HILLS BANCORPORATION FORM 10-K DECEMBER 31, 2007     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, 2007.
     Commission File Number 0-12668.HILLS BANCORPORATION(Exact name of Registrant as specified in its charter)


Iowa
     42-1208067(State or Other Jurisdiction of
     (IRS Employer Identification No.)Incorporation or Organization)131 Main Street, Hills, Iowa 52235(Address of principal executive offices)


Registrants telephone number,
including area code: (319) 679-2291 Securities Registered pursuant to Section 12 (b) of
the Act: None Securities Registered pursuant to Section 12 (g) of the Act:


No par value common
stockTitle of Class


Indicate by check mark if the
Registrant is well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o    No x



Indicate by check mark if the Registrant
is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o    No x




Indicate by check mark whether the
Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes   x No o




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. o


Indicate by check mark whether the
Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
See definition of accelerated filer and large accelerated filer in Rule 12b-2
of the Exchange Act. (Check one):Large accelerated filer  o        Accelerated filer  x      Non-accelerated filer   o


Indicate by check mark whether the
Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No x





While it is difficult to determine
the market value of shares owned by nonaffiliates (within the meaning of such term under
the applicable regulations of the Securities and Exchange Commission), the Registrant
estimates that the aggregate market value of the Registrants common stock held by
nonaffiliates on January 31, 2008 (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 $53.00 per share) was $193,727,000.


The number of shares outstanding of
the Registrants common stock as of February 29, 2008 is 4,487,407 shares of no par
value common stock.


DOCUMENTS INCORPORATED
BY REFERENCE


Portions of the Proxy Statement dated
March 21, 2008 for the Annual Meeting of the Shareholders of the Registrant to be held
April 21, 2008 (the Proxy Statement) are incorporated by reference in Part III of this
Form 10-K.

Page 1 of 97
HILLS BANCORPORATIONFORM
 10-K


TABLE OF CONTENTS



PagePART IItem 1.
     Business
     3General
     3Competition
     5The Economy
     6Supervision and Regulation
     7Consolidated Statistical Information
     12Item 1A.
     Risk Factors
     24Item 1B.
     Unresolved Staff Comments
     29Item 2.
     Properties
     29Item 3.
     Legal Proceedings
     30Item 4.
     Submission of Matters to a Vote of Security Holders
     30Part IIItem 5.
     Market for Registrant's Common Equity, Related Stockholder Mattersand Issuer Purchases of Equity Securities
     31Item 6.
     Selected Financial Data
     34Item 7.
     Management's Discussion and Analysis of Financial Condition andResults of Operation
     35Item 7A.
     Quantitative and Qualitative Disclosures about Market Risk
     50Item 8.
     Consolidated Financial Statements and Supplementary Data
     53Item 9.
     Changes In and Disagreements with Accountants on Accounting andFinancial Disclosure
     87Item 9A.
     Controls and Procedures
     87Item 9B.
     Other Information
     88Part IIIItem 10.
     Directors, Executive Officers and Corporate Governance
     88Item 11.
     Executive Compensation
     88Item 12.
     Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters
     88Item 13.
     Certain Relationships and Related Transactions, and Director Independence
     88Item 14.
     Principal Accounting Fees and Services
     88Part IVItem 15.
     Exhibits, Consolidated Financial Statement Schedules
     89Page 2 of 97
PART I




Item 1.
Business


GENERAL


Hills Bancorporation (the
Company) is a holding company principally engaged, through its subsidiary
bank, in the business of banking. The Company was incorporated December 12, 1982 and all
operations are conducted within the state of Iowa. The Company became owner of 100% of the
outstanding stock of Hills Bank and Trust Company, Hills, Iowa (Hills Bank and
Trust or the Bank) as of January 23, 1984 when stockholders of Hills
Bank and Trust exchanged their shares for shares of the Company. Effective July 1, 1996,
the Company formed a new subsidiary, Hills Bank, which acquired for cash all the
outstanding shares of a bank in Lisbon, Iowa. Subsequently an office of Hills Bank was
opened in Mount Vernon, Iowa, a community that is contiguous to Lisbon. Effective November
17, 2000, Hills Bank was merged into Hills Bank and Trust. On September 20, 1996, another
subsidiary, Hills Bank Kalona, acquired cash and other assets and assumed the deposits of
the Kalona, Iowa office of Boatmens Bank Iowa, N.A. Effective October 26, 2001,
Hills Bank Kalona was merged into Hills Bank and Trust.


Through its internet website
(www.hillsbank.com), the Company makes available, free of charge, by link to the
internet website of the Securities and Exchange Commission (www.sec.gov), the
Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K,
all amendments to those reports, and other filings with the Securities and Exchange
Commission, as soon as reasonably practicable after they are filed or furnished.


The Bank is a full-service commercial
bank extending its services to individuals, businesses, governmental units and
institutional customers. The Bank is actively engaged in all areas of commercial banking,
including acceptance of demand, savings and time deposits; making commercial, real estate,
agricultural and consumer loans; maintaining night and safe deposit facilities; and
performing collection, exchange and other banking services tailored for individual
customers. The Bank administers estates, personal trusts, and pension plans and provides
farm management and investment advisory and custodial services for individuals,
corporations and nonprofit organizations. The Bank makes commercial and agricultural
loans, real estate loans, automobile, installment and other consumer loans. In addition,
the Bank earns substantial fees from originating mortgages that are sold in the secondary
residential real estate market without mortgage servicing rights being retained.


The Bank has an established formal
loan origination policy. In general, the loan origination policy attempts to reduce the
risk of credit loss to the Bank by requiring, among other things, maintenance of minimum
loan to value ratios, evidence of appropriate levels of insurance carried by borrowers and
documentation of appropriate types and amounts of collateral and sources of expected
payment.


The Banks business is not
seasonal, except that loan origination fees are driven by interest rate movements and are
higher in a low rate environment. As of December 31, 2007, the Company had no employees
and the Bank had 330 full-time and 90 part-time employees.

Page 3 of 97
Item 1.
Business (Continued)Johnson County and Linn
County


The Banks primary trade area
includes the Johnson County communities of Iowa City, Coralville, Hills and North Liberty,
located near Interstate 80 and Interstate 380 in Eastern Iowa. These communities have a
combined population of approximately 93,300. Johnson County, Iowa has a population of
approximately 124,200. The University of Iowa in Iowa City has approximately 30,400
students and 25,200 full and part-time employees, including 7,100 employees of The
University of Iowa Hospitals and Clinics.


The Bank also operates offices in the
Linn County, Iowa communities of Lisbon, Marion, Mount Vernon and Cedar Rapids, Iowa.
Lisbon has a population of approximately 2,000 and Mount Vernon, located two miles from
Lisbon, has a population of about 3,800. Both communities are within easy commuting
distances to Cedar Rapids and Iowa City, Iowa. Cedar Rapids has a metropolitan population
of approximately 156,800, including approximately 30,600 from adjoining Marion, Iowa and
is located approximately 10 miles west of Lisbon, Iowa and approximately 25 miles north of
Iowa City on Interstate 380. The total population of Linn County is approximately 206,000.
The largest employer in the Cedar Rapids area is Rockwell Collins, manufacturer of
communications instruments, with about 8,500 employees.


Other large employers in the Johnson
and Linn County areas and their approximate number of employees are as follows (Data
source is Priority One):




Employer
     Type of Business
     EmployeesCedar Rapids and Linn-Mar School Districts
     Education
     3,500Hy-Vee Food Stores
     Grocery Stores
     3,000AEGON USA, Inc.
     Insurance
     2,800Whirlpool Corp.
     Appliances
     2,700St. Luke's Hospital
     Health Care
     2,600Mercy Medical Center
     Health Care
     2,100Pearson US
     Information Services - Computers
     1,900Iowa City Community School District
     Education
     1,600City of Cedar Rapids
     City Government
     1,500Wal-Mart Stores, Inc.
     Discount Store
     1,500Kirkwood Community College
     Education
     1,400ACT, Inc.
     Educational Testing Service
     1,300Mercy Iowa City
     Health Care
     1,300Veteran's Administration Medical Center
     Health Care
     1,300Quaker Oats Company
     Cereals and Chemicals
     1,100Washington County


The Bank has offices located in
Kalona and Wellman, Iowa, which are in Washington County. Kalona is located approximately
20 miles south of Iowa City. Wellman is located approximately 5 miles west of Kalona.
Kalona has a population of approximately 2,400 and Wellman has a population of about
1,500. The population of Washington County is approximately 21,700. Both Kalona and
Wellman are primarily agricultural communities, but are located within easy driving
distance for employment in Iowa City, Coralville and North Liberty (combined population
92,600) and Washington, Iowa (population 7,000).

Page 4 of 97
Item 1.
Business (Continued)


COMPETITION


Competition among financial
institutions in attracting and retaining deposits and making loans is intense.
Traditionally, our most direct competition for deposits has come from commercial banks,
savings institutions and credit unions doing business in our areas of operation.
Increasingly, we have experienced additional competition for deposits from nonbanking
sources, such as securities firms, insurance companies, money market mutual funds and
financial services subsidiaries of commercial and manufacturing companies. Competition for
loans comes primarily from other commercial banks, savings institutions, consumer finance
companies, credit unions, mortgage banking companies, insurance companies and other
institutional lenders. We compete primarily on the basis of products offered, customer
service and price. A number of institutions with which we compete enjoy the benefits of
fewer regulatory constraints and lower cost structures. Some have greater assets and
capital than we do and, thus, are better able to compete on the basis of price than we
are. Technological advances, which may diminish the importance of depository institutions
and other financial intermediaries in the transfer of funds between parties, could make it
more difficult for us to compete in the future.


Effective March 13, 2000, securities
firms and insurance companies that elect to become financial holding companies were
allowed to acquire banks and other financial institutions. This has increased the number
of competitors and intensified the competitive environment in which the Company conducts
business. The increasingly competitive environment is primarily a result of changes in
regulations and changes in technology and product delivery systems. These competitive
trends are likely to continue.


