5,575
  
  
  1,266
  
  
  681Loans,
  net
  
  
  868,194
  
  
  773,973
  
  
  677,117
  
  
  625,607
  
  
  564,700Deposits
  
  
  868,767
  
  
  802,321
  
  
  720,018
  
  
  652,706
  
  
  562,086Federal
  Home Loan Bank borrowings
  
  
  167,574
  
  
  167,606
  
  
  137,637
  
  
  120,668
  
  
  108,700Redeemable
  common stock
  
  
  14,864
  
  
  12,951
  
  
  12,194
  
  
  11,550
  
  
  10,953Stockholders
  equity
  
  
  96,765
  
  
  88,084
  
  
  78,155
  
  
  68,524
  
  
  60,264EARNINGS (Amounts in Thousands)Interest
  income
  
  $
  63,381
  
  $
  64,561
  
  $
  63,718
  
  $
  59,992
  
  $
  51,121Interest
  expense
  
  
  26,405
  
  
  31,141
  
  
  34,435
  
  
  33,064
  
  
  26,313Provision
  for loan losses
  
  
  424
  
  
  2,449
  
  
  924
  
  
  948
  
  
  900Other
  income
  
  
  13,356
  
  
  10,230
  
  
  9,257
  
  
  7,514
  
  
  6,437Other
  expenses
  
  
  28,641
  
  
  24,615
  
  
  22,859
  
  
  20,069
  
  
  18,309Income
  taxes
  
  
  6,998
  
  
  5,122
  
  
  4,613
  
  
  4,059
  
  
  3,570Net
  income
  
  
  14,269
  
  
  11,464
  
  
  10,144
  
  
  9,366
  
  
  8,466PER SHARENet
  income:Basic
  
  $
  9.44
  
  $
  7.65
  
  $
  6.78
  
  $
  6.26
  
  $
  5.70Diluted
  
  
  9.42
  
  
  7.58
  
  
  6.72
  
  
  6.21
  
  
  5.66Cash
  dividends
  
  
  1.90
  
  
  1.75
  
  
  1.60
  
  
  1.45
  
  
  1.30Book
  value as of December 31
  
  
  63.80
  
  
  58.68
  
  
  52.15
  
  
  45.82
  
  
  40.29Increase
  (decrease) in book value due to:ESOP obligation
  
  
  (9.80
  )
  
  (8.63
  )
  
  (8.14
  )
  
  (7.72
  )
  
  (7.32
  )Accumulated
  other comprehensive income
  
  
  2.04
  
  
  3.15
  
  
  2.02
  
  
  0.47
  
  
  (0.66
  )SELECTED RATIOSReturn on
  average assets
  
  
  1.24
  %
  
  1.10
  %
  
  1.11
  %
  
  1.14
  %
  
  1.18
  %Return on
  average equity
  
  
  15.36
  
  
  14.05
  
  
  13.94
  
  
  14.94
  
  
  14.54Net
  interest margin
  
  
  3.53
  
  
  3.58
  
  
  3.58
  
  
  3.62
  
  
  3.83Average
  stockholders equity to average total assets
  
  
  8.04
  
  
  7.85
  
  
  7.96
  
  
  7.63
  
  
  8.11Dividend
  payout ratio
  
  
  19.99
  
  
  22.87
  
  
  23.58
  
  
  23.18
  
  
  22.56Page 28 of 92

Item 7. Managements Discussion and Analysis of Financial
Condition And Results of Operations
Special Note Regarding
Forward-Looking Statements
The discussion following
contains certain forward-looking statements with respect to the financial
condition, the results of operations and business of the Company.  These statements involve certain risks and
uncertainties, which are often inherent in the ongoing operation of financial
institutions such as the Companys subsidiary bank.
Forward-looking
statements discuss matters that are not facts and are typically identified by
the words believe, expect, anticipate, target, goal, objective,
intend, estimate, will, can, would, should, could, may and
similar expressions.  They discuss
expectations about the future and are not guarantees.   Forward-looking statements speak only as of the date they are
made, and the Company undertakes no obligation to update them to reflect
changes that occur after the date they are made.
There are several factors
 many of which are beyond the control of the Company or its subsidiary Bank 
that could cause results to differ significantly from expectations.  Some of these factors are described below.  There are factors other than those described
below that could cause results to differ from expectations.  Any factor described below could by itself,
or together with one or more other factors, adversely affect the business,
earnings and/or financial condition of the Company and its subsidiary Bank.
The risks involved in the
operations and strategies of the Company and its subsidiary Bank include
competition from other financial institutions, changes in interest rates,
changes in economic or market conditions as well as events and trends affecting
specific assets, the effect of credit quality and market perceptions of value
on the fair values of financial instruments and regulatory factors.  These risks, which are not inclusive, cannot
be accurately estimated.
For example, a financial
institution may accept deposits at fixed interest rates, at different times and
for different terms, and lend funds at fixed interest rates, at different times
and for different terms.  In doing so,
it accepts the risk that its cost of funds may raise while the use of those
funds may be at a fixed rate. 
Similarly, although market rates of interest may decline, the financial
institution may have committed by virtue of the term of a deposit, to pay what
essentially becomes an above-market rate.
Loans, and the allowance
for loan losses, carry the risk that borrowers will not repay all funds in a
timely manner, as well as the risk of total loss.  The collateral pledged as security for loans may or may not have
the value that has been attributed to it. 
The loan loss reserve, while believed to be adequate, may prove
inadequate if one or more large-balance borrowers, or numerous mid-balance
borrowers, or a combination of both, experience financial difficulty for a
variety of reasons. These reasons may relate to the financial circumstances of
an individual borrower, or may be caused by negative economic circumstances at
the local, regional, national or international level that are beyond the
control of the borrowers or the lender.
Because the business of
banking is of a highly regulated nature, the decisions of governmental entities
can have a major effect on operating results. 
Changes to statutes, regulations or regulatory policies, including
changes in interpretation or implementation of statutes, regulations or
policies, could have substantial and unpredictable effects including increasing
the ability of non-banks to offer competing financial services and products.
Page 29 of 92

Item 7. Managements Discussion and Analysis of Financial
Condition And Results of Operations
The Banks success
depends, in part, on its ability to attract and retain key people.  Competition for the best people  in
particular individuals with technology experience  is intense.  The Bank may not be able to hire
well-qualified people or pay them enough to keep them.
All of these
uncertainties, as well as others, are present in the operations and business of
the Company, and stockholders are cautioned that the Companys actual results
may differ materially from those included in the forward-looking statements.
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 policy to
be related to the allowance for loan losses. The Companys allowance for loan
loss methodology incorporates a variety of risk considerations, both
quantitative and qualitative in establishing an allowance for loan loss that
management believes is appropriate at each reporting date. Quantitative factors
include the Companys historical loss experience, delinquency and charge-off
trends, collateral values, changes in non-performing loans, and other factors.
Quantitative factors also incorporate known information about individual loans,
including borrowers sensitivity to interest rate movements. Qualitative
factors include the general economic environment in the Companys markets,
including economic conditions throughout the Midwest and in particular, the
state of certain industries. Size and complexity of individual credits in
relation to loan structure, existing loan policies and pace of portfolio growth
are other qualitative factors that are considered in the methodology. As the
Company adds new products and increases the complexity of its loan portfolio,
it will enhance its methodology accordingly. This discussion and analysis
should be read in conjunction with the Companys financial statements and the
accompanying notes presented elsewhere herein, as well as the portion of this
Managements Discussion and Analysis section entitled Financial Condition -
Allowance for Loan Losses. Although management believes the levels of the
allowance as of both December 31, 2003 and 2002 were adequate to absorb
probable losses inherent in the loan portfolio, a decline in local economic
conditions, or other factors, could result in increasing losses that cannot be
reasonably predicted at this time.
Page 30 of 92

Item 7.
  Managements Discussion and Analysis of Financial
  Condition and Results of Operations (Continued)Financial Position
Year End Amounts (Amounts In Thousands)
  
  2003
  
  2002
  
  2001
  
  2000
  
  1999Loans, net of allowance
  for losses
  
  $
  870,154
  
  $
  780,857
  
  $
  682,692
  
  $
  626,873
  
  $
  565,381Investment securities
  
  
  236,157
  
  
  214,211
  
  
  189,960
  
  
  161,066
  
  
  156,198Deposits
  
  
  868,767
  
  
  802,321
  
  
  720,018
  
  
  652,706
  
  
  562,086Federal Home Loan Bank
  borrowings
  
  
  167,574
  
  
  167,606
  
  
  137,637
  
  
  120,668
  
  
  108,700Stockholders equity
  
  
  96,765
  
  
  88,084
  
  
  78,155
  
  
  68,524
  
  
  60,264Total assets
  
  
  1,183,223
  
  
  1,098,547
  
  
  976,105
  
  
  875,750
  
  
  773,966In 2003, total assets
grew $84.7 million, compared to an increase of $122.4 million for 2002.  The percentage increase in total assets was
7.71% in 2003, compared to 12.54% in 2002. 
Asset growth for both years was primarily reflected in higher loan
balances and investment securities.  In the year ended December 31, 2003, although
the total asset growth was down compared to the prior year, a review of the
balance sheets shows a reduction in federal funds sold of $19.3 million that were
used for asset acquisition.  As an
alternative, the Company could have borrowed from the FHLB and that would have
increased the asset growth by $19.3 million. 
Also, with the use of the federal funds and a good increase in deposits,
no additional amount of funding was required from the FHLB.  Given the overall interest rates on federal
funds and in order to use them more efficiently, it was a business decision to
switch to the loan and investment alternatives.
In 2003, net loans
increased by $89.3 million.   The net
loans include loans held for sale to the secondary market, which were
$1,960,000 at December 31, 2003, having decreased from the balance of
$6,884,000 at December 31, 2002.  In the
year 2003, as in 2002, the increase in loans was primarily attributable to real
estate mortgage loans which increased $75.2 million.  The increase for 2002 was $98.2 million with $88.0 in mortgage
real estate loans.  The increases in both
years were driven by the continued low level of interest rates which during 2003
were at fifty year lows.  In addition,
the overall economy in the Companys principal place of business, Johnson and
Linn Counties, remain in good economic 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 2001 and 2003, five new
banking locations were added in Johnson County and ten in Linn County.  The fifteen new locations include an office
of one of the states largest credit unions and several large Des Moines based
banks.  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.
Deposits increased $66.4
million, or 8.28% in 2003 compared to an increase of 11.43% in 2002.  Also, for funding purposes securities sold
under agreements to repurchase increased $9.1 million to $29.9 million after
having decreased $1.6 million in 2002. 
Deposits including repurchase agreements increased 9.18% in 2003
compared to 10.87% in 2002.  In 2003 and
also in 2002, growth continued in deposits due to uncertainties in the stock
market from 2001 and 2002, when the stock market had a significant downturn and
consumers have elected not to move quickly back to stocks as an
investment.  Also, in the last two
years, the Bank has established new offices in the Cedar Rapids and Marion area
and a relocated office on the Eastside of Iowa City, all of which have been
helpful in adding new deposit customers for the Bank.  In Linn
County, as of June 30, 2003, the Company had approximately $119 million in
deposits or 3.3% of the total deposit market of $3.6 billion.  The Bank has added three offices in the
Cedar Rapids-Marion area since 2000, with two of the offices added in 2003 and
2002, respectively to capitalize on the strong Linn County market which in
total, is twice the size of the Johnson County market.  Johnson County has fourteen banks and Linn
County has twenty-seven banks at the end of 2003.  In addition, there are two credit unions in Johnson County while
Linn County has ten credit unions.  In
the last two years the Company has increased its market share in both
counties.  While there is increasing
competition in the Linn County market, the Banks three newest offices in Linn
County grew by $45.7 million in 2002 and 2003, and management anticipates that
the Banks market share in Linn County will continue to grow in the years
ahead.
Page 31 of 92

Item 7.
  Managements Discussion and Analysis of Financial
  Condition and Results of Operations (Continued)In 2002, the Company
increased its borrowings from the Federal Home Loan Bank (FHLB) by a net $30
million to increase total advances at December 31, 2002 to $167.6 million.  As in prior years, the advances are used to
fund asset growth in years where deposit sources are not sufficient.  The increase in 2003 in deposits and
repurchase agreements coupled with a reduction in federal funds sold of $19.3
million were enough to not require any increase in the borrowings from the
FHLB.  It is expected that the FHLB
funding source will be used in the future when loan growth exceeds deposit
increases and the interest rates are favorable compared to other funding
alternatives.
Investment
securities increased by $21.9 million in 2003 and $24.3 million in 2002.  Because the portfolio is marked to market,
changes in the value of the portfolio may vary significantly from year to
year.  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.
Stockholders
equity was $96.8 million at December 31, 2003 compared to $88.1 million at
December 31, 2002.  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 $53.7 million and
paid shareholders dividends of $13.2 million, or 24.6% 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
  
  E.P.S.-
  Diluted2003
  
  
  $
  14,269
  
  
  