The Bank is in direct competition for
loans and deposits and financial services with a number of other banks and credit unions
in Johnson, Linn and Washington County. A comparison of the number of office locations and
deposits in the three counties as of June, 2007 (Most recent date of available data from
the FDIC and national credit union websites) is as follows:




Johnson County
     Linn County
     Washington CountyOffices
     Deposits (in millions)
     Offices
     Deposits (in millions)
     Offices
     Deposits (in millions)Hills Bank and Trust Company
     
     
     6
        
     $802
        
     5
        
     $253
        
     2
        
     $74Branches of largest competing regional bank
     7
        
     200
        
     9
        
     683
        
     1
        
     23Largest competing independent bank
     6
        
     432
        
     9
        
     430
        
     2
        
     158Largest competing credit union
     7
        
     468
        
     7
        
     393
        
     1
        
     14All other bank and credit union offices
     25
        
     486
        
     76
        
     2,674
        
     7
        
     190Total Market in County
     51
        
     $2,388
        
     106
        
     $4,433
        
     13
        
     $459Effective July 1, 2004, all
limitations on bank office locations of Iowa law were repealed, effectively allowing
statewide branching. Since that date, banks have been allowed to establish an unlimited
number of offices in any location in Iowa subject to regulatory approval. Since July 1,
2005, six new offices have been added in Johnson County and eight in Linn County, while
the population base has increased by 8,700, or 2.71%, in the last two years. The number of
banking offices in Washington County has remained the same during this period while its
population has grown by 700, or 3.33%. The total deposits in the three counties increased
$962 million, or 15.23%, since July 1, 2005.

Page 5 of 97
Item 1.
Business (Continued)


THE ECONOMY


The Banks primary trade
territory is Johnson and Linn County, Iowa. The Bank has two offices in Washington County,
Iowa. The table that follows shows employment information as of December 31, 2007,
regarding the labor force and unemployment levels in the three counties in which the Bank
has office locations along with comparable data on the United States and the State of
Iowa.




Labor Force
     Unemployed
     Rate %United States
     
     
     153,866,000
        
     7,655,000
        
     5.00
        %State of Iowa
     1,678,700
        
     67,600
        
     4.00
        %Johnson County
     78,500
        
     2,200
        
     2.80
        %Linn County
     116,900
        
     4,700
        
     4.00
        %Washington County
     13,100
        
     500
        
     3.90
        %The unemployment rate for the
Banks prime market area is favorable and the rate historically has been lower than
the unemployment rates for both the United States and the State of Iowa. The unemployment
rates in 2006 were 4.50% for the United States, 3.5% for the State of Iowa and 2.5%, 3.9%
and 3.1% for Johnson, Linn and Washington Counties, respectively. As discussed with the
employment table of large employers in Johnson and Linn County, the University of
Iowas impact on the local economy is very important in maintaining acceptable
employment levels. The FY 2007-2008 budget for the University of Iowa is $2.4 billion with
state appropriations of approximately $349 million, or about 14.3% of the total. In
addition, the University of Iowa Hospitals and Clinics have a FY 2007-2008 budget of $840
million with 1.60% coming from the State of Iowa appropriation. While the States
revenues have rebounded in the past three years, it is uncertain if the effects of a
slowdown in the overall economy, constraints in the federal budget and increased state
government expenses will lead to future shortfalls in funding for the University of Iowa
and the University of Iowa Hospitals and Clinics. Johnson and Linn Counties have been one
of the strongest economic areas in Iowa and have had substantial economic growth in the
past ten years. The largest segment of the employed population is employed in
manufacturing, management, professional or related occupations.


The economies in the counties
continue to be enhanced by local Iowa colleges and the University of Iowa. In addition to
providing quality employment, they enroll students who provide economic benefits to the
area. The following table indicates Fall 2007 enrollment.





College
     City
     EnrollmentThe University of Iowa
     
     
     Iowa City
     
     
     30,409Coe College
     Cedar Rapids
     1,316Cornell College
     Mount Vernon
     1,083Kirkwood Community College
     Cedar Rapids, Iowa City and Washington
     15,075Mount Mercy College
     Cedar Rapids
     1,506The Bank also serves a number of
smaller communities in Johnson, Linn and Washington counties that are more dependent upon
the agricultural economy, which historically has been affected by commodity prices and
weather. The average price per acre of farm land continues to be an important factor to
consider when reviewing the local economy. The average price per acre in Iowa in 2007 was
$3,908 compared to $3,204 in 2006, a 21.97% increase. The range of average land prices in
Johnson, Linn and Washington counties is between $4,289 and $4,683 per acre. The three
counties average increase was 17.32% in 2007. The Banks total agricultural loans
comprise about 4.4% of the Banks total loans.

Page 6 of 97
Item 1.
Business (Continued)


SUPERVISION AND
REGULATION


Financial institutions and their holding
companies are extensively regulated under federal and state law. As a result, the growth
and earnings performance of the Company can be affected not only by management decisions
and general economic conditions but also by the requirements of applicable state and
federal statutes and regulations and the policies of various governmental regulatory
authorities, including the Iowa Superintendent of Banking (the
Superintendent), the Board of Governors of the Federal Reserve System (the
Federal Reserve), the Federal Deposit Insurance Corporation (the
FDIC), the Internal Revenue Service and state taxing authorities and the
Securities and Exchange Commission (the SEC). The effect of applicable
statutes, regulations and regulatory policies can be significant and cannot be predicted
with a high degree of certainty.


Federal and state laws and
regulations generally applicable to financial institutions regulate, among other things,
the scope of business, investments, reserves against deposits, capital levels relative to
operations, the nature and amount of collateral for loans, the establishment of branches,
mergers, consolidations and dividends. The system of supervision and regulation applicable
to the Company and its subsidiary Bank establishes a comprehensive framework for their
respective operations and is intended primarily for the protection of the FDICs
deposit insurance funds and the depositors, rather than the stockholders, of financial
institutions. The enforcement powers available to federal and state banking regulators are
substantial and include, among other things, the ability to assess civil money penalties,
to issue cease-and-desist or removal orders and to initiate injunctive actions.


The following is a summary of the
material elements of the regulatory framework applicable to the Company and its subsidiary
Bank. It does not describe all of the statutes, regulations and regulatory policies that
apply, nor does it restate all of the requirements of the statutes, regulations and
regulatory policies that are described. As such, the following is qualified in its
entirety by reference to the applicable statutes, regulations and regulatory policies. Any
change in applicable law, regulations or regulatory policies may have a material effect on
the business of the Company and its subsidiary Bank.


Regulation of the Company


    General.
          The Company, as the sole shareholder of the Bank, is a bank holding company. As
          a bank holding company, the Company is registered with, and is subject to
          regulation by, the Federal Reserve under the Bank Holding Company Act, as
          amended (the BHCA). According to Federal Reserve Board policy,
          bank/financial holding companies are expected to act as a source of financial
          strength to each subsidiary bank and to commit resources to support each such
          subsidiary. This support may be required at times when a bank/financial holding
          company may not be able to provide support. Under the BHCA, the Company is
          subject to periodic examination by the Federal Reserve. The Company is also
          required to file with the Federal Reserve periodic reports of the Companys
          operations and such additional information regarding the Company and its
          subsidiaries as the Federal Reserve may require.


Investments and Activities.
Under the BHCA, a bank holding company must obtain Federal Reserve approval before: (i)
acquiring, directly or indirectly, ownership or control of any voting shares of another
bank or bank holding company if, after the acquisition, it would own or control more than
5% of the shares of the other bank or bank holding company (unless it already owns or
controls the majority of such shares), (ii) acquiring all or substantially all of the
assets of another bank or (iii) merging or consolidating with another bank holding
company. Subject to certain conditions (including certain deposit concentration limits
established by the BHCA), the Federal Reserve may allow a bank holding company to acquire
banks located in any state of the United States without regard to whether the acquisition
is prohibited by the law of the state in which the target bank is located. On approving
interstate acquisitions, however, the Federal Reserve is required to give effect to
applicable state law limitations on the aggregate amount of deposits that may be held by
the acquiring bank holding company and its insured depository institution affiliates in
the state in which the target bank is located (provided that those limits do not
discriminate against out-of-state depository institutions or their holding companies) and
state laws which require that the target bank have been in existence for a minimum period
of time (not to exceed five years) before being acquired by an out-of-state bank holding
company.

Page 7 of 97
Item 1.
Business (Continued)Investments and Activities
(cont.) The BHCA also generally prohibits the Company from acquiring direct or
indirect ownership or control of more than 5% of the voting shares of any company which is
not a bank and from engaging in any business other than that of banking, managing and
controlling banks or furnishing services to banks and their subsidiaries. This general
prohibition is subject to a number of exceptions. The principal exception allows bank
holding companies to engage in, and to own shares of companies engaged in, certain
businesses found by the Federal Reserve to be so closely related to banking . . . as
to be a proper incident thereto. Under current regulations of the Federal Reserve,
the Company either directly or through non-bank subsidiaries would be permitted to engage
in a variety of banking-related businesses, including the operation of a thrift, sales and
consumer finance, equipment leasing, the operation of a computer service bureau (including
software development) and mortgage banking and brokerage. The BHCA generally does not
place territorial restrictions on the domestic activities of non-bank subsidiaries of bank
holding companies.


Federal law also prohibits any person
from acquiring control of a bank holding company without prior notice to the
appropriate federal bank regulator. Control is defined in certain cases as the
acquisition of 10% or more of the outstanding shares of a bank or a bank holding company
depending on the circumstances surrounding the acquisition.


Regulatory Capital
Requirements


Bank holding companies are required to
maintain minimum levels of capital in accordance with Federal Reserve capital adequacy
guidelines. If capital falls below minimum guideline levels, a bank holding company, among
other things, may be denied approval to acquire or establish additional banks or non-bank
businesses.