  24.47
  %
  
  
  $
  9.422002
  
  
  
  11,464
  
  
  
  13.01
  
  
  
  
  7.582001
  
  
  
  10,144
  
  
  
  8.31
  
  
  
  
  6.722000
  
  
  
  9,366
  
  
  
  10.63
  
  
  
  
  6.211999
  
  
  
  8,466
  
  
  
  13.09
  
  
  
  
  5.66Net income for 2003
reached a record high of $14,269,000, or diluted earnings per share of
$9.42.  For 2003, diluted earnings per
share increased $1.84 per share, while 2002 results had increased $.51 per
share. For the year ended December 31, 2002, net income increased by $1,320,000
from the 2001 results. Net income for the year ended December 31, 2003,
represents a $2,805,000 increase over the reported income for the same period
in 2002.  The increase in net income is
related to three significant factors. The factors are the continued growth in
average earning assets, the decrease in the provision for loan losses and the
increase in the gain on sale of loans. Net interest income, including fees
increased $3.6 million for the year ended December 31, 2003 compared to
2002.  The improvement is due to an
increase in average earning assets of $116.4 million. The provision for loan
losses and its effect on net income is discussed in a later section of this
report.  The mortgage refinancing growth
continued in 2003 as the number of loans sold on the secondary market and the
resulting gain on sale was $4,278,000 which is $2,287,000 more than 2002.  The interest rates on secondary market loans
that are sold increased in late summer as long-term investment rates rose.  As a result of this, coupled with the fact
that many consumers had taken advantage of lower rates, the volume of loans
sold and the related level of income from this mortgage activity did not
continue in the fourth quarter of 2003.
Page 32 of 92

Item 7.
  Managements Discussion and Analysis of Financial
  Condition and Results of Operations (Continued)Annual
fluctuations in the Companys net income are driven primarily by three
important factors. The first important factor is net interest margin. Net
interest income of $40.0 million in 2003 was derived from the Companys $1.084
billion of average earning assets and its net interest margin of 3.53% for that
same year. 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 3.43%
would result in a $1 million decrease in net income before taxes.
The
second significant factor on the Companys net income is the provision for loan
losses. The majority of the Companys investments are in loans outstanding,
which amounted to more than $880 million in 2003. The Companys allowance for
loan losses was $12.6 million in 2003. An increase in problem loans would
result in a higher allocation to the loan loss reserve, which in turn would
reduce the Companys net income.
The
amount of loans sold on the secondary market is the third significant factor.
The gain on the sale of loans on the secondary market has ranged from $316,000
in 1999 to $4,278,000 in 2003. Sales of loans on the secondary market are
influenced by the real estate market and interest rates. Interest rates, which
also help spur new loan growth and secondary market loans (including
refinancing), have been at record lows when compared to interest rate levels
over the last fifty years. Effective June 25, 2003, the Federal Reserve Open
Market Committee lowered the federal funds target rate to 1.00%, the lowest
level since July 1958. Prior to the June 25, 2003 decrease, the target rate was
lowered 25 basis points on November 6, 2002. The June 25, 2003 decrease was the
thirteenth decrease since May 16, 2000, when the federal funds rate was 6.50%.
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 over the last few years, primarily due to
new loans.  The net interest margin has
remained steady over the last five years in spite of decreasing interest rates.  The net interest margin was 3.53% in 2003,
3.58% in 2002, 3.58% in 2001, 3.62% in 2000 and 3.83% in 1999.  The measure is shown on a
tax-equivalent basis using a rate of 34% to make the interest earned on taxable
and nontaxable assets more comparable.
Page 33 of 92

Item 7.
  Managements Discussion and Analysis of Financial
  Condition and Results of Operations (Continued)Net interest income on a
tax-equivalent basis changed in 2003 as follows:
Increase
  (Decrease)Change In
  Average
  Balance
  
  Change In
  AverageRateVolume
  Changes
  
  RateChanges
  
  NetChange(Amounts In Thousands)Interest income:Loans,
  net
  
  
  $
  95,888
  
  
  
  
  (0.87
  )%
  
  
  $
  6,704
  
  
  
  $
  (6,761
  )
  
  
  $
  (57
  )Taxable
  securities
  
  
  
  6,727
  
  
  
  
  (1.00
  )
  
  
  
  337
  
  
  
  
  (1,481
  )
  
  
  
  (1,144
  )Nontaxable
  securities
  
  
  
  7,320
  
  
  
  
  (0.45
  )
  
  
  
  423
  
  
  
  
  (266
  )
  
  
  
  157Federal
  funds sold
  
  
  
  6,442
  
  
  
  
  (0.56
  )
  
  
  
  83
  
  
  
  
  (221
  )
  
  
  
  (138
  )$
  116,377
  
  
  
  
  
  
  
  
  $
  7,547
  
  
  
  $
  (8,729
  )
  
  
  $
  (1,182
  )Interest expense:Interest-bearing
  demand deposits
  
  
  $
  26,864
  
  
  
  
  (0.32
  )%
  
  
  
  265
  
  
  
  
  (348
  )
  
  
  
  (83
  )Savings
  deposits
  
  
  
  19,858
  
  
  
  
  (0.58
  )
  
  
  
  271
  
  
  
  
  (1,221
  )
  
  
  
  (950
  )Time
  deposits
  
  
  
  17,774
  
  
  
  
  (1.30
  )
  
  
  
  818
  
  
  
  
  (5,159
  )
  
  
  
  (4,341
  )Securities
  sold under agreements to repurchase
  
  
  
  8,083
  
  
  
  
  (0.45
  )
  
  
  
  127
  
  
  
  
  (154
  )
  
  
  
  (27
  )FHLB
  borrowings
  
  
  
  14,052
  
  
  
  
  (0.10
  )
  
  
  
  773
  
  
  
  
  (108
  )
  
  
  
  665$
  86,631
  
  
  
  
  
  
  
  
  $
  2,254
  
  
  
  $
  (6,990
  )
  
  
  $
  (4,736
  )Change in net interest income
  
  
  
  
  
  
  
  
  
  
  
  
  $
  5,293
  
  
  
  $
  (1,739
  )
  
  
  $
  3,554Net interest income changes for 2002 were as follows:
Change In
  Average
  Balance
  
  Effect Of
  Volume
  Changes
  
  Effect Of
  Rate
  Changes
  
  NetChange(Amounts In Thousands)Interest-earning assets
  
  $
  117,683
  
  $
  8,423
  
  $
  (7,414
  )
  $
  1,009Interest-bearing liabilities
  
  
  102,576
  
  
  4,028
  
  
  (7,322
  )
  
  (3,294
  )Change in net interest income
  
  
  
  
  $
  4,395
  
  $
  (92
  )
  $
  4,303Page 34 of 92

Item 7.
  Managements Discussion and Analysis of Financial
   Condition and Results of Operations (Continued)A summary of the net
interest spread and margin is as follows:
(Tax
  Equivalent Basis)
  
  2003
  
  2002
  
  2001Yield on average interest-earning assets
  
  
  5.96
  %
  
  6.80
  %
  
  7.62
  %Rate on average interest-bearing liabilities
  
  
  2.83
  
  
  3.68
  
  
  4.63Net interest spread
  
  
  3.13
  
  
  3.12
  
  
  2.99Effect of noninterest-bearing funds
  
  
  0.40
  
  
  0.46
  
  
  0.59Net interest margin (tax equivalent interest income
  divided by average interest-earning assets)
  
  
  3.53
  %
  
  3.58
  %
  
  3.58
  %Provision For Loan Losses
The provision for loan
losses totaled $424,000, $2,449,000 and $924,000 for 2003, 2002 and 2001,
respectively.  Recoveries net of charge-off
for 2003 were $36,000 while charge-offs, net of recoveries, were $274,000 for
2002 and $1,402,000 for 2001.  The provision for loan losses in 2003 was
$424,000 compared to $2,449,000 in 2002 or a decrease of $2,025,000.  The provision adjustment computed on a
quarterly basis 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 level of impaired loans which are all non-accrual and loans
past due ninety days or more.  In
addition, management considers the credit quality based on their 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 reviewing 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 the loan.  The Company also
reviews 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 5% vacancy rate.  As of December 31, 2003, the unemployment
level in Johnson County and Linn County was 3.39% and 4.31%, respectively.  These levels compare favorably to the State
of Iowa at 4.36% and the national unemployment level at 5.72%.  The residential rental vacancy rates in 2003
in Johnson County, the largest trade area for the Company, were 4.06% in Iowa
City and 7.19% in Coralville.  The State
of Iowa vacancy rate is 8.2% and the national is 10.2%.  The rates for Iowa City and Coralville for
2001 were both under 2%.  Although the
vacancy rates have increased in the Companys trade areas, the Company has not
believed it necessary to increase the number of loans in a problem or watch
status based on its current evaluation of the loan portfolio.
The
level of problem or watch loans that were included in the reserve computation
increased significantly from December 31, 2001 to December 31, 2002 and
therefore resulted in the large provision increase in 2002.  The increase was due in particular for loans
that were in the swine production segment that were of major concern because of
the dollar amount of those loans and the severe price fluctuations that swine
producers experienced during that time period, management felt it prudent to
classify many of those loans as problem or watch loans.  The amount of problem or watch loans
considered in the estimate for December 31, 2003 was at balances that were
similar to December 31, 2002.  The
allowance for loan losses balance is also affected by the net charge-offs for
the periods presented.  For the year
ended December 31, 2003 and 2002, recoveries were $1,680,000 and $1,514,000,
respectively; and charge-offs were $1,644,000 in 2003 and $1,788,000 in 2002.
Page 35 of 92

Item 7.
  Managements Discussion and Analysis of Financial
   Condition And Results of Operations (Continued)The allowance for loan
losses totaled $12,585,000 at December 31, 2003 compared to $12,125,000 at
December 31, 2002.  The percentage of
the allowance to outstanding loans was 1.43% and 1.53% at December 31, 2003 and
2002, respectively. The
percentage of the loan loss allowance to gross loans was 1.46%, 1.66% and 1.72%
at December 31, 2001, 2000 and 1999, respectively.  The decrease was due to loan growth (fueled primarily by an
increase in real estate mortgages) and a decrease in the number of problem or
watch loans compared to 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 2003 is
consistent with the prior year. Beginning in 2001, the Bank refined the
methodology used to compute the allowance for loan losses, primarily by
applying estimated loss rates to several risk categories of loans instead of
more general categories of loans.
Agricultural loans
totaled $38,153,000 and $37,937,000 at December 31, 2003 and 2002,
respectively.  The level of agriculture
loans the last five years compared to total loans has been between 4.95% down
to 4.33% in 2003.  Management has
assessed the risks for agricultural loans 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 24,500 employees and because of the money it spends in Johnson
County, has a tremendous impact on the economy of the Banks primary trade
area.  In 2002 and 2003, the University
of Iowa helped Johnson Countys economy remain strong in spite of a weakened
national economy.  However, in the last
fifteen months the economy of the state of Iowa has weakened and the University
continues to suffer from budget cuts. For its fiscal year beginning July 1,
2004 the University expects continued budget constraints.  The possible effects on the local economy
cannot be predicted, but are likely to weaken the economy in future years.
Other Income
In 2003, the Companys
total other income increased $3,126,000 compared to the prior year.  Gain on sale of loans to the secondary
market for 2003 increased over the prior year by $2,287,000 due to continued
low interest rates that enabled borrowers to re-finance. Loans sold in 2001
were $1,165,000, an increase of $849,000 over 2000. Interest rates on secondary
market loans averaged under 6.05% the first half of 2003 compared to 6.69% in
2002 and 7.15% in 2001. Interest rates rose in the last quarter of 2003 and
this with the factor that many customers had refinanced in late 2002 and in
2003 reduced the volume of loans sold on the secondary market. In addition, the
increase in customer deposit accounts, along with increases in the fees,
accounted for a $327,000 increase in deposit account charges and fees.  Trust fees in 2003 had a $92,000 increase to
$2,444,000 due to more assets under management. The Trust Department has $623
million of assets under management at December 31, 2003 compared to $484
million at December 31, 2002.  Trust
fees are based on total assets under management.  The trust assets that are the most volatile are those that are
held in common stock.  Approximately 51%
of trust assets are held in common stocks and with the major decline in the
market in 2002, this effected the growth of the trust assets and trust
fees.  During the last half of 2003, the
major stock indices have all shown much improvement and as a result the asset
growth has been in part due to market value increases.  An example of the increases is the Dow Jones
Industrial Average which was down approximately 16% in 2002 was up over 25% in
2003.  Due to the majority of the trust
assets growth in terms of new accounts and market value increases coming in the
last six months, trust fees did not increase significantly for 2003.
Other
fees and charges increased $90,000 from 2002 compared to 2003.  In 2003, the credit card processing fee
income increased by $507,000 to $698,000. 
Also, in the other expenses section, the credit card processing expense
in 2003 was $957,000 compared to $398,000 in 2002, or an increase of
$559,000.  Effective on January 1, 2003,
the Company began including the gross amount of merchant charges in other
income rather than netting it with related processing charges.  This change had no effect on the income
shown for credit card processing but did decrease the fee income and processing
expense by approximately $400,000 for 2002 and 2001.  Total other income was also offset by $177,000 due to investment
securities losses in the fourth quarter of 2003.  In 2002, no securities losses were reported.
Page 36 of 92