The Federal Reserves capital
guidelines establish the following minimum regulatory capital requirements for bank
holding companies: a risk-based requirement expressed as a percentage of total
risk-weighted assets, and a leverage requirement expressed as a percentage of total
assets. The risk-based requirement consists of a minimum ratio of total capital to total
risk-weighted assets of 8%, at least one-half of which must be Tier 1 capital. The
leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 3%
for the most highly rated companies, with a minimum requirement of 4% for all others.


The risk-based and leverage standards
described above are minimum requirements. Higher capital levels will be required if
warranted by the particular circumstances or risk profiles of individual banking
organizations. For example, the Federal Reserves capital guidelines contemplate that
additional capital may be required to take adequate account of, among other things,
interest rate risk, or the risks posed by concentration of credit, nontraditional
activities or securities trading activities. Further, any banking organization
experiencing or anticipating significant growth would be expected to maintain capital
ratios (i.e., Tier 1 capital less all intangible assets), well above the minimum levels.
Current Federal Reserve minimum requirements for a well capitalized organization
experiencing significant growth are a leverage ratio of 5%, a Tier 1 risk-based capital
ratio of 6% and total risk-based capital ratio of 10%. As of December 31, 2007, the
Company had regulatory capital in excess of the Federal Reserves minimum and
well-capitalized definition requirements, with a leverage ratio of 9.18%, with total Tier
1 risk-based capital ratio of 12.11% and a total risk-based capital ratio of 13.37%.


     Dividends.
          The Iowa Business Corporation Act (IBCA) allows the Company to make
          distributions, including cash dividends, to its shareholders unless, after
          giving effect to such distributions, either (i) the Company would not be able to
          pay its debts as they become due in the ordinary course of business or (ii) the
          Companys total assets would be less than the sum of its total liabilities
          plus the amount that would be needed to satisfy preferential shareholder rights,
          if any, that are superior to the rights of those receiving the distribution.
          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.

Page 8 of 97
Item 1.
Business (Continued)Federal Securities Regulation.
The Companys common stock is registered with the SEC under the Securities Exchange
Act of 1934, as amended (the Exchange Act). Consequently, the Company is
subject to the information, proxy solicitation, insider trading and other restrictions and
requirements of the SEC under the Exchange Act.


Regulation of the Bank


     General.
          The Bank is an Iowa-chartered bank, the deposit accounts of which are insured by
          the FDICs Bank Insurance Fund (BIF). As an Iowa-chartered,
          FDIC insured bank, the Bank is subject to the examination, supervision,
          reporting and enforcement requirements of the Superintendent of Banking of the
          State of Iowa (the Superintendent), as the chartering authority for
          Iowa banks, and the FDIC, as administrator of the BIF.


Deposit Insurance. As an
FDIC-insured institution, the Bank is required to pay deposit insurance premium
assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which
all insured depository institutions are placed into one of nine categories and assessed
insurance premiums based upon their respective levels of capital and results of
supervisory evaluations. Institutions classified as well-capitalized (as defined by the
FDIC) and considered healthy, pay the lowest premium while institutions that are less than
adequately capitalized (as defined by the FDIC) and considered of substantial supervisory
concern, pay the highest premium. Risk classification of all insured institutions is made
by the FDIC for each semi-annual assessment period. The Bank is currently paying the
minimum assessment under the FDICs risk assessment system.


Capital Requirements. Among
the requirements and restrictions imposed upon state banks by the Superintendent are the
requirements to maintain reserves against deposits, restrictions on the nature and amount
of loans, and restrictions relating to investments, opening of bank offices and other
activities of state banks. Changes in the capital structure of state banks are also
approved by the Superintendent. State banks must have a Tier 1 risk-based leverage ratio
of 6.5% plus a fully funded loan loss reserve. In certain instances, the Superintendent
may mandate higher capital, but the Superintendent has not imposed such a requirement on
the Bank. In determining the Tier 1 risk-based leverage ratio, the Superintendent uses
total equity capital without unrealized securities gains and the allowance for loan losses
less any intangible assets. At December 31, 2007, the Tier 1 risk-based leverage
ratio of the Bank was 9.17% and exceeded the ratio required by the Superintendent.


Capital adequacy for banks took on an
added dimension with the establishment of a formal system of prompt corrective action
under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). This
system uses bank capital levels to trigger supervisory actions designed to quickly correct
banking problems. Capital adequacy zones are used by the federal banking agencies to
trigger these actions. The ratios and the definition of adequate capital are
the same as those used by the agencies in their capital adequacy guidelines.


Federal law provides the federal
banking regulators of the Bank with broad power to take prompt corrective action to
resolve the problems of undercapitalized banking institutions. The extent of the
regulators powers depends on whether the institution in question is well
capitalized, adequately capitalized, undercapitalized,
significantly undercapitalized or critically undercapitalized, in
each case as defined by regulation. Under prompt corrective action, banks that are
inadequately capitalized face a variety of mandatory and discretionary supervisory
actions. For example, undercapitalized banks must restrict asset growth,
obtain prior approval for business expansion, and have an approved plan to restore
capital. Critically undercapitalized banks must be placed in receivership or
conservatorship within 90 days unless some other action would result in lower long-term
costs to the deposit insurance fund.


Supervisory Assessments. All
Iowa banks are required to pay supervisory assessments to the Superintendent to fund the
Superintendents examination and supervision operations. Effective July 1, 2002 the
Superintendent changed the method of computation of the supervisory assessment from
billing for each state examination completed based on an hourly rate, to billing on an
annual basis based on the assets of the bank, the expected hours needed to conduct
examinations of that size bank and an additional amount if more work is required. For
fiscal 2007, the assessment total was $122,613.

Page 9 of 97
Item 1.
Business (Continued)Community Investment and Consumer
Protection Laws. The Community Reinvestment Act requires insured institutions to offer
credit products and take other actions that respond to the credit needs of the community.
Banks and other depository institutions also are subject to numerous consumer-oriented
laws and regulations. These laws include the Truth in Lending Act, the Truth in Savings
Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the
Equal Credit Opportunity Act and the Fair Housing Act.


     Dividends.
          The Iowa Banking Act provides that an Iowa bank may not pay dividends in an
          amount greater than its undivided profits.


The payment of dividends by any
financial institution or its holding company is affected by the requirement to maintain
adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a
financial institution generally is prohibited from paying any dividends if, following
payment thereof, the institution would be undercapitalized. As described above, the Bank
exceeded its minimum capital requirements under applicable guidelines as of December 31,
2007. Notwithstanding the availability of funds for dividends, however, the Superintendent
may prohibit the payment of any dividends by the Bank if the Superintendent determines
such payment would constitute an unsafe or unsound practice. The ability of the Company to
pay dividends to its stockholders is dependent upon dividends paid by the Bank. The Bank
is subject to certain statutory and regulatory restrictions on the amount it may pay in
dividends. To maintain acceptable capital ratios in the Bank, certain of its retained
earnings are not available for the payment of dividends. To maintain a ratio of total
risk-based capital to assets of 8%, only $19,427,000 of the Companys total retained
earnings of $144,122,000 as of December 31, 2007 are available for the payment of
dividends to the Company.


Insider Transactions. The Bank
is subject to certain restrictions imposed by federal law on extensions of credit to the
Company and its subsidiaries, on investments in the stock or other securities of the
Company and its subsidiaries and the acceptance of the stock or other securities of the
Company or its subsidiaries as collateral for loans. Certain limitations and reporting
requirements are also placed on extensions of credit by the Bank to its directors and
officers, to directors and officers of the Company and its subsidiaries, to principal
stockholders of the Company, and to related interests of such directors,
officers and principal stockholders. In addition, federal law and regulations may affect
the terms upon which any person becoming a director or officer of the Company or one of
its subsidiaries or a principal stockholder of the Company may obtain credit from banks
with which the Bank maintains a correspondent relationship.


Safety and Soundness
Standards. The federal banking agencies have adopted guidelines that establish
operational and managerial standards to promote the safety and soundness of federally
insured depository institutions. The guidelines set forth standards for internal controls,
information systems, internal audit systems, loan documentation, credit underwriting,
interest rate exposure, asset growth, compensation, fees and benefits, asset quality and
earnings.


In general, the safety and soundness
guidelines prescribe the goals to be achieved in each area, and each institution is
responsible for establishing its own procedures to achieve those goals. If an institution
fails to comply with any of the standards set forth in the guidelines, the
institutions primary federal regulator may require the institution to submit a plan
for achieving and maintaining compliance. If an institution fails to submit an acceptable
compliance plan, or fails in any material respect to implement a compliance plan that has
been accepted by its primary federal regulator, the regulator is required to issue an
order directing the institution to cure the deficiency. Until the deficiency cited in the
regulators order is cured, the regulator may restrict the institutions rate of
growth, require the institution to increase its capital, restrict the rates the
institution pays on deposits or require the institution to take any action the regulator
deems appropriate under the circumstances. Noncompliance with the standards established by
the safety and soundness guidelines may also constitute grounds for other enforcement
action by the federal banking regulators, including cease and desist orders and civil
money penalty assessments.

Page 10 of 97
Item 1.
Business (Continued)Branching Authority.
Historically, Iowas intrastate branching statutes have been rather restrictive when
compared with those of other states. Effective July 1, 2004, all limitations on bank
office location were repealed, which effectively allowed statewide branching. Since that
date, banks have been allowed to establish an unlimited number of offices in any location
in Iowa subject only to regulatory approval.


Under the Riegle-Neal Act, both state
and national banks are allowed to establish interstate branch networks through
acquisitions of other banks, subject to certain conditions, including certain limitations
on the aggregate amount of deposits that may be held by the surviving bank and all of its
insured depository institution affiliates. The establishment of new interstate branches or
the acquisition of individual branches of a bank in another state (rather than the
acquisition of an out-of-state bank in its entirety) is allowed by the Riegle-Neal Act
only if specifically authorized by state law. The legislation allowed individual states to
opt-out of certain provisions of the Riegle-Neal Act by enacting appropriate
legislation prior to June 1, 1997. Iowa permits interstate bank mergers, subject to
certain restrictions, including a prohibition against interstate mergers involving an Iowa
bank that has been in existence and continuous operation for fewer than five years.