Item 7.
  Managements Discussion and Analysis of Financial
  Condition And Results of Operations (Continued)In 2002, the Companys
total other income increased $973,000 compared to the prior year.  Gain on sale of loans revenue for 2002
increased over the prior year by $826,000 due to continued low interest rates
that enabled borrowers to re-finance. 
Interest rates on secondary market loans averaged under 6.50% the last
half of 2002 compared to 7.15% in 2001. 
In addition, the increase in customer deposit accounts, along with
changes in the fee structure, accounted for an $189,000 increase in deposit
account charges and fees.  Trust fees in
2002 were virtually unchanged form 2001, a $47,000 increase.  The number of trust accounts under
management increased in 2002, but the continued decline in stock values had the
effect of reducing trust fees which are based on asset value.
Other Expenses
Total
other expenses were $28,641,000 and $24,615,000 for the year ended December 31,
2003 and 2002, respectively.  The
increase includes $2,212,000 in salaries and benefits, which is the direct
result of salary adjustments for 2003 and a net increase in full-time
equivalents of fifteen since December 31, 2002.  The new employees added included nine in the secondary loan
market department and eleven in the Marion office, which opened in February
2003.   Medical expenses included with
salaries and benefits increased to $1.1 million from $825,000 in 2002.  This increase is due to the hiring of new
employees and to 20% increases in health and drug claim costs.  All other expenses other than salaries and
benefits increased a total of $1,814,000 or 16.57%.  Credit card processing fees, which composed part of the other
expenses, increased $559,000 and was offset by $507,000 of increased fee income
of credit card processing included in the other income section.  Direct expenses for the secondary market for
items such as direct underwriting expense and related expenses were $285,000
higher in 2003 than in 2002.  The
increase is the result of the higher volume of loans that were sold on the
secondary market during 2003.  Direct
expenses for the secondary market will decrease if the volume of loans sold on
the secondary market decreases.
Other expenses increased
$1,756,000 in 2002. Of the increase, salaries and benefits accounted for
$1,804,000, occupancy and furniture and equipment expense accounted for $76,000
of the increase and all other expenses decreased $124,000.  The salaries and employee benefits increased
as a direct result of salary adjustments for 2002 and staff additions primarily
at the new office locations. Total full-time equivalent employees increased
between years by twenty-four. The benefits include a $150,000 increase in
medical insurance costs due to increasing medical costs. The increased
occupancy and furniture and equipment expense was the result of new locations
added and new equipment purchases both in 2001 and 2002. Other expenses
decreased $124,000 between 2001 and 2002. The other expenses in 2001 included
$261,000 for amortization of intangible assets, which consisted principally of
goodwill, equal to the excess of cost over fair value of net assets acquired in
business combinations of two banks in 1996 accounted for under the purchase method.
As discussed in the section of Impact of Recently Issued Accounting Standards
amortization of goodwill ceased effective on January 1, 2002.
Income Taxes
Income tax expense was
$6,998,000, $5,122,000 and $4,613,000 for the years ended December 31, 2003,
2002 and 2001, respectively.  The
corresponding percentage of income taxes compared to income before income taxes
is 32.91%   in 2003, 30.88% in 2002 and
31.26% in 2001.  The percentages are up
slightly from 2002 to 2003 due to an increase in pre tax income for the year
without a corresponding increase in non-taxable interest income due to lower
interest rates in 2003.
Impact of Recently Issued
Accounting Standards
The FASB  has issued Statement No. 143, Accounting
for Asset Retirement Obligations which requires that the fair value of a
liability for an asset retirement obligation be recognized in the period in
which it is incurred if a reasonable estimate of fair value can be made.  The associated asset retirement costs are
capitalized as part of the carrying amount of the long-lived asset.  For the Company, the Statement was effective
January 1, 2003, and implementation did not have any impact on the financial
statements.
Page 37 of 92

Item 7.
  Managements Discussion and Analysis of Financial Condition
  And Results of Operations (Continued)The FASB has issued
Statement No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment
of FASB Statement No. 13, and Technical Corrections.  This statement is applicable to debt extinguishments and their
classification; certain sale-leaseback transactions and intangible assets of
motor carriers. Implementation of these provisions of the Statement had no
effect and is not expected to have a material impact on the Companys financial
statements.
The
FASB has issued Statement No. 146, Accounting for Costs Associated with Exit
or Disposal Activities.  The provisions
of the Statement are effective for exit or disposal activities that are
initiated after December 31, 2002. 
Implementation of the Statement did not have a material impact on the
Companys financial statements.
The
FASB has issued Interpretation No. 45, Guarantors Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others- an interpretation of FASB Statements No. 5, 57, and 107 and rescission
of FASB Interpretation No. 34.  This
Interpretation elaborates on the disclosures to be made by a guarantor in its
interim and annual financial statements about its obligations under certain
guarantees that it has issued.  It also
clarifies that a guarantor is required to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee. The initial recognition and measurement provisions of
the Interpretation are applicable on a prospective basis to guarantees issued
or modified after December 31, 2002. 
Implementation of these provisions of the Interpretation is not expected
to have a material impact on the Companys consolidated financial statements.  The disclosure requirements of the
Interpretation are effective for financial statements of interim or annual
periods ending after December 15, 2002. 
The adoption of Interpretation No. 45s measurement and recognition
provisions did not have a material impact to the Companys financial position
or results of operations.
In
October 2002, the FASB issued Statement of Financial Accounting Standards
No.147, Acquisition of Certain Financial Institutions, an Amendment to FASB
Statements No.72 and 144 and FASB Interpretation No.9. The statement removes
acquisitions of financial institutions from the scope of the previous issued
statements and interpretation and requires that those transactions be accounted
for in accordance with Statement of Financial Accounting Standards No.141,
Business Combinations and Statement of Financial Accounting Standards No.142,
Goodwill and Intangible Assets.  Thus,
the requirement to recognize (and subsequently amortize) any excess of the fair
value of liabilities assumed over the fair value of tangible and identifiable
intangible assets acquired as an unidentifiable intangible asset no longer
applies to acquisitions within the scope of this statement. The Company adopted
FASB No. 147 on October 1, 2002 and the adoption resulted in no
reclassification or revisions to prior period financial statements.
In
January 2003, the FASB issued Interpretation No.46,Consolidation of Variable
Interest Entities, which addresses consolidation by business enterprises of
variable interest entities which have certain characteristics by requiring that
if a business enterprise has a controlling interest in a variable interest
entity, the assets, liabilities and results of activities of the variable
interest entity be included in the consolidated financial statements with those
of the business enterprise.  This
statement applies to variable interest entities created after January 31, 2003
and to variable interest entities in which an enterprise obtains an interest
after that date. For variable interest acquired before February 1, 2003, it
applies in the first fiscal year or interim period beginning after June 15,
2003. The Company has adopted the various provisions of this statement but
presently does not have any variable interest entities that would be required
to be included in its consolidated financial statements.
Page 38 of 92

Item 7.
  Managements Discussion and Analysis of Financial
  Condition And Results of Operations (Continued)In
May 2003, the FASB issued Statement of Financial Accounting Standards No. 150,
Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity. This statement established standards for how an issuer
classifies and measures certain financial instruments with characteristics of
both liabilities and equity. It requires that an issuer classify a financial
instrument that is within its scope as a liability (or asset in some
circumstances). Many of those instruments were previously classified as equity.
The statement is effective for financial instruments entered into or modified
after May 31, 2003, and otherwise is effective at the beginning of the first
interim period beginning after June 15, 2003. 
The Company adopted the statement on July 1, 2003 and such adoption did
not have a material effect on its financial position or results of operations.
In
April 2003, the FASB issued Statement of Financial Accounting Standards No.
149, Amendment of Statement 133 on Derivative Instruments and Hedging
Activities (SFAS 149). SFAS 149 amends Statement 133 for decisions made (1)
as part of the Derivatives Implementation Group process that effectively
required amendments to Statement 133, (2) in connection with other FASB
projects dealing with financial instruments, and (3) in connection with the
implementation issues raised in relation to the application of the definition
of a derivative, in particular, the meaning of an initial net investment that
is smaller than would be required for other types of contracts that would be
expected to have a similar response to changes in market factors, the meaning
of underlying, and the characteristics of a derivative that contains
financing components. SFAS 149 is generally effective for contracts entered
into or modified after June 30, 2003 and for hedging relationships designated
after June 30, 2003. The Company adopted SFAS 149 on July 1, 2003 and such
adoption did not have a material effect on its financial position or results of
operations.
Page 39 of 92

Item
  7.
  Managements
  Discussion and Analysis of Financial Condition and Results of Operations
  (Continued)Interest Rate Sensitivity and Liquidity Analysis
At December 31, 2003, the
Companys interest rate sensitivity report is as follows (amounts in
thousands):
Repricing
  Maturities
  Immediately
  
  Days
  
  More Than
  One Year
  
  Total2-30
  
  31-90
  
  91-180
  
  181-365Earning assets:Federal funds sold
  
  $
  13,233
  
  $
  
  
  $
  
  
  $
  
  
  $
  
  
  $
  
  
  $
  13,233Investment securities
  
  
  
  
  
  3,377
  
  
  5,310
  
  
  14,191
  
  
  21,067
  
  
  192,212
  
  
  236,157Loans
  
  
  5,832
  
  
  65,012
  
  
  36,949
  
  
  40,998
  
  
  72,264
  
  
  661,685
  
  
  882,740Total
  
  
  19,065
  
  
  68,389
  
  
  42,259
  
  
  55,189
  
  
  93,331
  
  
  853,897
  
  
  1,132,130Sources of funds:Interest-bearing checking and savings accounts
  
  
  137,747
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  221,270
  
  
  359,017Certificates of deposit
  
  
  
  
  
  32,728
  
  
  53,083
  
  
  81,963
  
  
  53,484
  
  
  172,287
  
  
  393,545Other borrowings - FHLB
  
  
  
  
  
  60,000
  
  
  30,000
  
  
  10,000
  
  
  10,000
  
  
  57,574
  
  
  167,574Repurchase agreements and federal funds
  
  
  29,926
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  29,926167,673
  
  
  92,728
  
  
  83,083
  
  
  91,963
  
  
  63,484
  
  
  451,131
  
  
  950,062Other sources, primarily
  noninterest-bearing
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  116,206
  
  
  116,206Total sources
  
  
  167,673
  
  
  92,728
  
  
  83,083
  
  
  91,963
  
  
  63,484
  
  
  567,337
  
  
  1,066,268InterestRate Gap
  
  $
  (148,608
  )
  $
  (24,339
  )
  $
  (40,824
  )
  $
  (36,774
  )
  $
  29,847
  
  $
  286,560
  
  $
  65,862Cumulative Interest Rate
  Gap at December 31, 2003
  
  $
  (148,608
  )
  $
  (172,947
  )
  $
  (213,771
  )
  $
  (250,545
  )
  $
  (220,698
  )
  $
  65,862The 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 their callable
dates because they may be called if interest rates rise over current rates.
Inflation
Inflation has an impact
on the growth of total assets and has resulted in the need to increase equity
capital to maintain an appropriate equity to asset ratio.  The results of operations have been affected
by inflation, but the effect has been minimal.
Page 40 of 92

Item
  7.
  Managements
  Discussion and Analysis of Financial Condition and Results of Operations
  (Continued)Liquidity and Capital Resources
On an unconsolidated
basis, the Company had cash balances of $2,343,000 as of December 31,
2003.  In 2003, the holding company
received dividends of $2,856,000 from its subsidiary bank and used those funds
to pay dividends to its stockholders of $2,853,000.
As of December 31, 2003
and 2002, stockholders equity, before deducting for the maximum cash
obligation related to ESOP, was $111,629,000 and $101,035,000
respectively.  This measure of equity as
a percent of total assets was 9.43% at December 31, 2003 and 9.20% at December
31, 2002.  As of December 31, 2003,
total equity was 8.18% of assets compared to 8.02% of assets at the prior year
end.  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 total approximately $10,820,000, $6,092,000 and
$7,015,000 as of December 31, 2003, 2002 and 2001, respectively.
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, 2003,
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.  One of the most
significant standards of operation of state banks is the six and one-half
percent (6 1/2%) primary capital to total assets ratio generally required by
the Superintendent.  In certain
instances, the Superintendent may mandate higher capital, but the Superintendent
has not imposed such a requirement on the Bank.  The Superintendent defines the term primary capital to mean the
sum of stockholders equity and the allowance for loan losses less any
intangible assets.  In determining the
primary capital ratio, the Superintendent uses the total assets as of the date
of computation.  At December 31, 2003,
the primary capital to total assets ratio of the Bank exceeded the ratio
required by the Superintendent.
Page 41 of 92