State Bank Activities. Under
federal law and FDIC regulations, FDIC insured state banks are prohibited, subject to
certain exceptions, from making or retaining equity investments of a type, or in an
amount, that are not permissible for a national bank. Federal law and FDIC regulations
also prohibit FDIC insured state banks and their subsidiaries, subject to certain
exceptions, from engaging as principal in any activity that is not permitted for a
national bank or its subsidiary, respectively, unless the Bank meets, and continues to
meet, its minimum regulatory capital requirements and the FDIC determines the activity
would not pose a significant risk to the deposit insurance fund of which the Bank is a
member. These restrictions have not had, and are not currently expected to have, a
material impact on the operations of the Bank.

Page 11 of 97
Item 1.
Business (Continued)


CONSOLIDATED STATISTICAL
INFORMATION


The following consolidated
statistical information reflects selected balances and operations of the Company and the
Bank for the periods indicated.


The following tables show (1) average
balances of assets, liabilities and stockholders equity, (2) interest income and
expense on a tax equivalent basis, (3) interest rates and interest differential and (4)
changes in interest income and expense.


AVERAGE BALANCES(Average Daily Basis)



Years Ended December 312007
     2006
     2005(Amounts In Thousands)ASSETSCash and cash equivalents
     $22,145
        
     $23,840
        
     $24,533Taxable securities
     114,271
        
     123,376
        
     141,337Nontaxable securities
     88,727
        
     82,031
        
     76,858Federal funds sold
     6,527
        
     878
        
     7,295Loans, net
     1,305,485
        
     1,217,009
        
     1,060,011Property and equipment, net
     21,700
        
     22,301
        
     22,061Other assets
     31,036
        
     27,984
        
     25,949$1,589,891
        
     $1,497,419
        
     $1,358,044LIABILITIES AND STOCKHOLDERS' EQUITYNoninterest-bearing demand deposits
     $137,271
        
     $135,249
        
     $133,046Interest-bearing demand deposits
     157,483
        
     140,171
        
     144,866Savings deposits
     261,914
        
     264,210
        
     259,267Time deposits
     575,738
        
     518,313
        
     467,878Short-term borrowings
     51,880
        
     63,358
        
     30,044FHLB borrowings
     248,804
        
     231,691
        
     190,438Other liabilities
     11,591
        
     10,387
        
     8,843Redeemable common stock held byEmployee Stock Ownership Plan
     21,573
        
     20,787
        
     18,635Stockholders' equity
     123,637
        
     113,253
        
     105,027$1,589,891
        
     $1,497,419
        
     $1,358,044Page 12 of 97
Item 1.
Business (Continued)INTEREST INCOME AND
EXPENSE





Years Ended December 312007
     2006
     2005(Amounts In Thousands)Income:Loans (1)
     $88,937
        
     $80,393
        
     $66,822Taxable securities
     4,706
        
     4,438
        
     4,795Nontaxable securities (1)
     4,852
        
     4,462
        
     4,130Federal funds sold
     325
        
     40
        
     235Total interest income
     98,820
        
     89,333
        
     75,982Expense:Interest-bearing demand deposits
     2,246
        
     1,372
        
     989Savings deposits
     6,034
        
     5,318
        
     3,619Time deposits
     26,997
        
     21,151
        
     15,057Short-term borrowings
     2,151
        
     2,801
        
     749FHLB borrowings
     12,524
        
     11,720
        
     9,949Total interest expense
     49,952
        
     42,362
        
     30,363Net interest income
     $48,868
        
     $46,971
        
     $45,619(1)  Presented on a tax equivalent basis using a rate of 35% for the three years presented.


Page 13 of 97
Item 1.
Business (Continued)INTEREST RATES AND
INTEREST DIFFERENTIAL





Years Ended December 312007
     2006
     2005Average yields:Loans (1)
     6.80
        %
     6.59
        %
     6.29
        %Loans (tax equivalent basis)
     6.81
        
     6.61
        
     6.30Taxable securities
     4.12
        
     3.60
        
     3.39Nontaxable securities
     3.55
        
     3.54
        
     3.49Nontaxable securities (tax equivalent basis)
     5.47
        
     5.44
        
     5.37Federal funds sold
     4.98
        
     4.51
        
     3.21Average rates paid:Interest-bearing demand deposits
     1.43
        
     0.98
        
     0.69Savings deposits
     2.30
        
     2.01
        
     1.40Time deposits
     4.69
        
     4.08
        
     3.22Short-term borrowings
     4.15
        
     4.42
        
     2.49FHLB borrowings
     5.03
        
     5.06
        
     5.22Yield on average interest-earning assets
     6.52
        
     6.28
        
     5.91Rate on average interest-bearing liabilities
     3.85
        
     3.47
        
     2.77Net interest spread (2)
     2.68
        
     2.81
        
     3.14Net interest margin (3)
     3.24
        
     3.31
        
     3.56(1)
Non-accruing
loans are not significant and have been included in the average           loan balances
for purposes of this computation.(2)
Net
interest spread is the difference between the yield on average           interest-earning
assets and the yield on average interest-paying liabilities           stated on a tax
equivalent basis using a federal rate of 35% for the three years           presented.(3)
Net
interest margin is net interest income, on a tax equivalent basis, divided           by
average interest-earning assets. The net interest margin declined $0.07 in           2007
and $0.25 in 2006. The margin compression was the result of the continued
          flattening of the yield curve and pricing pressure on loans and short-term
          deposits.Page 14 of 97
Item 1. Business
(Continued)


CHANGES IN INTEREST
INCOME AND EXPENSE



Changes Due
To Volume
     Changes Due
To Rates
     Total
Changes(Amounts In Thousands)Year ended December 31, 2007:Change in interest income:Loans
     $5,844
        
     $2,700
        
     $8,544Taxable securities
     (321
        )
     589
        
     268Nontaxable securities
     364
        
     26
        
     390Federal funds sold
     255
        
     30
        
     2856,142
        
     3,345
        
     9,487Change in interest expense:Interest-bearing demand deposits
     (169
        )
     (704
        )
     (873
        )Savings deposits
     374
        
     (1,091
        )
     (717
        )Time deposits
     (2,343
        )
     (3,503
        )
     (5,846
        )Federal funds purchased and securities soldunder agreements to repurchase
     681
        
     (31
        )
     650FHLB borrowings
     (866
        )
     62
        
     (804
        )(2,323
        )
     (5,267
        )
     (7,590
        )Change in net interest income
     $3,819
        
     $(1,922
        )
     $1,897Year ended December 31, 2006:Change in interest income:Loans
     $9,897
        
     $3,674
        
     $13,571Taxable securities
     (633
        )
     276
        
     (357
        )Nontaxable securities
     278
        
     54
        
     332Federal funds sold
     (206
        )
     11
        
     (195
        )9,336
        
     4,015
        
     13,351Change in interest expense:Interest-bearing demand deposits
     18
        
     (402
        )
     (384
        )Savings deposits
     150
        
     (1,846
        )
     (1,696
        )Time deposits
     (1,621
        )
     (4,475
        )
     (6,096
        )Federal funds purchased and securities soldunder agreements to repurchase
     (954
        )
     (1,098
        )
     (2,052
        )FHLB borrowings
     (2,155
        )
     384
        
     (1,771
        )(4,562
        )
     (7,437
        )
     (11,999
        )Change in net interest income
     $4,774
        
     $(3,422
        )
     $1,352Rate volume variances are allocated
on a consistent basis using the absolute values of changes in volume compared to the
absolute values of the changes in rates. Loan fees included in interest income are not
material. Interest on nontaxable securities and loans is shown at tax equivalent amounts.

Page 15 of 97
Item 1.
Business (Continued)LOANS


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







December 31,2007
     2006
     2005
     2004
     2003(Amounts In Thousands)Agricultural
     
     
     $60,004
        
     $49,223
        
     $43,730
        
     $39,116
        
     $38,153Commercial and financial
     132,070
        
     118,339
        
     91,501
        
     70,453
        
     47,938Real estate, construction
     123,144
        
     114,199
        
     83,456
        
     72,388
        
     66,644Real estate, mortgage
     1,020,802
        
     983,489
        
     906,188
        
     797,958
        
     696,453Loans to individuals
     36,289
        
     31,827
        
     32,201
        
     32,106
        
     31,591Total
     $1,372,309
        
     $1,297,077
        
     $1,157,076
        
     $1,012,021
        
     $880,779There 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, 2007:






Amount
Of Loans
     One Year
Or Less (1)
     One To
Five Years
     Over Five
Years(Amounts In Thousands)Commercial
     
     
     $185,757
        
     $108,909
        
     $70,421
        
     $6,427Real Estate
     1,150,206
        
     320,348
        
     772,716
        
     57,142Other
     36,346
        
     8,563
        
     20,583
        
     7,200Totals
     $1,372,309
        
     $437,820
        
     $863,720
        
     $70,769The types of interest rates applicable to these principal payments are shown below:



Fixed rate
     
     
     $670,718
        
     $190,689
        
     $416,855
        
     $63,174Variable rate
     701,591
        
     247,131
        
     446,865
        
     7,595$1,372,309
        
     $437,820
        
     $863,720
        
     $70,769(1)
A
significant portion of the commercial loans are due in one year or less. A
          significant percentage of the notes are re-evaluated prior to their maturity
and           are likely to be extended.Page 16 of 97
Item 1.
Business (Continued)NONACCRUAL, PAST DUE,  RESTRUCTURED AND NON-PERFORMING LOANS


The following table summarizes the
Companys non-accrual, past due, restructured and non-performing loans as of
December 31 for each of the years presented:







2007
     2006
     2005
     2004
     2003(Amounts In Thousands)Nonaccrual loans
     
     
     $4,948
        
     $879
        
     $175
        
     $808
        
     $3,944Accruing loans past due90 days or more
     6,019
        
     4,983
        
     1,910
        
     2,313
        
     2,296Restructured loans
     -
        
     -
        
     -
        
     -
        
     -Non-performing (includes non-accrual loans)
     39,583
        
     14,681
        
     16,602
        
     18,977
        
     18,177Loans held for investment
     1,372,309
        
     1,297,077
        
     1,157,076
        
     1,012,021
        
     880,779Ratio of allowance for loan losses to loans held for investment
     1.44
        %
     1.38
        %
     1.33
        %
     1.36
        %
     1.43
        %Ratio of allowance for loan losses to non-performing loans
     49.79
        
     121.59
        
     92.52
        
     72.67
        
     69.24The Company does not have a
significant amount of loans that are past due less than 90 days where there are serious
doubts as to the ability of the borrowers to comply with the loan repayment terms.


Loans are placed on non-accrual
status when management believes the collection of future principal and interest is not
reasonably assured. The increase in non-accrual loans from December 31, 2006 to December
31, 2007 relates to six borrower relationships consisting of 17 loans that have an
aggregate balance of approximately $4.9 million as of December 31, 2007. Non-accrual loans
represent 0.36% of total loans as of December 31, 2007 compared to 0.07% of total loans as
of December 31, 2006. The non-accrual loans are considered to be impaired loans for
purposes of reviewing the adequacy of the loan loss reserve. Interest income was reduced
by $279,000, $34,000 and $19,000 for the years ended December 31, 2007, 2006 and 2005,
respectively, by the classification of the loans as non-accrual.


Accruing loans past due 90 days or
more increased $1.0 million from 2006 to $6,019,000 as of December 31, 2007. Real estate
loans make up approximately $4.3 million, or 88%, of this total. As of December 31, 2007
and 2006, loans 90 days past due and accruing were 0.44% and 0.38% of total loans,
respectively. Management believes that loans 90 days past due and accruing are adequately
collaterized.


The Company has no individual
borrower or borrowers engaged in the same or similar industry exceeding 10% of total
loans. The Company has no interest-bearing assets, other than loans, that meet the
non-accrual, past due, restructured or potential problem loan criteria.


Non-performing loans increased by
$24.9 million from December 31, 2006 to December 31, 2007. Non-performing loans were 2.88%
of loans as of December 31, 2007 and 1.13% as of December 31, 2006. Non-performing loans,
which are considered impaired, include any loan that has been placed on nonaccrual status.
Non-performing loans also include loans that, based on managements evaluation of
current information and events, the Bank expects to be unable to collect in full according
to the contractual terms of the original loan agreement. These loans are also considered
impaired loans. This increase in non-performing loans is due primarily to the
deterioration in credit quality of eight borrower relationships that have an aggregate
balance of approximately $33.5 million as of December 31, 2007. The allowance did not
increase as sharply as the impaired balances because the majority of the impaired loans
are secured by real estate and are generally well-collateralized. The Company believes
that the allowance for loan losses is at a level commensurate with the overall risk
exposure of the loan portfolio. However, if economic conditions deteriorate, certain
borrowers may experience difficulty and the level of nonperforming loans, chargeoffs and
delinquencies could continue to rise and require further increases in the provision for
loan losses.


Specific allowances for losses on
non-accrual and non-performing loans are established if the loan balances exceed the net
present value of the relevant future cash flows or the fair value of the relevant
collateral if the loan is collateral dependent.

Page 17 of 97
Item 1.
Business (Continued)SUMMARY OF LOAN LOSS
EXPERIENCE


The following table summarizes the
Banks loan loss experience for each of the last five years:







Year Ended December 31,2007
     2006
     2005
     2004
     2003(Amounts In Thousands)Allowance for loan lossesat beginning of year
     $17,850
        
     $15,360
        
     $13,790
        
     $12,585
        
     $12,125Charge-offs:Agriculture
     343
        
     40
        
     -
        
     78
        
     26Commercial and financial
     1,422
        
     677
        
     802
        
     224
        
     266Real estate, mortgage
     622
        
     529
        
     392
        
     431
        
     478Loans to individuals
     531
        
     627
        
     981
        
     635
        
     8742,918
        
     1,873
        
     2,175
        
     1,368
        
     1,644Recoveries:Agriculture
     44
        
     44
        
     47
        
     36
        
     88Commercial and financial
     479
        
     863
        
     191
        
     151
        
     661Real estate, mortgage
     299
        
     223
        
     265
        
     104
        
     318Loans to individuals
     427
        
     222
        
     1,141
        
     812
        
     6131,249
        
     1,352
        
     1,644
        
     1,103
        
     1,680Net charge-offs (recoveries)
     1,669
        
     521
        
     531
        
     265
        
     (36
        )Provision for loan losses (1)
     3,529
        
     3,011
        
     2,101
        
     1,470
        
     424Allowance for loan lossesat end of year
     $19,710
        
     $17,850
        
     $15,360
        
     $13,790
        
     $12,585Ratio of net charge-offs (recoveries)during year to average loans outstanding
     0.13
        %
     0.04
        %
     0.05
        %
     0.03
        %
     0.00
        %(1)
For
financial reporting purposes, management reviews the loan portfolio and
          determines the allowance for loan losses, which represents managements
          judgment of the probable losses inherent in the Companys loan portfolio.
          The loan loss provision is the amount necessary to adjust the allowance to the
          level considered appropriate by management. The adequacy of the allowance is
          reviewed quarterly and considers the impact of economic conditions on the
          borrowers ability to repay, loan collateral values, past collection
          experience, the risk characteristics of the loan portfolio and such other
          factors that deserve current recognition. The growth of the loan portfolio is a
          significant element in the determination of the provision for loan losses.Page 18 of 97
Item 1. Business
(Continued)


ALLOCATION OF THE
ALLOWANCE FOR LOAN LOSSES


The Bank regularly reviews a
substantial portion of the loans in the portfolio and assesses whether the loans are
impaired. If the loans are impaired, the Bank determines if a specific allowance is
appropriate. In addition, the Banks management also reviews and, where determined
necessary, provides allowances based upon reviews of specific borrowers and provides
allowances for areas that management considers are of higher credit risk (agricultural
loans and constructed model real estate homes). Loans for which there are no specific
allowances are classified into one or more risk categories. Based upon the risk category
assigned, the Bank allocates a percentage, as determined by management, for a required
allowance needed. The percentage begins with historical loss experience factors, which are
then adjusted for current economic factors.


The following table presents the
allowance for loan losses on loans by type of loans and the percentage in each category to
total loans as of December 31, 2007, 2006, 2005, 2004 and 2003:











2007
     
     2006Amount
     % of TotalAllowance
     % of Loansto Total Loans
     
     Amount
     % of Total Allowance
     % of Loans
to Total Loans(In Thousands)
     
     
     
     (In Thousands)Agriculture
     
     
     $1,614
        
     8.19
        %
     4.37
        %
     
     $1,509
        
     8.45
        %
     3.79
        %Commercial
     4,382
        
     22.23
        
     9.62
        
     
     3,700
        
     20.73
        
     9.12Real estate, construction
     2,568
        
     13.03
        
     8.97
        
     
     2,064
        
     11.56
        
     8.80Real estate, mortgage
     10,335
        
     52.44
        
     74.40
        
     
     9,782
        
     54.80
        
     75.82Consumer
     811
        
     4.11
        
     2.64
        
     
     795
        
     4.46
        
     2.47$19,710
        
     100.00
        %
     100.00
        %
     
     $17,850
        
     100.00
        %
     100.00
        %2005
     
     2004Agriculture
     $1,528
        
     9.95
        %
     3.78
        %
     
     $1,736
        
     12.59
        %
     3.87
        %Commercial
     2,676
        
     17.42
        
     7.91
        
     
     1,913
        
     13.87
        
     6.96Real estate, construction
     1,339
        
     8.72
        
     7.21
        
     
     1,471
        
     10.67
        
     7.15Real estate, mortgage
     9,061
        
     58.99
        
     78.32
        
     
     7,872
        
     57.08
        
     78.85Consumer
     756
        
     4.92
        
     2.78
        
     
     798
        
     5.79
        
     3.17$15,360
        
     100.00
        %
     100.00
        %
     
     $13,790
        
     100.00
        %
     100.00
        %2003Agriculture
     $2,470
        
     19.63
        %
     4.33
        %Commercial
     1,421
        
     11.29
        
     5.44Real estate, construction
     1,076
        
     8.55
        
     7.57Real estate, mortgage
     6,775
        
     53.83
        
     79.07Consumer
     843
        
     6.70
        
     3.59$12,585
        
     100.00
        %
     100.00
        %The allowance for loan losses
increased $1.9 million in 2007. The increase in and changes in the allocation of the
allowance were due to volume of loans outstanding and a deterioration in credit quality.
Due to the volume increase in loans outstanding of $78.2 million in 2007, the allocation
increased approximately $563,000.

Page 19 of 97
Item 1.
Business (Continued)The increase in allocations based on
current credit quality was $1,294,000. This increase includes an allocation of $383,000
related to watch loans. While balances of watch loans decreased $4.3 million from 2006 to
2007, the increase in the allocation resulted from the composition of loans included in
this classification. The $4.3 million decrease in watch loans is comprised of improvements
of $9.2 million in multi-family residential mortgages, $3.3 million in 1-to-4 family
residential mortgages and $2.1 million in agricultural real estate loans. These
improvements are offset by increase in the watch classification of $4.4 million in
construction loans, $4.4 million in commercial loans and $1.5 million in agricultural
operating loans. Substandard loan balances were $48.6 million in 2007 and $20.6 in 2006.
The increase in allocation related to substandard loans of $911,000 resulted from the
deterioration of the credit quality of eight borrower relationships having an aggregate
balance of approximately $33.5 million as of December 31, 2007. The increase in
substandard loans of $28.0 million includes $8.6 million in commercial real estate loans,
$7.6 million in multi-family residential mortgages, $6.7 million in 1-to-4 family
residential mortgages, $2.8 million in agricultural real estate loans, $1.3 million in
commercial loans and $1.0 million in construction loans.


Residential real estate loan products
that include features such as loan-to-values in excess of 100%, interest only payments or
adjustable-rate mortgages, which expose a borrower to payment increases in excess of
changes in the market interest rate, increase the credit risk of a loan. The Bank does not
offer this type of loan product.