Item
  7.
  Managements
  Discussion and Analysis of Financial Condition and Results of Operations
  (Continued)The actual amounts and capital ratios as of December
31, 2003 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 ProvisionsAmount
  
  Ratio
  
  Ratio
  
  RatioAs of December 31, 2003:Company:Total risk based capital
  
  $
  116,035
  
  
  14.56
  %
  
  8.00
  %
  
  
  10.00
  %Tier 1 risk based capital
  
  
  106,042
  
  
  13.31
  
  
  4.00
  
  
  
  6.00Leverage ratio
  
  
  106,042
  
  
  8.87
  
  
  3.00
  
  
  
  5.00Bank:Total risk based capital
  
  
  112,641
  
  
  14.15
  
  
  8.00
  
  
  
  10.00Tier 1 risk based capital
  
  
  102,661
  
  
  12.90
  
  
  4.00
  
  
  
  6.00Leverage ratio
  
  
  102,661
  
  
  8.60
  
  
  3.00
  
  
  
  5.00The Bank is classified as
well capitalized by FDIC capital guidelines.
On a consolidated basis,
2003 cash flows from operations provided $22,145,000 and net increases in
deposits provided $66,446,000.  These
cash flows were invested in net loans of $94,645,000, and net securities of
$25,693,000. Also, federal funds sold decreased by $19,281,000 to assist in the
funding of the loans and investments growth. 
In addition, $2,952,000 was used to purchase property and equipment.
At December 31, 2003, the
Bank had total outstanding loan commitments and unused portions of lines of
credit totaling $139,422,000. 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, 2003 can obtain an additional $139 million from the FHLB
based on the current real estate mortgage loans held.  In addition, the Bank has arranged $111 million of credit lines
at three banks.  The borrowings would be
secured by the Banks investment securities. 
As a further source of liquidity, $69 million of additional securities
are available to be pledged or liquidated.
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 42 of 92

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, 2003 and 2002, loan balances to related individuals and businesses
totaled $32,454,000 and $27,813,000, respectively.  Deposits from related parties totaled $5,800,000 and $6,599,000
as of December 31, 2003 and 2002, 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 rates increase over an extended period of time.  Inversely, the Companys yields and cost of
funds will decrease when market rates decline. 
The Company is able to manage these swings to some extent by attempting
to control the maturity or rate adjustments of its interest-earning assets and
interest-bearing liabilities over given periods of time.
The Bank maintains an
asset/liability committee, which meets at least quarterly to review the
interest rate sensitivity position and to review 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 43 of 92

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.
2004
  
  2005
  
  2006
  
  2007
  
  2008
  
  Thereafter
  
  Total
  
  Fair Value(Amounts In Thousands)Assets:Loans,
  fixed:Balance
  
  $
  94,619
  
  $
  26,387
  
  $
  50,804
  
  $
  69,245
  
  $
  113,128
  
  $
  44,500
  
  $
  398,683
  
  $
  441,178Average
  interest rate
  
  
  6.59
  %
  
  7.12
  %
  
  6.59
  %
  
  6.43
  %
  
  6.01
  %
  
  5.89
  %
  
  6.35
  %Loans,
  variable:Balance
  
  $
  52,340
  
  $
  3,563
  
  $
  1,962
  
  $
  5,052
  
  $
  35,061
  
  $
  384,118
  
  $
  482,096
  
  $
  482,096Average
  interest rate
  
  
  6.51
  %
  
  5.75
  %
  
  6.35
  %
  
  5.60
  %
  
  4.46
  %
  
  5.96
  %
  
  5.91
  %Investments (1):Balance
  
  $
  65,445
  
  $
  54,905
  
  $
  50,634
  
  $
  39,605
  
  $
  16,050
  
  $
  22,751
  
  $
  249,390
  
  $
  249,501Average
  interest rate
  
  
  3.88
  %
  
  4.14
  %
  
  3.12
  %
  
  3.14
  %
  
  3.73
  %
  
  4.91
  %
  
  3.75
  %Liabilities:Liquid
  deposits (2):Balance
  
  $
  359,017
  
  $
  
  
  $
  
  
  $
  
  
  $
  
  
  $
  
  
  $
  359,017
  
  $
  359,017Average
  interest rate
  
  
  0.61
  %
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  0.61
  %Deposits, certificates:Balance
  
  $
  221,257
  
  $
  56,699
  
  $
  47,309
  
  $
  47,851
  
  $
  20,428
  
  $
  
  
  $
  393,544
  
  $
  391,798Average
  interest rate
  
  
  2.89
  %
  
  2.81
  %
  
  4.08
  %
  
  4.29
  %
  
  3.57
  %
  
  
  
  
  3.23
  %(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.Item 8.
Financial Statements and Supplementary Data
The financial statements
and supplementary data are included on Pages 45 through 77.
Page 44 of 92

INDEPENDENT
AUDITORS REPORT

To the Board of Directors 
Hills Bancorporation
Hills, Iowa

We have audited the accompanying consolidated balance sheet of Hills
Bancorporation and subsidiary as of December 31, 2003, and the related
consolidated statements of income, comprehensive income, stockholders equity,
and cash flows for the year then ended. 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
audit.
We conducted our audit in accordance with auditing standards
generally accepted in the United States of America. 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
audit provides a reasonable basis for our opinion.
In our opinion, the 2003 consolidated financial statements referred to
above present fairly, in all material respects, the financial position of Hills
Bancorporation and subsidiary as of December 31, 2003, and the results of their
operations and their cash flows for the year then ended in conformity with
accounting principles generally accepted in the United States of America.
MESSAGEJanuary 30,
2004
Page 45 of 92


INDEPENDENT
AUDITORS REPORT
To
the Board of Directors 
Hills Bancorporation
Hills, Iowa
We
have audited the accompanying consolidated balance sheet of Hills
Bancorporation and subsidiary as of December 31, 2002 and the related
consolidated statements of income, comprehensive income, stockholders equity
and cash flows for the years ended December 31, 2002 and 2001.  These financial statements are the
responsibility of the Companys management. 
Our responsibility is to express an opinion on these financial
statements based on our audits.
We
conducted our audits in accordance with auditing standards generally accepted
in the United States of America.  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 subsidiary as of December 31, 2002, and the results of their
operations and their cash flows for the years ended December 31, 2002 and 2001
in conformity with accounting principles generally accepted in the United
States of America.
MESSAGEIowa City, Iowa 
February 25, 2003
Page 46 of 92


HILLS
BANCORPORATION
CONSOLIDATED BALANCE SHEETS
December 31, 2003 and 2002
(Amounts In Thousands, Except Shares)
2003
 
 2002ASSETSCash and due from banks
 (Note 9)
 
 $
 24,194
 
 $
 32,647Investment securities
 (Note 2):Available for sale (amortized cost 2003 $214,530 ; 2002
 $190,313)
 
 
 219,430
 
 
 197,807Held to maturity (fair value 2003 $8,064 ; 2002 $8,303)
 
 
 7,953
 
 
 8,022Stock of Federal Home Loan
 Bank
 
 
 8,774
 
 
 8,382Federal funds sold
 
 
 13,233
 
 
 32,514Loans held for sale
 
 
 1,960
 
 
 6,884Loans, net (Notes 3, 6 and
 10)
 
 
 868,194
 
 
 773,973Property and equipment,
 net (Note 4)
 
 
 22,210
 
 
 21,500Accrued interest
 receivable
 
 
 7,303
 
 
 7,278Deferred income taxes
 (Note 8)
 
 
 2,411
 
 
 1,971Goodwill
 
 
 2,500
 
 
 2,500Other assets
 
 
 5,061
 
 
 5,069$
 1,183,223
 
 $
 1,098,547LIABILITIES
 AND STOCKHOLDERS EQUITYLiabilitiesNoninterest-bearing deposits
 
 $
 116,206
 
 $
 107,833Interest-bearing deposits (Note 5)
 
 
 752,561
 
 
 694,488Total deposits
 
 
 868,767
 
 
 802,321Securities sold under agreements to repurchase (Note 6)
 
 
 29,926
 
 
 20,798Federal Home Loan Bank borrowings (FHLB) (Note 7)
 
 
 167,574
 
 
 167,606Accrued interest payable
 
 
 1,735
 
 
 2,134Other liabilities
 
 
 3,592
 
 
 4,6531,071,594
 
 
 997,512Commitments and
 Contingencies (Notes 8 and 14)Redeemable Common Stock
 Held By Employee StockOwnership Plan (ESOP) (Note 8)
 
 
 14,864
 
 
 12,951Stockholders Equity (Note
 10)Capital stock, no par value; authorized 10,000,000
 shares; issued 2003
 1,516,678 shares; 2002 1,501,054 shares
 
 
 11,353
 
 
 10,541Retained earnings
 
 
 97,189
 
 
 85,773Accumulated other
 comprehensive income
 
 
 3,087
 
 
 4,721111,629
 
 
 101,035Less maximum cash obligation related to ESOP shares (Note
 8)
 
 
 14,864
 
 
 12,95196,765
 
 
 88,084$
 1,183,223
 
 $
 1,098,547See Notes to
Consolidated Financial Statements.
Page 47 of 92


HILLS
BANCORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands, Except Per Share Amounts)
2003
 
 2002
 
 2001Interest income:Loans, including fees
 
 $
 54,362
 
 $
 54,363
 
 $
 52,986Investment securities:Taxable
 
 
 6,268
 
 
 7,412
 
 
 7,670Nontaxable
 
 
 2,369
 
 
 2,266
 
 
 1,930Federal funds sold
 
 
 382
 
 
 520
 
 
 1,132Total interest income
 
 
 63,381
 
 
 64,561
 
 
 63,718Interest expense:Deposits
 
 
 16,926
 
 
 22,294
 
 
 26,634Securities sold under agreements to repurchase
 
 
 389
 
 
 375
 
 
 617FHLB borrowings
 
 
 9,090
 
 
 8,472
 
 
 7,184Total interest expense
 
 
 26,405
 
 
 31,141
 
 
 34,435Net interest income
 
 
 36,976
 
 
 33,420
 
 
 29,283Provision for loan losses
 (Note 3)
 
 
 424
 
 
 2,449
 
 
 924Net interest income after provision for
 loan losses
 
 
 36,552
 
 
 30,971
 
 
 28,359Other income:Net gain on sale of loans
 
 
 4,278
 
 
 1,991
 
 
 1,165Trust fees
 
 
 2,444
 
 
 2,352
 
 
 2,399Deposit account charges and fees
 
 
 3,624
 
 
 3,297
 
 
 3,108Credit card processing fee income
 
 
 698
 
 
 191
 
 
 232Other fees and charges
 
 
 2,489
 
 
 2,399
 
 
 2,353Net losses on sale of investment securities
 
 
 (177
 )
 
 
 
 
 13,356
 
 
 10,230
 
 
 9,257Other expenses:Salaries and employee benefits
 
 
 15,879
 
 
 13,667
 
 
 11,863Occupancy
 
 
 1,899
 
 
 1,817
 
 
 1,826Furniture and equipment
 
 
 3,008
 
 
 2,892
 
 
 2,807Office supplies and postage
 
 
 1,245
 
 
 1,167
 
 
 1,198Advertising and business development
 
 
 1,769
 
 
 1,390
 
 
 1,273Credit card processing expense
 
 
 957
 
 
 398
 
 
 384Other
 
 
 3,884
 
 
 3,284
 
 
 3,50828,641
 
 
 24,615
 
 
 22,859Income before income taxes
 
 
 21,267
 
 
 16,586
 
 
 14,757Federal and state income
 taxes (Note 9)
 
 
 6,998
 
 
 5,122
 
 
 4,613Net income
 
 $
 14,269
 
 $
 11,464
 
 $
 10,144Earnings per share:Basic
 
 $
 9.44
 
 $
 7.65
 
 $
 6.78Diluted
 
 
 9.42
 
 
 7.58
 
 
 6.72See Notes to
Consolidated Financial Statements.
Page 48 of 92


HILLS
BANCORPORATION
CONSOLIDATED
STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)
2003
 
 2002
 
 2001Net income
 
 $
 14,269
 
 $
 11,464
 
 $
 10,144Other comprehensive income
 (loss),Unrealized gains on securities:Unrealized holding gains (losses) arising during the
 year, net of income taxes 2003 $(960); 2002 $998; 2001 $1,366
 
 
 (1,746
 )
 
 1,700
 
 
 2,323Less: reclassification adjustment for losses included in
 net income, net of income taxes
 
 
 112
 
 
 
 
 
 Other comprehensive income
 (loss)
 
 
 (1,634
 )
 
 1,700
 
 
 2,323Comprehensive
 income
 
 $
 12,635
 
 $
 13,164
 
 $
 12,467See Notes to Consolidated
Financial Statements.
Page 49 of 92


HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY 
Years Ended December 31, 2003, 2002 and 2001 
(Amounts In Thousands, Except Share Amounts)
Capital
 Stock
 
 Retained
 Earnings
 
 Accumulated
 Other
 Comprehensive
 Income (Loss)
 
 Maximum
 Cash
 Obligation
 Related
 To ESOP
 Shares
 
 TotalBalance, December 31, 2000
 
 $
 10,197
 
 $
 69,179
 
 
 $
 698
 
 
 
 $
 (11,550
 )
 
 $
 68,524Issuance of 3,233 shares of common stock
 
 
 165
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 165Redemption of 158 shares of common stock
 
 
 (8
 )
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 (8
 )Change related to ESOP shares
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 (644
 )
 
 
 (644
 )Net income
 
 
 
 
 
 10,144
 
 
 
 
 
 
 
 
 
 
 
 
 10,144Income tax benefit related to stock based compensation
 
 
 43
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 43Cash dividends ($1.60 per share)
 
 
 
 
 
 (2,392
 )
 
 
 
 
 
 
 
 
 
 
 
 (2,392
 )Other comprehensive income
 
 
 
 
 
 
 
 
 
 2,323
 
 
 
 
 
 
 
 
 2,323Balance, December 31, 2001
 
 
 10,397
 
 
 76,931
 
 
 
 3,021
 
 
 
 
 (12,194
 )
 
 
 78,155Issuance of 2,891 shares of common stock
 
 
 127
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 127Redemption of 395 shares of common stock
 
 
 (30
 )
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 (30
 )Change related to ESOP shares
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 (757
 )
 
 
 (757
 )Net income
 
 
 
 
 
 11,464
 
 
 
 
 
 
 
 
 
 
 
 
 11,464Income tax benefit related to stock based compensation
 
 
 47
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 47Cash dividends ($1.75 per share)
 
 
 
 
 
 (2,622
 )
 
 
 
 
 
 
 
 
 
 
 
 (2,622
 )Other comprehensive income
 
 
 
 
 
 
 
 
 
 1,700
 
 
 
 
 
 
 
 
 1,700Balance, December 31, 2002
 
 
 10,541
 
 
 85,773
 
 
 
 4,721
 
 
 
 
 (12,951
 )
 
 
 88,084Issuance of 15,624 shares of common stock
 
 
 465
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 465Change related to ESOP shares
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 (1,913
 )
 
 
 (1,913
 )Net income
 
 
 
 
 
 14,269
 
 
 
 
 
 
 
 
 
 
 
 
 14,269Income tax benefit related to stock based compensation
 
 
 347
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 347Cash dividends ($1.90 per share)
 
 
 
 
 
 (2,853
 )
 
 
 
 
 
 
 
 
 
 
 
 (2,853
 )Other comprehensive income
 
 
 
 
 
 
 
 
 
 (1,634
 )
 
 
 
 
 
 
 
 (1,634
 )Balance, December 31, 2003
 
 
 11,353
 
 
 97,189
 
 
 
 3,087
 
 
 
 
 (14,864
 )
 
 
 96,765See Notes to
Consolidated Financial Statements.
Page 50 of 92


HILLS BANCORPORATION
CONSOLIDATED
STATEMENTS OF CASH FLOWS
Years Ended December 31, 2003, 2002 and 2001 
(Amounts In Thousands)
2003
 
 2002
 
 2001Cash Flows from Operating
 ActivitiesNet income
 
 $
 14,269
 
 $
 11,464
 
 $
 10,144Adjustments to reconcile net income to net cash provided
 by operating activities:Depreciation
 
 
 2,242
 
 
 2,316
 
 
 2,212Amortization
 
 
 
 
 
 
 
 
 301Provision for loan losses
 
 
 424
 
 
 2,449
 
 
 924Net losses on sale of investment securities
 
 
 177
 
 
 
 
 
 Compensation paid by issuance of common stock
 
 
 90
 
 
 75
 
 
 121Deferred income taxes
 
 
 520
 
 
 (1,096
 )
 
 47(Increase) decrease in accrued interest receivable
 
 
 (25
 )
 
 (21
 )
 
 266Amortization of bond discount
 
 
 976
 
 
 431
 
 
 171(Increase) decrease in other assets
 
 
 8
 
 
 (741
 )
 
 (359
 )Increase (decrease) in accrued interest and other
 liabilities
 
 
 (1,460
 )
 
 1,095
 
 
 (49
 )Loans originated for sale
 
 
 (316,637
 )
 
 (176,195
 )
 
 (90,207
 )Proceeds on sales of loans
 
 
 325,839
 
 
 176,877
 
 
 87,063Net gain on sales of loans
 
 
 (4,278
 )
 
 (1,991
 )
 
 (1,165
 )Net cash provided by operating
 activities
 
 
 22,145
 
 
 14,663
 
 
 9,469Cash Flows from Investing
 ActivitiesProceeds from maturities of investment securities:Available for sale
 
 
 73,529
 
 
 59,140
 
 
 47,282Held to maturity
 
 
 3,639
 
 
 3,819
 
 
 3,668Proceeds from sales of available for sale securities
 
 
 11,658
 
 
 
 
 
 Purchases of investment securities:Available for sale
 
 
 (110,949
 )
 
 (84,943
 )
 
 (76,327
 )Held to maturity
 
 
 (3,570
 )
 
 
 
 
 Federal funds sold, net
 
 
 19,281
 
 
 (3,086
 )
 
 (1,363
 )Loans made to customers, net of collections
 
 
 (94,645
 )
 
 (99,305
 )
 
 (52,434
 )Purchases of property and equipment
 
 
 (2,952
 )
 
 (2,819
 )
 
 (6,710
 )Net cash used in investing activities
 
 
 (104,009
 )
 
 (127,194
 )
 
 (85,884
 )Cash Flows from Financing
 ActivitiesNet increase in deposits
 
 
 66,446
 
 
 82,303
 
 
 67,312Net increase (decrease) in federal funds purchased and
 securities sold under agreements to repurchase
 
 
 9,128
 
 
 (1,611
 )
 
 5,848Borrowings from FHLB
 
 
 
 
 
 30,000
 
 
 17,000Payments on FHLB borrowings
 
 
 (32
 )
 
 (31
 )
 
 (31
 )Stock options exercised
 
 
 375
 
 
 52
 
 
 44Income tax benefits related to stock based compensation
 
 
 347
 
 
 47
 
 
 43Redemption of common stock
 
 
 
 
 
 (30
 )
 
 (8
 )Dividends paid
 
 
 (2,853
 )
 
 (2,622
 )
 
 (2,392
 )Net cash provided by financing
 activities
 
 
 73,411
 
 
 108,108
 
 
 87,816(Continued)
Page 51 of 92


HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 2003, 2002 and 2001 
(Amounts In Thousands)
2003
 
 2002
 
 2001Increase
 (decrease) in cash and due from banks
 
 $
 (8,453
 )
 $
 (4,423
 )
 $
 11,401Cash and due from banks:Beginning
 
 
 32,647
 
 
 37,070
 
 
 25,669Ending
 
 $
 24,194
 
 $
 32,647
 
 $
 37,070Supplemental DisclosuresCash payments for:Interest paid to
 depositors
 
 $
 17,325
 
 $
 22,843
 
 $
 26,884Interest paid on other obligations
 
 
 9,479
 
 
 8,847
 
 
 8,504Income taxes
 
 
 7,817
 
 
 5,245
 
 
 4,974Noncash financing
 activities:Increase in maximum cash obligation related toESOP shares
 
 $
 1,913
 
 $
 757
 
 $
 644See Notes to
Consolidated Financial Statements.
Page 52 of 92


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, 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.
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 stock-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, 2003 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, 2003 and
2002.

Stock of the Federal Home Loan Bank is carried at cost.
Premiums and discounts on debt securities are amortized over the
contractual lives 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.
Page 53 of 92

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
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 impaired when, based on current information and
events, it is probable the Bank will not be able to collect all amounts
due.  The portion of the allowance for
loan losses applicable to impaired loans has been computed based on the present
value of the estimated future cash flows of interest and principal discounted
at the loans effective interest rate or on the fair value of the collateral for
collateral dependent loans.  The entire
change in present value of expected cash flows of impaired loans or of
collateral value is reported as 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 impaired 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.
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.

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.

Page 54 of 92


HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS

Note 1.   Nature of Activities and Significant
Accounting Policies (Continued)
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. Effective January
1, 2002, the Company discontinued the amortization of goodwill, but makes an
annual assessment for possible impairment. The change in this accounting policy
reduced goodwill amortization by $261,000 for the years ended December 31, 2003
and 2002 compared to the year ended December 31, 2001. The carrying amount of
goodwill as of December 31, 2003 and 2002 totaled $2,500,000 net of accumulated
amortization of $1,398,000 and is included in other assets.
The table below reconciles reported earnings for the year ended
December 31, 2001 to adjusted earnings, which excludes goodwill amortization.

(Amount in
 thousands, except per share amounts)Reported
 Earnings
 
 Goodwill
 Amortization
 
 Adjusted
 EarningsIncome before income tax
 expense
 
 
 $
 14,757
 
 
 
 $
 261
 
 
 
 $
 15,018Income tax expense
 
 
 
 4,613
 
 
 
 
 63
 
 
 
 
 4,676Net income
 
 
 $
 10,144
 
 
 
 $
 198
 
 
 
 $
 10,342Basic earnings per share
 
 
 $
 6.78
 
 
 
 $
 0.13
 
 
 
 $
 6.91Diluted earnings per share
 
 
 $
 6.72
 
 
 
 $
 0.13
 
 
 
 $
 6.85Stock awards
and options:  
Compensation expense for stock issued through the stock award plan is
accounted for using the intrinsic value based method of accounting prescribed
by APB Opinion No. 25, Accounting for Stock Issued to Employees.  Under this method, compensation is 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, is amortized
straight line to expense over the vesting period of five years of service.  No stock-based employee compensation cost is
reflected in net income 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.  Therefore, the options
have no intrinsic value at the date of grant. 
See Note 8 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 55 of 92


HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS

Note 1.   Nature of Activities and Significant
Accounting Policies (Continued)
Trust assets: 
Trust assets, other than cash deposits, held by the Bank in fiduciary or
agency capacities for its customers are not included in these statements since
they are not assets of the Company.
Earnings per share:  Basic per-share amounts are computed by dividing net income (the
numerator) by the weighted-average number of common shares outstanding (the
denominator).  Diluted per share amounts
assume the conversion, exercise or issuance of all potential common stock
equivalents unless the effect is to reduce the loss or increase the income per
common share from continuing operations.
Following is a reconciliation of the denominator:
Year Ended
 December 31,2003
 
 2002
 
 2001Weighted average number of
 shares
 
 
 1,511,317
 
 
 1,499,269
 
 
 1,497,064Potential number of
 dilutive shares
 
 
 3,709
 
 
 12,106
 
 
 12,432Total shares to compute
 diluted earnings per share
 
 
 1,515,026
 
 
 1,511,375
 
 
 1,509,496There are no
potentially dilutive securities that have not been included in the
determination of diluted shares.
Statement of cash flows:  For purposes of reporting cash flows, cash
and due from banks includes cash on hand and amounts due from banks (including
cash items in process of clearing). 
Cash flows from loans originated by the Bank, deposits and federal funds
sold and securities sold under agreements to repurchase are reported net.

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 11 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 believed to be
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.
Page 56 of 92

HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of
Activities and Significant Accounting Policies (Continued)
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 demand deposits equal their carrying amounts,
which represent the amount payable on demand. 
The carrying amounts for variable-rate, fixed-term money market accounts
and certificates of deposit are estimated using a discounted cash flow
calculation that applies interest rates currently being offered on certificates
to a schedule of aggregated expected monthly maturities on time deposits.

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 carrying amount of accrued interest
payable approximates its fair value.