The subprime mortgage banking
environment has been experiencing considerable strain from rising delinquencies and
liquidity pressures and some subprime mortgage lenders have failed. The increased scrutiny
of the subprime lending market is one of the factors that have impacted general market
conditions as well as perceptions of the Companys business. The Companys
underwriting standards have been structured to limit exposure to the types of loans that
are currently experiencing high foreclosures and loss rates. Management believes that the
Companys mortgage loan portfolio has minimal exposure to loans generally considered
to be subprime loans.


Page 20 of 97
Item 1.
Business (Continued)INVESTMENT SECURITIES


The following tables show the
carrying value of the investment securities, including stock of the Federal Home Loan
Bank, which are principally held by the Bank as of December 31, 2007, 2006 and 2005 and
the maturities and weighted average yields of the investment securities as of December 31,
2007:




December 31,2007
     2006
     2005(Amounts In Thousands)Carrying value:Other securities (FHLB, FHLMC and FNMA)
     $104,965
        
     $94,068
        
     $105,482Stock of the Federal Home Loan Bank
     14,169
        
     12,757
        
     12,000Obligations of state and political subdivisions
     94,634
        
     84,159
        
     79,519$213,768
        
     $190,984
        
     $197,001December 31, 2007Carrying
Value
     Weighted
Average
Yield(Amounts In Thousands)Obligations of other securities (FHLB, FHLMC and FNMA), maturities:Within 1 year
     $33,898
        
     3.54
        %From 1 to 5 years
     66,940
        
     4.54From 5 to 10 years
     4,127
        
     5.25$104,965Stock of the Federal Home Loan Bank, maturities within 1 year
     $14,169
        
     3.7
        %Obligations of state and political subdivisions, maturities:Within 1 year
     $11,592
        
     5.79
        %From 1 to 5 years
     38,665
        
     4.98From 5 to 10 years
     42,955
        
     5.61Over 10 years
     1,422
        
     6.17$94,634Total
     $213,768Page 21 of 97
Item 1.
Business (Continued)INVESTMENT SECURITIES


As of December 31, 2007, the Company
held no investment  securities  exceeding 10% of stockholders'  equity, other than
securities of the U. S. Government agencies and corporations.


The weighted average yield is based
on the amortized cost of the investment securities. The yields are computed on a
tax-equivalent basis using a federal tax rate of 35%.


DEPOSITS


The following tables show the amounts
of average deposits and average rates paid on such deposits for the years ended
December 31, 2007, 2006 and 2005 and the composition of the certificates of deposit
issued in denominations in excess of $100,000 as of December 31, 2007:








December 31,2007
     Rate

    2006

    Rate

    2005

    Rate(Amounts In Thousands)Average noninterest-bearing deposits
     
     
     $137,271
        
     -
        
     $135,249
        
     -
        
     $133,046
        
     -Average interest-bearing
      demand    deposits
    
     157,483
        
     1.43
        %
     140,171
        
     0.98
        %
     144,866
        
     0.69
        %Average savings deposits
     261,914
        
     2.30
        
     264,210
        
     2.01
        
     259,267
        
     1.40Average time deposits
     575,738
        
     4.69
        
     518,313
        
     4.08
        
     467,878
        
     3.22$1,132,406
        
     
        
     $1,057,943
        
     
        
     $1,005,057Time certificates issued in amounts
of $100,000 or more with maturity in:






Amount
     Rate
     Amount
     Rate
     Amount
     Rate(Amounts In Thousands)3 months or less
     
     
     $33,857
        
     4.89
        %
     $27,220
        
     4.62
        %
     $17,288
        
     2.90
        %3 through 6 months
     36,111
        
     4.96
        
     44,161
        
     5.01
        
     11,320
        
     3.236 through 12 months
     38,525
        
     4.81
        
     53,967
        
     5.10
        
     35,080
        
     3.98Over 12 months
     22,666
        
     4.61
        
     24,104
        
     4.45
        
     35,001
        
     4.07$131,159
        
     
        
     $149,452
        
     
        
     $98,689There were no deposits in foreign
banking offices.

Page 22 of 97
Item 1.
Business (Continued)RETURN ON
STOCKHOLDERS EQUITY AND ASSETS


The following table presents the
return on average assets, return on average stockholders equity, the dividend payout
ratio and average stockholders equity to average assets ratio for the years ended
December 31, 2007, 2006 and 2005:




2007
     2006
     2005Return on average assets
     
     
     1.02
        %
     1.04
        %
     1.12
        %Return on average stockholders' equity
     13.06
        
     13.74
        
     14.47Dividend payout ratio
     23.99
        
     23.75
        
     22.44Average stockholders' equity to average assets ratio
     7.78
        
     7.56
        
     7.73SHORT-TERM BORROWINGS


The following table shows outstanding
balances, weighted average interest rates at year end, maximum month-end balances, average
month-end balances and weighted average interest rates of federal funds purchased and
securities sold under agreements to repurchase during 2007, 2006 and 2005:





2007
     2006
     2005(Amounts In Thousands)Outstanding balance as of December 31
     
     
     $87,076
        
     $59,063
        
     $34,537Weighted average interest rate at year end
     3.90
        %
     4.40
        %
     3.45
        %Maximum month-end balance
     87,076
        
     96,039
        
     52,849Average month-end balance
     51,880
        
     63,358
        
     30,044Weighted average interest rate for the year
     4.15
        %
     4.42
        %
     2.49
        %FEDERAL HOME LOAN BANK
BORROWINGS


The following table shows outstanding
balances, weighted average interest rates at year end, maximum month-end balances, average
month-end balances and weighted average interest rates of Federal Home Loan Bank
borrowings during 2007, 2006 and 2005:





2007
     2006
     2005(Amounts In Thousands)Outstanding balance as of December 31
     
     
     $265,348
        
     $235,379
        
     $223,161Weighted average interest rate at year end
     4.93
        %
     5.00
        %
     5.00
        %Maximum month-end balance
     265,348
        
     248,161
        
     223,161Average month-end balance
     248,804
        
     231,691
        
     190,438Weighted average interest rate for the year
     5.03
        %
     5.06
        %
     5.22
        %Page 23 of 97
Item 1A.
Risk FactorsThe performance of our Company is
subject to various risks. We consider the risks described below to be the most significant
risks we face, but such risks are not the only risk factors that could affect us.
Additional risks and uncertainties not currently known to us or that we currently deem to
be immaterial also may materially and adversely affect our business, financial condition
or results of operations. For a discussion of the impact of risks on our financial
condition and results of operations in recent years and on forward looking statements
contained in this report, reference is made to Item 7 below.


We may be adversely affected by
economic conditions in the local economies in which we conduct our operations, and in the
United States in general.


Unfavorable or uncertain economic and
market conditions may adversely affect our business and profitability. Our business faces
various material risks, including credit risk and the risk that the demand for our
products and services will decrease. Foreign or domestic terrorism or geopolitical events
could shock commodity and financial markets and cause an economic downturn. In an economic
downturn, our credit risk and litigation expense would increase. Also, decreases in
consumer confidence, real estate values, interest rates and investment returns, usually
associated with a downturn, could make the types of loans we originate less profitable.


We may incur losses because of
ineffective risk management processes and strategies.


We seek to monitor and control our
risk exposure through a variety of financial, credit, operational, compliance and legal
reporting systems. We employ risk monitoring and risk mitigation techniques, but those
techniques and the judgments that accompany their application may not be adequate to deal
with unexpected economic and financial events or the specifics and timing of such events.
Thus, we may, in the course of our activities, incur losses despite our risk management
efforts.


Our profitability and liquidity
may be adversely affected by a deterioration in the credit quality of, or defaults by,
third parties who owe us money or other assets.


We are exposed to the risk that third
parties that owe us money or other assets will not perform their obligations. These
parties may default on their obligations to us due to bankruptcy, lack of liquidity,
operational failure or other reasons. Our rights against third parties may not be
enforceable in all circumstances. In addition, a deterioration in the credit quality of
third parties whose securities or obligations we hold could result in losses and/or
adversely affect our ability to use those securities or obligations for liquidity
purposes.


A failure in our operational
systems or infrastructure, or those of third parties, could impair our liquidity, disrupt
our business, damage our reputation and cause losses.


Shortcomings or failures in our
internal processes, people or systems could lead to impairment of our liquidity, financial
loss, disruption of our business, liability to our customers, regulatory interventions or
damage to our reputation. Our financial, accounting, data processing or other operating
systems and facilities may fail to operate properly or become disabled as a result of
events that are wholly or partially beyond our control, adversely affecting our ability to
process transactions. We also face the risk of operational failure or termination of any
of the clearing agents, exchanges, clearing houses or other financial intermediaries we
use to facilitate transactions. Any such failure or termination could adversely affect our
ability to effect transactions, service our customers and manage exposure to risk.


Despite the contingency plans and
facilities we have in place, our ability to conduct business may be adversely impacted by
a disruption in the infrastructure that supports our business and the communities in which
we are located. This may include a disruption involving electrical, communications,
transportation or other services used by us or by third parties with which we conduct
business. If a disruption occurs in one location and our employees in that location are
unable to occupy our offices or communicate with or travel to other locations, our ability
to service and interact with our customers may suffer and we may be unable to successfully
implement contingency plans that depend on communication or travel.

Page 24 of 97
Item 1A.
Risk Factors (Continued)Our operations rely on the secure
processing, storage and transmission of confidential and other information in our computer
systems and networks. Although we take protective measures and endeavor to modify them as
circumstances warrant, our computer systems, software and networks may be vulnerable to
unauthorized access, computer viruses or other malicious code and other events that could
have a security impact. If one or more of such events occur, this potentially could
jeopardize our or our customers confidential and other information processed and
stored in, and transmitted through, our computer systems and networks, or otherwise cause
interruptions or malfunctions in our, our customers or third parties
operations, which could result in significant losses or damage to our reputation. We may
be required to expend significant additional resources to modify our protective measures
or to investigate and remedy vulnerabilities or other exposures. In the event of such a
security breach, we may be subject to litigation and financial losses that are either not
insured against or not fully covered through any insurance maintained by us.