Page 57 of 92


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, 2003 or 2002.  The carrying amount of available-for-sale
securities and their approximate fair values were as follows December 31 (in
thousands):

The amortized cost and fair value of investment securities available
for sale are as follows:
Amortized
 Cost
 
 Gross
 Unrealized
 Gains
 
 Gross
 Unrealized
 (Losses)
 
 Estimated
 Fair
 ValueDecember 31, 2003:U. S. Treasury
 
 $
 6,020
 
 $
 118
 
 $
 
 
 $
 6,138U. S. Government agencies and corporations
 
 
 150,155
 
 
 2,635
 
 
 (80
 )
 
 152,710State and political subdivisions
 
 
 58,355
 
 
 2,287
 
 
 (60
 )
 
 60,582Total
 
 $
 214,530
 
 $
 5,040
 
 $
 (140
 )
 $
 219,430December 31, 2002:U. S. Treasury
 
 $
 6,035
 
 $
 330
 
 
 
 
 $
 6,365U. S. Government agencies and corporations
 
 
 129,916
 
 
 5,020
 
 
 
 
 
 134,936State and political subdivisions
 
 
 54,362
 
 
 2,159
 
 
 (15
 )
 
 56,506Total
 
 $
 190,313
 
 $
 7,509
 
 $
 (15
 )
 $
 197,807The amortized
cost and estimated fair market value of available-for-sale securities
classified according to their contractual maturities at December 31, 2003, were
as follows (in thousands):
Amortized
 Cost
 
 Fair
 ValueDue in one year or less
 
 $
 37,212
 
 $
 37,909Due after one year through
 five years
 
 
 157,806
 
 
 161,510Due after five years
 through ten years
 
 
 19,079
 
 
 19,566Due over ten years
 
 
 433
 
 
 445Total
 
 $
 214,530
 
 $
 219,430As of December
31, 2003, investment securities with a carrying value of $41,932,000 were
pledged to collateralize public and trust deposits, short-term borrowings and
for other purposes, as required or permitted by law.
Page 58 of 92


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):



2003
 
 2002
 
 2001Sales proceeds
 
 $
 11,658
 
 $
 
 
 $
 Gross realized gains
 
 
 
 
 
 
 
 
 Gross realized losses
 
 
 (177
 )
 
 
 
 
 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, 2003 (in
thousands):
Less than 12 months
 
 12 months or more
 
 Total#
 
 Fair Value
 
 Unrealized
 Loss
 
 %
 
 #
 
 Fair Value
 
 Unrealized
 Loss
 
 %
 
 #
 
 Fair Value
 
 Unrealized
 Loss
 
 %Descriptionof SecuritiesU.S. Government
 agencies and corporations
 
 
 5
 
 $
 13,018
 
 $
 (80
 )
 
 
 0.61
 %
 
 0
 
 
 $
 
 
 
 
 $
 
 
 
 
 0.00
 %
 
 5
 
 $
 13,018
 
 
 $
 (80
 )
 
 
 0.61
 %State and municipal bonds
 
 
 31
 
 
 6,093
 
 
 (60
 )
 
 
 0.98
 
 
 0
 
 
 
 
 
 
 
 
 
 
 
 
 0.00
 
 
 31
 
 
 6,093
 
 
 
 (60
 )
 
 
 0.98Total temporarily impaired
 securities
 
 
 36
 
 $
 19,111
 
 $
 (140
 )
 
 
 0.73
 %
 
 0
 
 
 $
 
 
 
 
 $
 
 
 
 
 0.00
 %
 
 36
 
 $
 19,111
 
 
 $
 (140
 )
 
 
 0.73
 %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, 2003
was as follows: U.S. government agency backed securities; (5 positions issued
and guaranteed by FNMA, FHLB, or FHLMC); and state and municipal bonds (26 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.
Investment Securities
Held to Maturity:

Amortized
 Cost
 
 Gross
 Unrealized
 Gains
 
 Gross
 Unrealized
 (Losses)
 
 Estimated
 Fair
 Value(Amounts
 in Thousands)December 31,
 2003:State and
 political subdivisions
 
 
 $
 7,953
 
 
 
 $
 127
 
 
 
 $
 (16
 )
 
 
 $
 8,064December 31,
 2002:State and
 political subdivisions
 
 
 $
 8,022
 
 
 
 $
 281
 
 
 
 $
 
 
 
 
 $
 8,303Page 59 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS


Note 2. Investment
Securities (Continued)

The amortization cost and estimated fair market value of securities
held to maturity classified according to their contractual maturities at
December 31, 2003, were as follows (in thousands):




Amortized
 Cost
 
 Fair
 ValueDue in one year or less
 
 $
 6,646
 
 $
 6,688Due after one year through
 five years
 
 
 1,207
 
 
 1,263Due after five years
 through ten years
 
 
 100
 
 
 113Total
 
 $
 7,953
 
 $
 8,064The 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, 2003 (in
thousands):
Less than 12 months
 
 12 months or more
 
 TotalDescription of Securities
 
 #
 
 Fair
 Value
 
 Unrealized
 Loss
 
 %
 
 #
 
 Fair
 Value
 
 Unrealized
 Loss
 
 %
 
 #
 
 Fair
 Value
 
 Unrealized
 Loss
 
 %State and municipal bonds
 
 
 1
 
 $
 3,554
 
 $
 (16
 )
 
 
 0.45
 %
 
 0
 
 
 $
 
 
 
 
 $
 
 
 
 
 0.00
 %
 
 1
 
 $
 3,554
 
 
 $
 (16
 )
 
 
 0.45
 %Total temporarily impaired
 securities
 
 
 1
 
 $
 3,554
 
 $
 (16
 )
 
 
 0.45
 %
 
 0
 
 
 $
 
 
 
 
 $
 
 
 
 
 0.00
 %
 
 1
 
 $
 3,554
 
 
 $
 (16
 )
 
 
 0.45
 %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 investment with a gross unrealized loss as of December 31, 2003
was a local county capital note due June 1, 2004.  The impairment in the above table was not due to the
deterioration in the credit quality of the issue that might result in the
non-collection of contractual principal and interest.  The cause of the impairment is due to changes in interest
rates.
Note 3. Loans

The composition of loans is as follows:

December
 31,2003
 
 2002(Amounts
 In Thousands)Agricultural
 
 $
 38,153
 
 $
 37,937Commercial and financial
 
 
 47,938
 
 
 46,828Real estate:Construction
 
 
 66,644
 
 
 47,201Mortgage
 
 
 696,453
 
 
 621,226Loans to individuals
 
 
 31,591
 
 
 32,906880,779
 
 
 786,098Less allowance for loan
 losses
 
 
 12,585
 
 
 12,125$
 868,194
 
 $
 773,973Page 60 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS


Note 3. Loans (continued)

Changes in the allowance for loan losses are as follows:

Year Ended
 December 31,2003
 
 2002
 
 2001(Amounts
 In Thousands)Balance, beginning
 
 $
 12,125
 
 $
 9,950
 
 $
 10,428Provision charged to expenses
 
 
 424
 
 
 2,449
 
 
 924Recoveries
 
 
 1,680
 
 
 1,514
 
 
 1,139Loans charged off
 
 
 (1,644
 )
 
 (1,788
 )
 
 (2,541
 )Balance, ending
 
 $
 12,585
 
 $
 12,125
 
 $
 9,950Information
about impaired and nonaccrual loans as of and for the years ended December 31,
2003, 2002 and 2001 are as follows:
2003
 
 2002
 
 2001(Amounts
 In Thousands)Loans receivable for which
 there is a related allowance for loan losses
 
 $
 3,793
 
 $
 4,588
 
 $
 4,417Loans receivable for which
 there is no related allowance for loan losses
 
 
 14,384
 
 
 11,673
 
 
 6,871Total impaired loans
 
 $
 18,177
 
 $
 16,261
 
 $
 11,288Related allowance for
 credit losses on impaired loans
 
 $
 802
 
 $
 547
 
 $
 897Average balance of
 impaired loans
 
 
 17,883
 
 
 12,739
 
 
 11,200Nonaccrual loans (included
 as impaired loans)
 
 
 3,944
 
 
 1,538
 
 
 1,001Loans past due ninety days
 or more and still accruing
 
 
 2,296
 
 
 2,516
 
 
 2,921Interest income recognized
 on impaired loans
 
 
 1,202
 
 
 962
 
 
 962Note 4. Property and Equipment
The major classes of property and equipment and the total accumulated
depreciation are as follows:

December
 31,2003
 
 2002(Amounts
 In Thousands)Land
 
 $
 3,715
 
 $
 3,715Buildings and improvements
 
 
 17,743
 
 
 17,041Furniture and equipment
 
 
 20,706
 
 
 18,45642,164
 
 
 39,212Less accumulated
 depreciation
 
 
 19,954
 
 
 17,712Net
 
 $
 22,210
 
 $
 21,500Page 61 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 5. Interest-Bearing Deposits


A summary of these deposits is as follows:

December
 31,2003
 
 2002(Amounts
 In Thousands)NOW and other demand
 
 $
 135,254
 
 $
 98,415Savings
 
 
 223,763
 
 
 201,890Time, $100,000 and over
 
 
 61,966
 
 
 60,536Other time
 
 
 331,578
 
 
 333,647$
 752,561
 
 $
 694,488Time deposits
have a maturity as follows:



December 31,2003
 
 2002(Amounts
 in thousands)Due in one year or less
 
 $
 221,257
 
 $
 174,595Due after one year through
 two years
 
 
 56,699
 
 
 132,282Due after two years
 through three years
 
 
 47,309
 
 
 17,726Due after three years
 through four years
 
 
 47,851
 
 
 36,336Due over four years
 
 
 20,428
 
 
 33,244$
 393,544
 
 $
 394,183Note 6. Short-Term Borrowings
The following table sets forth selected information for short-term
borrowings securities sold under agreements to repurchase with an original
maturity of less than one year as of December 31 (in thousands):




2003
 
 2002Repurchase
 agreements with customers, renewable daily, interest payable monthly, secured
 by U.S. Government agencies (1)
 
 $
 29,926
 
 $
 20,798(1)
 The weighted average interest rate on
 short-term borrowings outstanding as of December 31, 2003 and 2002 was 1.00%
 and 1.52%, 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 promise 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, 2003, $29.9 million of
securities sold under repurchase agreements with an interest rate of 1.00%,
maturing in 2004, were collateralized by U.S. Government agencies having an
estimated fair value of $30.6 million and a amortized cost of $29.7
million.
Page 62 of 92

HILLS
BANCORPORATION
NOTES TO FINANCIAL STATEMENTS

Note 7. Federal Home Loan Bank Borrowings
As of December
31, 2003 and 2002, the borrowings were as follows:
2003
 
 2002(Effective interest rates as of December 31, 2003)
 
 (Amounts
 In Thousands)Due 2005, 3.80%
 
 $
 4,350
 
 $
 4,350Due 2006, 4.08%
 
 
 22,750
 
 
 22,750Due 2007, 4.48%
 
 
 20,000
 
 
 20,000Due 2008, 5.22% to 6.00%
 
 
 40,474
 
 
 40,506Due 2009, 5.66% to 6.22%
 
 
 40,000
 
 
 40,000Due 2010, 5.77% to 6.61%
 
 
 40,000
 
 
 40,000$
 167,574
 
 $
 167,606$120,000,000
of the borrowings is callable at various dates now through 2005.
The borrowings are collateralized by 1-4 family mortgage loans with an
aggregate face amount of $201,089,000. 
As of December 31, 2003, the Company held Federal Home Loan Bank stock
with a cost of $8,774,000.

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 $108,000, $93,000 and
$79,000 for the years ended December 31, 2003, 2002 and 2000,
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 traded,
a sponsor must reflect the maximum cash obligation related to those securities
outside of stockholders equity to liabilities.  As of December 31, 2003 and 2002, the shares held by the ESOP,
fair value and maximum cash obligation were as follows:



2003
 
 2002Shares held
 by the ESOP
 
 
 147,172
 
 
 147,172Fair value
 per share
 
 $
 101.00
 
 $
 88.00Maximum cash
 obligation
 
 $
 14,864,000
 
 $
 12,951,000Page 63 of 92

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 $862,000, $741,000 and $636,000 for the
years ended December 31, 2003, 2002 and 2001, respectively.

The Company has a Stock Option and Incentive Plan for certain key
employees and directors whereby shares of common stock have been reserved for
awards in the form of stock options or restricted stock awards.  Under the plan, the aggregate number of
options and shares granted cannot exceed 66,000 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. 
No compensation expense has been charged to expense using the intrinsic
value based method as prescribed by APB No. 25.
The following table illustrates the effect on net income and earnings
per share had compensation cost for all of the stock-based compensation plans
been determined based on the grant date values of awards (the method described
in FASB Statement No. 123, Accounting for Stock-Based Compensation):
Years
 Ended December 31,2003
 
 2002
 
 2001Net income:As reported
 
 $
 14,269
 
 $
 11,464
 
 $
 10,144Deduct total stock-based employee compensation expense
 determined under fair value based method for all awards, net of related tax
 effects
 
 
 (25
 )
 
 (18
 )
 
 (13
 )Pro forma
 
 $
 14,244
 
 $
 11,446
 
 $
 10,131Basic earnings per share:As reported
 
 $
 9.44
 
 $
 7.65
 
 $
 6.79Pro forma
 
 $
 9.42
 
 $
 7.64
 
 $
 6.77Diluted earnings per
 share:As reported
 
 $
 9.42
 
 $
 7.58
 
 $
 6.72Pro forma
 
 $
 9.40
 
 $
 7.57
 
 $
 6.71Page 64 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS


Note 8. Employee
Benefit Plans (Continued)

A summary of the stock options is as follows:

Number
 Of Shares
 
 Weighted
 Average
 Exercise PriceBalance, December 31, 2000
 
 
 
 20,462
 
 
 
 $
 27.15Granted
 
 
 
 10,400
 
 
 
 
 77.00Exercised
 
 
 
 (1,683
 )
 
 
 
 26.17Balance, December 31, 2001
 
 
 
 29,179
 
 
 
 $
 44.98Granted
 
 
 
 636
 
 
 
 
 73.81Exercised
 
 
 
 (2,000
 )
 
 
 
 26.17Balance, December 31, 2002
 
 
 
 27,815
 
 
 
 $
 46.99Granted
 
 
 
 6,200
 
 
 
 
 90.10Exercised
 
 
 
 (14,724
 )
 
 
 
 25.47Balance, December 31, 2003
 
 
 
 19,291
 
 
 
 $
 77.27The weighted
average fair value of options granted in 2003 and 2002 and 2001 was $16.20 per
share, $20.13 per share, and $15.00 per share, respectively.
The fair value of stock options granted was determined utilizing the
Black Scholes Valuation model. 
Significant assumptions include:




2003
 
 2002
 
 2001Risk-free
 interest rate
 
 
 4.57
 %
 
 4.84
 %
 
 4.40
 %Expected
 option life
 
 
 10 years
 
 
 10 years
 
 
 10 yearsExpected
 volatility
 
 
 6.69
 %
 
 2.00
 %
 
 10.77
 %Expected
 dividends
 
 
 2.16
 %
 
 2.13
 %
 
 2.20
 %Other
pertinent information related to the options outstanding at December 31, 2003
is as follows:
Exercise Price
 
 
 Number
 Outstanding
 
 
 Remaining
 Contractual Life
 
 
 Number
 Exercisable$
 41.00
 
 
 
 2,055
 
 
 
 39
 Months
 
 
 
 
 2,05577.00
 
 
 
 10,400
 
 
 
 89
 Months
 
 
 
 
 73.00
 
 
 
 378
 
 
 
 92
 Months
 
 
 
 
 75.00
 
 
 
 258
 
 
 
 96
 Months
 
 
 
 
 88.00
 
 
 
 5,200
 
 
 
 108
 Months
 
 
 
 
 101.00
 
 
 
 1,000
 
 
 
 120
 Months
 
 
 
 
 19,291
 
 
 
 
 
 
 
 
 2,055As of December
31, 2003, 45,976 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 900, 891
and 1,550 shares of common stock to a group of employees in 2003, 2002 and
2001, respectively.  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,
2003, 2002 and 2001 was $61,000, $50,000 and $44,000, respectively.
Page 65 of 92


HILLS BANCORPORATION
NOTES TO FINANCIAL STATEMENTS

Note 9. Income Taxes
Income taxes for the years ended December 31, 2003, 2002 and 2001 are
summarized as follows:
2003
 
 2002
 
 2001(Amounts
 In Thousands)Current:Federal
 
 $
 5,465
 
 $
 5,258
 
 $
 3,819State
 
 
 1,013
 
 
 960
 
 
 747Deferred:Federal
 
 
 453
 
 
 (949
 )
 
 41State
 
 
 67
 
 
 (147
 )
 
 6$
 6,998
 
 $
 5,122
 
 $
 4,613Deferred
income tax liabilities and assets arose from the following temporary
differences:



December
 31,2003
 
 2002(Amounts
 In Thousands)Deferred income tax
 assets:Allowance for loan losses
 
 $
 4,694
 
 $
 4,515Deferred compensation
 
 
 761
 
 
 624Certain accrued expenses
 
 
 224
 
 
 301Other
 
 
 56
 
 
 150Gross deferred tax assets
 
 
 5,735
 
 
 5,590Deferred income tax
 liabilities:Property and equipment
 
 
 1,146
 
 
 716FHLB dividends
 
 
 130
 
 
 130Unrealized gains on investment securities
 
 
 1,813
 
 
 2,773Other
 
 
 235
 
 
 Gross deferred tax liabilities
 
 
 3,324
 
 
 3,619Net deferred income tax asset
 
 $
 2,411
 
 $
 1,971Page 66 of 92

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, 2003, 2002 and 2001 is reflected in the financial statements as
follows:

Year Ended
 December 31,2003
 
 2002
 
 2001(Amounts
 In Thousands)Consolidated statements of
 income
 
 $
 520
 
 $
 (1,096
 )
 $
 47Consolidated statements of
 stockholders equity
 
 
 (960
 )
 
 998
 
 
 1,366$
 (440
 )
 $
 (98
 )
 $
 1,413The income tax
provisions for the years ended December 31, 2003, 2002 and 2001 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:
2003
 
 2002
 
 2001Amount
 
 %Of
 PretaxIncome
 
 Amount
 
 %Of
 PretaxIncome
 
 Amount
 
 %Of
 PretaxIncome(Amounts
 In Thousands)Expected provision
 
 $
 7,443
 
 
 35.0
 %
 $
 5,805
 
 
 35.0
 %
 $
 5,165
 
 
 35.0
 %Tax-exempt interest
 
 
 (875
 )
 
 (4.1
 )
 
 (875
 )
 
 (5.3
 )
 
 (745
 )
 
 (5.0
 )Interest expense
 limitation
 
 
 110
 
 
 0.5
 
 
 128
 
 
 0.8
 
 
 143
 
 
 1.0State income taxes, net of
 federal income tax benefit
 
 
 702
 
 
 3.3
 
 
 547
 
 
 3.3
 
 
 493
 
 
 3.3Income tax credits
 
 
 (234
 )
 
 (1.1
 )
 
 (345
 )
 
 (2.1
 )
 
 (345
 )
 
 (2.3
 )Other
 
 
 (148
 )
 
 (0.7
 )
 
 (138
 )
 
 (0.8
 )
 
 (98
 )
 
 (0.7
 )$
 6,998
 
 
 32.9
 %
 $
 5,122
 
 
 30.9
 %
 $
 4,613
 
 
 31.3
 %Page 67 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS


Note 10.
 Regulatory Capital Requirements,
 Restrictions on Subsidiary Dividends and Cash RestrictionsThe 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, 2003 and 2002, the Company and the Bank met all capital
adequacy requirements to which they are subject.
As of December 31, 2003, 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 changes the institutions
category.
The actual amounts and capital ratios as of December 31, 2003 and 2002,
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 ProvisionsAmount
 
 Ratio
 
 Ratio
 
 RatioAs of December 31, 2003:Company:Total risk based capital
 
 $
 116,035
 
 
 14.56
 %
 
 8.00
 %
 
 
 10.00
 %Tier 1 risk based capital
 
 
 106,042
 
 
 13.31
 
 
 4.00
 
 
 
 6.00Leverage ratio
 
 
 106,042
 
 
 8.87
 
 
 3.00
 
 
 
 5.00Bank:Total risk based capital
 
 
 112,641
 
 
 14.15
 
 
 8.00
 
 
 
 10.00Tier 1 risk based capital
 
 
 102,661
 
 
 12.90
 
 
 4.00
 
 
 
 6.00Leverage ratio
 
 
 102,661
 
 
 8.60
 
 
 3.00
 
 
 
 5.00Page 68 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS


Note 10.
 Regulatory Capital Requirements,
 Restrictions on Subsidiary Dividends and Cash Restrictions (continued)Actual
  
  For
  Capital
  Adequacy
  Purposes
  
  To Be Well
  Capitalized Under
  Prompt Corrective
  Action ProvisionsAmount
  
  Ratio
  
  Ratio
  
  RatioAs of December 31, 2002:Company:Total
  risk based capital
  
  $
  102,921
  
  
  
  14.19
  %
  
  
  8.00
  %
  
  
  10.00
  %Tier 1
  risk based capital
  
  
  93,814
  
  
  
  12.93
  
  
  
  4.00
  
  
  
  6.00Leverage
  ratio
  
  
  93,814
  
  
  
  8.64
  
  
  
  3.00
  
  
  
  5.00Bank:Total
  risk based capital
  
  
  100,288
  
  
  
  13.84
  
  
  
  8.00
  
  
  
  10.00Tier 1
  risk based capital
  
  
  91,189
  
  
  
  12.58
  
  
  
  4.00
  
  
  
  6.00Leverage
  ratio
  
  
  91,189
  
  
  
  8.41
  
  
  
  3.00
  
  
  
  5.00The 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 $10,820,000
as of December 31, 2003 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 $2,092,000 and
$1,405,000 as of December 31, 2003 and 2002, respectively.

Page 69 of 92

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, 2003 and 2002:
Year Ended
 December 31,2003
 
 2002(Amounts
 In Thousands)Balance, beginning
 
 $
 27,813
 
 $
 24,440Advances
 
 
 10,570
 
 
 15,607Collections
 
 
 (5,929
 )
 
 (12,234
 )Balance, ending
 
 $
 32,454
 
 $
 27,813Deposits from
related parties are accepted subject to the same interest rates and terms as
those from nonrelated parties.
Page 70 of 92


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, 2003 and 2002 are as follows:
2003
 
 2002Carrying
 Amount
 
 Estimated
 Fair Value
 
 Carrying
 Amount
 
 Estimated
 Fair Value(Amounts
 In Thousands)Cash and due from banks
 
 $
 24,194
 
 $
 24,194
 
 $
 32,647
 
 $
 32,647Federal funds sold
 
 
 13,233
 
 
 13,233
 
 
 32,514
 
 
 32,514Investment securities
 
 
 236,157
 
 
 236,268
 
 
 214,211
 
 
 214,492Loans
 
 
 870,154
 
 
 923,274
 
 
 780,857
 
 
 839,398Accrued interest
 receivable
 
 
 7,303
 
 
 7,303
 
 
 7,278
 
 
 7,278Deposits
 
 
 868,767
 
 
 867,021
 
 
 802,321
 
 
 783,784Federal funds purchased
 and securities sold under agreements to
 repurchase
 
 
 29,926
 
 
 29,926
 
 
 20,798
 
 
 20,798Borrowings from Federal
 Home Loan Bank
 
 
 167,574
 
 
 168,718
 
 
 167,606
 
 
 169,085Accrued interest payable
 
 
 1,735
 
 
 1,735
 
 
 2,134
 
 
 2,134Face Amount
 
 
 
 
 Face AmountOff-balance sheet
 instruments:Loan commitments
 
 $
 139,422
 
 $
 
 
 $
 112,260
 
 $
 Letters of credit
 
 
 12,063
 
 
 
 
 
 12,650
 
 
 Page 71 of 92

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
December 31, 2003 and 2002
(Amounts In Thousands)
2003
 
 2002ASSETSCash
 
 $
 2,343
 
 $
 1,856Investment securities
 available for sale
 
 
 507
 
 
 514Investment in subsidiary
 bank
 
 
 108,248
 
 
 98,410Other assets
 
 
 950
 
 
 564Total assets
 
 $
 112,048
 
 $
 101,344LIABILITIES
 AND STOCKHOLDERS EQUITYLiabilities
 
 $
 419
 
 $
 309Redeemable common stock
 held by ESOP
 
 
 14,864
 
 
 12,951Stockholders equity:Capital stock
 
 
 11,353
 
 
 10,541Retained earnings
 
 
 97,189
 
 
 85,773Accumulated other
 comprehensive income
 
 
 3,087
 
 
 4,721111,629
 
 
 101,035Less maximum cash obligation related to ESOP shares
 
 
 14,864
 
 
 12,951Total stockholders equity
 
 
 96,765
 
 
 88,084Total liabilities and stockholders
 equity
 
 $
 112,048
 
 $
 101,344Page 72 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS

Note 13. Parent Company Only Financial Information (Continued)

CONDENSED STATEMENTS OF INCOME
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)

2003
 
 2002
 
 2001Interest on investment
 securities
 
 $
 17
 
 $
 25
 
 $
 32Dividends received from
 subsidiary
 
 
 2,856
 
 
 2,623
 
 
 2,392Other expenses
 
 
 (112
 )
 
 (80
 )
 
 (112
 )Income before income tax benefit and
 equity in subsidiarys undistributed income
 
 
 2,761
 
 
 2,568
 
 
 2,312Income tax benefit
 
 
 36
 
 
 23
 
 
 292,797
 
 
 2,591
 
 
 2,341Equity in subsidiarys
 undistributed income
 
 
 11,472
 
 
 8,873
 
 
 7,803Net income
 
 $
 14,269
 
 $
 11,464
 
 $
 10,144Page 73 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS


Note 13. Parent
Company Only Financial Information (Continued)

CONDENSED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2003, 2002 and 2001
(Amounts In Thousands)

2003
 
 2002
 
 2001Cash flows from operating
 activities:Net income
 
 $
 14,269
 
 $
 11,464
 
 $
 10,144Noncash items included in net income:Undistributed income of subsidiary
 
 
 (11,472
 )
 
 (8,873
 )
 
 (7,803
 )(Increase) decrease in other assets
 
 
 (379
 )
 
 8
 
 
 (43
 )Increase (decrease) in liabilities
 
 
 110
 
 
 73
 
 
 (13
 )Net cash provided by operating
 activities
 
 
 2,528
 
 
 2,672
 
 
 2,285Cash flows from investing
 activities:Proceeds from maturities of investment securities
 
 
 
 
 
 250
 
 
 250Purchase of investment securities
 
 
 
 
 
 (243
 )
 
 (271
 )Net cash provided (used in) by investing
 activities
 
 
 