Changing interest rates
may adversely affect our profits.


Our income and cash flows depend to a
great extent on the difference between the interest rates earned by us on interest-earning
assets such as loans and investment securities and the interest rates paid by us on
interest-bearing liabilities such as deposits and borrowings. If interest rates decrease,
our net interest income could be negatively affected if interest earned on
interest-earning assets, such as loans, mortgage-related securities, and other investment
securities, decreases more quickly than interest paid on interest-bearing liabilities,
such as deposits and borrowings. This would cause our net income to go down. In addition,
if interest rates decline, our loans and investments may be prepaid earlier than expected,
which may also lower our income. Rising interest rates may hurt our income because they
may reduce the demand for loans and the value of our investment securities. Higher
interest rates could adversely affect housing and other sectors of the economy that are
interest-rate sensitive. Higher interest rates could cause deterioration in the quality of
our loan portfolio. Interest rates are highly sensitive to many factors that are beyond
our control, including general economics conditions and monetary policies established by
the Federal Reserve Board. Interest rates do and will continue to fluctuate, and we cannot
predict future Federal Reserve Board actions or other factors that will cause rates to
change.


We experience intense
competition for loans and deposits.


Competition among financial
institutions in attracting and retaining deposits and making loans is intense.
Traditionally, our most direct competition for deposits has come from commercial banks,
savings institutions and credit unions doing business in our areas of operation.
Increasingly, we have experienced additional competition for deposits from nonbanking
sources, such as securities firms, insurance companies, money market mutual funds and
corporate and financial services subsidiaries of commercial and manufacturing companies.
Competition for loans comes primarily from other commercial banks, savings institutions,
consumer finance companies, credit unions, mortgage banking companies, insurance companies
and other institutional lenders. We compete primarily on the basis of products offered,
customer service and price. A number of institutions with which we compete enjoy the
benefits of fewer regulatory constraints and lower cost structures. Some have greater
assets and capital than we do and, thus, are better able to compete on the basis of price
than we are. The increasingly competitive environment is primarily a result of changes in
regulation and changes in technology and product delivery systems. These competitive
trends are likely to continue.


We are subject to substantial
regulation which could adversely affect our business and operations.


As a financial institution, we are
subject to extensive state and federal regulation and supervision which materially affects
our business. Such regulation and supervision is primarily intended for the protection of
customers, federal deposit insurance funds and the banking system as a whole, not our
shareholders. Statutes, regulations and policies to which we are subject may be changed at
any time, and the interpretation and the application of those laws and regulations by our
regulators is also subject to change. There can be no assurance that future changes in
such statutes, regulations and policies or in their interpretation or application will not
adversely affect us. We have established policies, procedures and systems designed to
comply with these regulatory and operational risk requirements. However, we face
complexity and costs in our compliance efforts. Adverse publicity and damage to our
reputation arising from the failure or perceived failure to comply with legal, regulatory
or contractual requirements could affect our ability to attract and retain customers or
could result in enforcement actions, fines, penalties and lawsuits.

Page 25 of 97
Item 1A.
Risk Factors (Continued)If we do not continue to meet or
exceed regulatory capital requirements and maintain our well-capitalized
status, there could be an adverse effect on the manner in which we do business and on the
confidence of our customers in us.


Under regulatory capital adequacy
guidelines, we must meet guidelines that involve quantitative measures of assets,
liabilities and certain off-balance sheet items. Failure to meet minimum capital
requirements could have a material effect on our financial condition and could subject us
to a variety of enforcement actions, as well as certain restrictions on our business.
Failure to maintain the status of well capitalized under the regulatory
framework could adversely affect the confidence that our customers have in us, which can
lead to a decline in the demand for our products and affect the prices that we are able to
charge for our products and services.


If we are not able to anticipate
and keep pace with rapid changes in technology, or do not respond to rapid technological
changes in our industry, our business can be adversely affected.


Our financial performance depends, in
part, on our ability to develop and market new and innovative services, and to adopt or
develop new technologies that differentiate our products or provide cost efficiencies. The
risks inherent in this process include rapid technological change in the industry, our
ability to access technical and other information from customers, and the significant and
ongoing investments required to bring new services to market in a timely fashion at
competitive prices. A further risk is the introduction by competitors of services that
could replace or provide lower-cost alternatives to our products and services.


Our performance may be adversely
affected if we are unable to hire and retain qualified employees.


Our performance is largely dependent
on the talents and efforts of our employees. Competition in the financial services
industry for qualified employees is intense. Our ability to compete effectively depends on
our ability to attract new employees and to retain and motivate our existing employees.


Our allowance for loan losses may
not be adequate to cover actual losses.


Like all financial institutions, we
maintain an allowance for loan losses to provide for loan defaults and non-performance.
Our allowance for loan losses is based on our historical loss experience as well as an
evaluation of the risks associated with its loan portfolio, including the size and
composition of the loan portfolio, current economic conditions and concentrations within
the portfolio. Our allowance for loan losses may not be adequate to cover actual losses,
and future provisions for loan losses could materially and adversely affect our financial
results.


Our reported financial results
depend in part on managements selection of accounting methods and certain
assumptions and estimates.


Our accounting policies and methods
are fundamental to how we record and report our financial condition and results of
operations. Our management must exercise judgment in selecting and applying many of these
accounting policies and methods so they comply with generally accepted accounting
principles (GAAP) and reflect managements judgment of the most appropriate manner to
report our financial condition and results of operations. In some cases, management must
select the accounting method to apply from two or more acceptable methods, any of which
might be reasonable under the circumstances yet might result in our reporting materially
different results than would have been reported under a different method.

Page 26 of 97
Item 1A.
Risk Factors (Continued)Changes in accounting standards
could materially impact our consolidated financial statements.


From time to time, the Financial
Accounting Standards Board (FASB) changes the financial accounting and reporting standards
that govern the preparation of our consolidated financial statements. These changes can be
hard to predict and can materially impact how we record and report financial condition and
results of operations. In some cases, we could be required to apply a new or revised
standard retroactively, resulting in restatement of prior period consolidated financial
statements.


We are exposed to risk of
environmental liability when we take title to properties.


In the course of our business, we may
foreclose on and take title to real estate. As a result, we could be subject to
environmental liabilities with respect to these properties. We may be held liable to a
governmental entity or to third parties for property damage, personal injury,
investigation and clean-up costs incurred by these parties in connection with
environmental contamination or may be required to perform investigation or remediation
activities that could be substantial. In addition, if we are the owner or former owner of
a contaminated site, it may be subject to common law claims by third parties based on
damages and costs resulting from environmental contamination emanating from the property.
If we become subject to significant environmental liabilities, our financial condition and
results of operations could be adversely affected.


Commercial loans make up a
significant portion of our loan portfolio.


Our commercial loans are primarily
made based on the identified cash flow of the borrower and secondarily on the underlying
collateral provided by the borrower. Most often, this collateral is accounts receivable,
inventory, machinery or real estate. In the case of loans secured by accounts receivable,
the availability of funds for the repayment of these loans may be substantially dependent
on the ability of the borrower to collect amounts due from its customers. The other types
of collateral securing these loans may depreciate over time, may be difficult to appraise
and may fluctuate in value based on the success of the business.


Our loan portfolio has a large
concentration of real estate loans, which involve risks specific to real estate value.


Real estate lending is a large
portion of our loan portfolio and included home equity, commercial, construction and
residential loans. The market value of real estate can fluctuate significantly in a short
period of time as a result of market conditions in the geographic area in which the real
estate is located. Adverse developments affecting real estate values in our market could
increase the credit risk associated with our loan portfolio. Also, real estate lending
typically involves higher loan principal amounts and the repayment of the loans generally
is dependent, in large part, on sufficient income from the properties securing the loans
to cover operating expenses and debt service. Economic events or governmental
regulations outside of the control of the borrower could negatively impact the future
cash flow and market values of the affected properties.


If the loans that are collateralized
by real estate become troubled during a time when market conditions are declining or have
declined, then we may not be able to realize the amount of security that we anticipated at
the time of originating the loan, which could cause us to increase our provision for loan
losses and adversely affect our operating results and financial condition.

Page 27 of 97
Item 1A.
Risk Factors (Continued)Our real estate loans also include
construction loans, including land acquisition and development. Construction, land
acquisition and development lending involve additional risks because funds are advanced
based upon estimates of costs and the estimated value of the completed project. Because of
the uncertainties inherent in estimating construction costs, as well as the market value
of the completed project and the effects of governmental regulation on real property, it
is relatively difficult to evaluate accurately the total funds required to complete a
project and the related loan-to-value ratio. As a result, commercial construction loans
often involve the disbursement of substantial funds with repayment dependent, in part, on
the success of the ultimate project and the ability of the borrower to sell or lease the
property, rather than the ability of the borrower or guarantor to repay principal and
interest. If our appraisal of the value of the completed project proves to be overstated,
we may have inadequate security for the repayment of the loan upon completion of
construction of the project.


Our agricultural loans may involve
a greater degree of risk than other loans, and the ability of the borrower to repay may be
affected by many factors outside of the borrowers control.


Payments on agricultural real estate
loans are dependent on the profitable operation or management of the farm property
securing the loan. The success of the farm may be affected by many factors outside the
control of the borrower, including adverse weather conditions that prevent the planting of
a crop or limit crop yields (such as hail, drought and floods), loss of livestock due to
disease or other factors, declines in market prices for agricultural products (both
domestically and internationally) and the impact of government regulations (including
changes in price supports, subsidies and environmental regulations). In addition, many
farms are dependent on a limited number of key individuals whose injury or death may
significantly affect the successful operation of the farm. If the cash flow from a farming
operation is diminished, the borrowers ability to repay the loan may be impaired.
The primary crops in our market areas are corn and soybeans. Accordingly, adverse
circumstances affecting these crops could have an adverse effect on our agricultural real
estate loan portfolio.