 
 
 7
 
 
 (21
 )Cash flows from financing
 activities:Common stock issued
 
 
 465
 
 
 97
 
 
 157Income tax benefits related to stock based compensation
 
 
 347
 
 
 47
 
 
 43Dividends paid
 
 
 (2,853
 )
 
 (2,622
 )
 
 (2,392
 )Net cash (used in) financing activities
 
 
 (2,041
 )
 
 (2,478
 )
 
 (2,192
 )Increase in cash
 
 
 487
 
 
 201
 
 
 72Cash balance:Beginning
 
 
 1,856
 
 
 1,655
 
 
 1,583Ending
 
 $
 2,343
 
 $
 1,856
 
 $
 1,655Page 74 of 92

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 $21,801,000.  The concentrations of credit by type of loan
are set forth in Note 3.  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, 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, 2003 and 2002 is as follows:

2003
 
 2002(Amounts
 In Thousands)Firm loan commitments and
 unused portion of lines of credit:Home equity loans
 
 $
 8,643
 
 $
 6,923Credit card participations
 
 
 17,946
 
 
 15,057Commercial, real estate and home construction
 
 
 72,860
 
 
 51,272Commercial lines
 
 
 39,973
 
 
 39,008Outstanding letters of
 credit
 
 
 12,063
 
 
 12,650Page 75 of 92

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, 2003 and 2002
no amounts have been recorded as liabilities for the Banks potential
obligations under these guarantees.
Page 76 of 92

HILLS BANCORPORATION

NOTES TO FINANCIAL STATEMENTS


Note 15. Quarterly Results of Operations
(unaudited, amounts in thousands, except per share amounts)

Quarter EndedMarch
 
 June
 
 September
 
 December
 
 Year2003:Interest income
 
 $
 15,814
 
 $
 15,926
 
 $
 15,855
 
 $
 15,786
 
 $
 63,381Interest expense
 
 
 6,895
 
 
 6,715
 
 
 6,501
 
 
 6,294
 
 
 26,405Net interest income
 
 $
 8,919
 
 $
 9,211
 
 $
 9,354
 
 $
 9,492
 
 $
 36,976Provision for loan losses
 
 
 484
 
 
 (35
 )
 
 (326
 )
 
 301
 
 
 424Other income
 
 
 3,169
 
 
 3,845
 
 
 3,878
 
 
 2,464
 
 
 13,356Other expense
 
 
 6,565
 
 
 6,927
 
 
 7,046
 
 
 8,103
 
 
 28,641Income before income taxes
 
 $
 5,039
 
 $
 6,164
 
 $
 6,512
 
 $
 3,552
 
 $
 21,267Income taxes
 
 
 1,658
 
 
 2,037
 
 
 2,193
 
 
 1,110
 
 
 6,998Net income
 
 $
 3,381
 
 $
 4,127
 
 $
 4,319
 
 $
 2,442
 
 $
 14,269Basic earnings per share
 
 $
 2.25
 
 $
 2.73
 
 $
 2.85
 
 $
 1.61
 
 $
 9.44Diluted earnings per share
 
 
 2.24
 
 
 2.72
 
 
 2.85
 
 
 1.61
 
 
 9.422002:Interest income
 
 $
 15,521
 
 $
 15,928
 
 $
 16,510
 
 $
 16,602
 
 $
 64,561Interest expense
 
 
 7,990
 
 
 7,879
 
 
 7,948
 
 
 7,416
 
 
 31,141Net interest income
 
 $
 7,531
 
 $
 8,049
 
 $
 8,562
 
 $
 9,186
 
 $
 33,420Provision for loan losses
 
 
 236
 
 
 251
 
 
 244
 
 
 1,718
 
 
 2,449Other income
 
 
 2,397
 
 
 2,205
 
 
 2,504
 
 
 3,124
 
 
 10,230Other expense
 
 
 5,881
 
 
 6,179
 
 
 6,079
 
 
 6,384
 
 
 24,615Income before income taxes
 
 $
 3,811
 
 $
 3,824
 
 $
 4,743
 
 $
 4,208
 
 $
 16,586Income taxes
 
 
 1,188
 
 
 1,151
 
 
 1,507
 
 
 1,276
 
 
 5,122Net income
 
 $
 2,623
 
 $
 2,673
 
 $
 3,236
 
 $
 2,932
 
 $
 11,464Basic earnings per share
 
 $
 1.75
 
 $
 1.78
 
 $
 2.15
 
 $
 1.97
 
 $
 7.65Diluted earnings per share
 
 
 1.74
 
 
 1.76
 
 
 2.14
 
 
 1.94
 
 
 7.58Page 77 of 92

PART II

Item 9. Changes In
and Disagreements With Accountants on Accounting and Financial Disclosure

On May 13, 2003, upon the recommendation and approval of its Audit
Committee, the Company terminated its relationship with McGladrey & Pullen
LLP (McGladrey & Pullen) as its independent auditor and appointed the
firm of KPMG LLP (KPMG) to be the Companys Auditor for the 2003 fiscal
year.  There were no disagreements with
KPMG on any matter of accounting principles or practices, financial statement
disclosures, or auditing scope or procedure. 
KPMG has not audited any of the Companys financial statements for
year-ends prior to December 31, 2002 and therefore is unable to express an
opinion on any prior years financial information.

McGladrey & Pullens audit reports on the Companys consolidated
financial statements for each of the fiscal years ended December 31, 2002 and
2001 did not contain an adverse opinion or disclaimer of opinion, nor were they
qualified or modified as to uncertainty, audit scope or accounting principles.
During the two fiscal years ended December 31, 2002 and 2001 and the
subsequent interim preceding the decision to change independent auditors, there
were no disagreements with McGladrey & Pullen on any matter of accounting
principles or practices, financial statement disclosures, or auditing scope or
procedure which, if not resolved to McGladrey & Pullens satisfaction would
have caused them to make reference to the subject matter of the disagreement in
connection with the audit reports on the Companys consolidated financial
statements for such year, and there were no reportable events as defined in
Item 304 (a)(1)(v) of Regulation S-K.
In the years ended December 31, 2002 and 2001 and up to May 13,  2003, the date of KPMGs engagement, the
Company did not consult KPMG with respect to the application of accounting
principles to a specified transaction, either completed or proposed, or the
type of audit opinion that might be rendered on the Companys consolidated
financial statements, or any other matters or reportable events as set forth in
Items 304 (a)(2)(i) and (ii) of Regulation S-K.
Item 9A.  Controls and Procedures

As of the end of the period
covered by this report, the Company carried out an evaluation, under the
supervision and with the participation of the Companys management, including
the Companys Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operations of the Companys disclosure controls
and procedures, and as defined in Exchange Act Rule 15d-15(e).  Based upon that evaluation, the Companys
Chief Executive Officer and Chief Financial Officer concluded that the
Companys disclosure controls and procedures are effective in enabling the
Companys periodic SEC filings within the required time period.  There have been no changes in the Companys
internal controls over financial reporting that occurred during the Companys
most recent fiscal quarter that has materially affected, or is reasonably
likely to materially affect, the Companys internal control over financial
reporting.

Page 78 of 92

PART III
Item 10. Directors
and Executive Officers of the Registrant
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 22, 2004 for the Annual Meeting of
Stockholders on April 19, 2004.  Such
information is incorporated herein by reference.
No current member of the Audit Committee is a financial expert.  The Company hopes to add a financial expert
as a member of the Board of Directors and the Audit Committee in the near
future.
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.
 PrattTreasurerHills
 Bancorporation131 Main
 StreetHills,
 Iowa  52235Item 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 19,
2004.  Such information is incorporated
herein by reference.

Item 12. Security
Ownership of Certain Beneficial Owners and Management and Related Shareholders
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 19, 2004.  Such information is incorporated herein by
reference.
Item 13. Certain
Relationships and Related Transactions
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 19, 2004. 
Such information is incorporated herein by reference.
Item 14. Principal
Accountant Fees and Services
Information required by this
item is contained in the Registrants Proxy Statement dated March 22, 2004,
under the heading Independent Auditors  Change of Auditors in 2003, which
section is incorporated herein by this reference.
Page 79 of 92

PART IV
Item 15. Exhibits,
Financial Statements, Schedules and Reports on Form 8-K
Form 10-K
 Reference(a)
 1.
 Financial
 StatementsIndependent
 auditors reports on the financial statements
 45 - 46Consolidated
 balance sheets as of December 31, 2003 and 2002
 47Consolidated
 statements of income for the years ended December 31, 2003, 2002, and 2001
 48Consolidated
 statements of comprehensive income for the years ended December 31, 2003,
 2002 and 2001
 49Consolidated
 statements of stockholders equity for the years ended December 31, 2003,
 2002 and 2001
 50Consolidated
 statements of cash flows for the years ended December 31, 2003,2002 and 2001
 51 - 52Notes to
 financial statements
 53 - 772.
 Financial
 Statements SchedulesAll
 schedules are omitted because they are not applicable or not required, or
 because the required information is included in the consolidated financial
 statements or notes thereto.(a)
 3.
 Exhibits3.1
 Articles of
 Incorporation filed as Exhibit 3 of Form 10-K for the year ended December 31,
 1993 are incorporated by reference.3.2
 By-Laws
 filed as Exhibit 3 of Form 10-K for the year ended December 31, 1993 are
 incorporated by reference.10.1
 Material
 Contract (Employee Stock Ownership Plan) filed as Exhibit 10(a) in Form 10-K
 for the year ended December 31, 1993 is incorporated by reference.10.2
 Material
 Contract (1993 Stock Incentive Plan) filed as Exhibit 10(b) in Form 10-K for
 the year ended December 31, 1993 is incorporated by reference.10.3
 Material
 Contract (1995 Deferred Compensation Plans) filed as Exhibit 10(c) in Form
 10-K for the year ended December 31, 1995 is incorporated by reference.10.4
 Material
 Contract (2000 Stock Option and Incentive Plan) filed as Exhibit 10(d) in
 Form 10-K for the year ended December 31, 2001 is incorporated by reference.11
 Statement
 regarding Computation of Basic and Diluted Earnings Per Share on Page 83.16
 Letter
 Regarding Change in Certifying Accountant on Page 84.21
 Subsidiary
 of the Registrant is Attached on Page 85.23
 Consents of
 Accountants is Attached on Pages 86 - 87.KPMG LLPMcGladrey & Pullen LLP31
 Certifications
 under Section 302 of the Sarbanes-Oxley Act of 2002 on Pages 88 - 91.32
 Certifications
 under Section 906 of the Sarbanes-Oxley Act of 2002 on Page 92.(b)
 
 Reports on
 Form 8-K:The
 Registrant filed no reports on Form 8-K for the three months ended December
 31, 2003.Page 80 of 92

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 BANCORPORATIONDate: March 9, 2004
 By: /s/ Dwight O.
 SeegmillerDwight O. Seegmiller,
 Director and PresidentDate: March 9, 2004
 By: /s/ James G. PrattJames G. Pratt, Treasurer
 and Chief Accounting OfficerPursuant 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
 REGISTRANTDate: March 9, 2004
 By: /s/ Willis M. BywaterWillis M. Bywater,
 DirectorDate: March 9, 2004
 By: /s/ Thomas J. GillThomas J. Gill, DirectorDate: March 9, 2004
 By: /s/ Donald H. GringerDonald H. Gringer,
 DirectorDate: March 9, 2004
 By: /s/ Michael E. HodgeMichael E. Hodge, DirectorDate: March 9, 2004
 By: /s/ Richard W. ObermanRichard W. Oberman,
 DirectorDate: March 9, 2004
 By: /s/ Theodore H. PachaTheodore H. Pacha,
 DirectorDate: March 9, 2004
 By: /s/ Ann M. RhodesAnn M. Rhodes, DirectorDate: March 9, 2004
 By: /s/ Ronald E. StutsmanRonald E. Stutsman,
 DirectorDate: March 9, 2004
 By: /s/ Sheldon E. YoderSheldon E. Yoder, DirectorPage 81 of 92

HILLS
BANCORPORATION
ANNUAL REPORT OF FORM 10-K FOR THE
FISCAL YEAR ENDED DECEMBER 31, 2003

Exhibit
 Number
 
 Description
 
 Page Number
 In The Sequential
 Numbering System
 For 2003 Form 10-K11
 
 Statement Re Computation
 of Basic and Diluted Earnings Per Share
 
 83
 of 9216
 
 Letter Regarding Change in
 Certifying Accountant
 
 84
 of 9221
 
 Subsidiary of the
 Registrant
 
 85
 of 9223
 
 Consent of Independent
 Certified Public AccountantsKPMG LLP
 
 86
 of 92McGladrey & Pullen LLP
 
 87
 of 9231
 
 Certifications under
 Section 302 of the Sarbanes-Oxley Act of 2002
 
 88
 - 91 of 9232
 
 Certifications under
 Section 906 of the Sarbanes-Oxley Act of 2002
 
 92
 of 92Page 82 of 92