We also originate agricultural
operating loans. As with agricultural real estate loans, the repayment of operating loans
is dependent on the successful operation or management of the farm property. Likewise,
agricultural operating loans involve a greater degree of risk than lending on residential
properties, particularly in the case of loans that are unsecured or secured by rapidly
depreciating assets such as farm equipment or assets such as livestock or crops. The
primary livestock in our market areas is hogs. In these cases, any repossessed collateral
for a defaulted loan may not provide an adequate source of repayment of the outstanding
loan balance as a result of the greater likelihood of damage, loss or depreciation.


A decline in local and national
real estate markets may impact our operations and/or financial condition.


There has been a slowdown in the
national housing market as evidenced by reports of reduced levels of new and existing home
sales, increasing inventories of houses on the market, stagnant to declining property
values, a decline in building permits, and an increase in the time houses remain on the
market. In recent years some lenders made many adjustable-rate mortgage loans, lowered
their credit standards with respect to mortgage loans and home equity loans, and created
collateralized debt obligations which included such mortgage loans. The slowdown in the
national housing market created uncertainty and liquidity issues relating to the value of
such mortgage loans, which causes disruption in credit markets. In early 2008, the Federal
Reserve lowered the federal funds rate and the discount rate and took other actions to
improve the liquidity situation. Concern about the impact of a slowing economy caused
Congress to enact, and President Bush to sign into law, the Economic Stimulus Package of
2008. Although management believes that the Bank has maintained appropriate lending
standards and that these trends have yet to materially affect our local economy or our
business and profitability, no assurance can be given that these conditions will not
directly or indirectly affect our operations. If these conditions continue or worsen, they
may result in a decrease in interest income or an adverse impact on our loan losses.

Page 28 of 97
Item 1B.
Unresolved Staff CommentsNone.




Item 2.
PropertiesThe Companys office and the
main office of the Bank are located at 131 Main Street, Hills, Iowa. This is a brick
building containing approximately 45,000 square feet. A portion of the building was built
in 1977, a two-story addition was completed in 1984, and a two-story brick addition was
completed in February 2001. With the completion of the 2001 addition, the entire
Banks processing and administrative systems, including trust, were consolidated in
Hills, Iowa.


The other offices of Hills Bank and
Trust, which are owned by the Bank except as, otherwise indicated below, are as follows:


1.
The
Iowa City office, located at 1401 South Gilbert Street, is a one-story brick
                    building containing approximately 15,400 square feet. The branch has
five                     drive-up teller lanes and a drive-up, 24-hour ATM. The Banks
trust                     department customer service representatives are located here.
This building was                     constructed in 1982 and has been expanded several
times, most recently in 1998.2.
The
Coralville office is a two-story building built in 1972 and expanded in 2001
                    that contains approximately 23,000 square feet of space. This office
is equipped                     with four drive-up teller lanes and one ATM and is used
primarily for retail                     banking services.3.
A
2,800 square foot branch bank in North Liberty, Iowa was opened for business
                    in 1986. This office is a full-service location including three
drive-up teller                     lanes and a drive-up ATM.4.
The
Bank leases an office at 201 South Clinton Street in downtown Iowa City with
                    approximately 5,800 square feet. The office has two 24-hour ATMs
and is                     located in the Old Capitol Town Center. The lease expires in
2014 with four                     additional five year terms available at the Banks
option.5.
In
December 2001, the Bank opened a new East Side office location at 2621
                    Muscatine Avenue, Iowa City. The office is a 5,800 square foot,
one-story                     building, and it has three drive-up lanes and a drive-up
ATM.6.
The
Lisbon office is a two-story brick building in Lisbon, Iowa with
                    approximately 3,000 square feet of banking retail space located on
the first                     floor. The building was extensively remodeled in 1996 and
has one drive-up lane                     and a walk-up, 24-hour ATM.7.
The
Mount Vernon office opened in February 1998 with the completion of a
                    full-service, 4,200 square foot office, with four drive-up lanes and
a drive-up                     ATM.8.
In
February 2000, the Bank opened a 2,900 square foot branch office in downtown
                    Cedar Rapids that is leased. In April 2001, an additional contiguous
2,100                     square feet of space was leased and then remodeled for retail
banking purposes.                     The leases expire in 2011 and have one five year
renewal option.9.
The
Kalona office is a 6,400 square foot building that contains a walk-up
                    24-hour ATM and one drive-up lane. This is an older building that was
remodeled                     in late 1998.10.
In
March of 2002, the Bank opened its eleventh office, and the second office
                    location in the Cedar Rapids market. The new 7,200 square foot
one-story                     building has three drive-up lanes and a drive-up ATM. The
location of the office                     is on Williams Boulevard in Southwest Cedar
Rapids.11.
A
full service office opened on February 10, 2003 in Marion, Iowa, after
                    extensive remodeling of the property located at 800 11th Street. The
office is a                     two-story building having approximately 8,400 square feet
with three drive-up                     lanes and a drive-up ATM.Page 29 of 97
Item 2.
Properties (Continued)12.
In
June of 2005, the Bank opened a limited purpose office at the Oaknoll
                    Retirement Residence in Iowa City. The office is open on the second
and fourth                     Tuesday of each month. The office opens deposit accounts,
provides deposit                     services, trust and investment services and check
cashing. It does not perform                     loan origination services. This office
is neither owned nor leased by the Bank.13.
In
September of 2006, the Bank opened an office in Wellman, Iowa, its second
                    location in Washington County. The office consists of two buildings
with the                     primary office space located at 229 8th Avenue.
The secondary                     location houses a drive-up ATM.All of the properties owned by the
Bank are free and clear of any mortgages or other encumbrances of any type. See Note 14 to
the Consolidated Financial Statements for minimum future rental commitments for leased
properties.




Item 3.
Legal ProceedingsThere are no material pending legal
proceedings. Neither the Company nor the Bank holds any properties that are the subject of
hazardous waste clean-up investigations.




Item 4.
Submission of Matters to a Vote of Security HoldersNo matters were submitted to a vote
of security holders for the three months ended December 31, 2007.

Page 30 of 97
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. The Companys stock
is not actively traded. As of January 31, 2008, the Company had 1,574 stockholders.


Based on the Companys stock
transfer records and information informally provided to the Company, its stock trading
transactions have been as follows:




Year

    Number of Shares 
      Traded

    Number of 
      Transactions
     High Selling Price
     Low Selling Price2007
     
     
     31,699
        
     46
        
     $53.00
        
     $50.00
        (1)2006
     71,696
        
     36
        
     50.00
        
     46.50
        (2)2005
     11,858
        
     27
        
     46.50
        
     37.00
        (3)(1)
2007
transactions included repurchases by the Company of 25,492 shares of stock under the 2005
Stock Repurchase Plan approved on August 8, 2005 (the "Repurchase Plan").  2007
transactions made under the Repurchase Plan were made at prices that ranged from $50.00
to $53.00 per share.  All transactions under the Repurchase Plan were at a price equal to
the most recent quarterly independent appraisal of the shares of the Company's common
stock.(2)
2006
transactions included repurchases by the Company of 66,521 shares of stock under the
Repurchase Plan.  2006 transactions made under the Repurchase Plan were made at prices
that ranged from $46.50 to $50.00 per share.(3)
2005
transactions included repurchases by the Company of 1,400 shares of stock under the
Repurchase Plan.  2005 transactions made under the Repurchase Plan were made at prices
that ranged from $45.00 to $46.50 per share.The Company paid aggregate annual
cash dividends in 2007, 2006 and 2005 of $3,873,000, $3,696,000 and $3,412,000
respectively, or $.86 per share in 2007, $.81 per share in 2006 and $.75 per share in
2005. In January 2008, the Company declared and paid a dividend of $.91 per share totaling
$4,086,000. The decision to declare any such cash dividends in the future and the amount
thereof rests within the discretion of the Board of Directors and will remain subject to,
among other things, certain regulatory restrictions imposed on the payment of dividends by
the Bank, and the future earnings, capital requirements and financial condition of the
Company.


Page 31 of 97
PART II


Item 5.
Market for the Registrants Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity SecuritiesThe following performance graph
provides information regarding cumulative, five-year shareholder returns on an indexed
basis of the Companys Common Stock compared to the NASDAQ Market Index and the
Regional-Southwest Banks Index prepared by HEMSCOTT (formerly CoreData, Inc.) of Richmond,
Virginia. The latter index reflects the performance of thirty-four bank holding companies
operating principally in the Midwest as selected by HEMSCOTT. The indexes assume the
investment of $100 on December 31, 2002 in Company Common Stock, the NASDAQ Index and the
Regional-Southwest Banks Index, with all dividends reinvested.

Hills Bancorporation
Performance Graph (2002-2007)

2002
     2003
     2004
     2005
     2006
     2007HILLS BANCORPORATION
     
     
     $100.00
        
     $117.25
        
     $131.52
        
     $168.64
        
     $184.50
        
     $198.93REGIONAL-SOUTHWEST BANKS
     $100.00
        
     $132.48
        
     $159.08
        
     $166.46
        
     $189.27
        
     $167.92NASDAQ MARKET INDEX
     $100.00
        
     $150.36
        
     $163.00
        
     $166.58
        
     $183.68
        
     $201.91Note regarding the performance graph: Cumulative five-year Shareholder returns on an indexed basis.
The indexes assume the investment of $100 in year with all dividends reinvested.


Page 32 of 97
PART II


Item 5.
Market for the Registrants Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities (Continued)The following table sets forth the
Companys equity compensation plan information as of December 31, 2007, all of which
relates to stock options issued under stock option plans approved by stockholders of the
Company:








Plan Category
     Number of securities
to be issued upon exercise
of outstanding options,
warrants and rights
(a)
     Weighted-average exercise
price of outstanding
options, warrants and rights
(b)
     Number of securities remaining
available for future issuance under
equity compensation plans
[excluding securities reflected in column (a)]
(c)Equity compensationplans approved bysecurity holders
     48,365
        
     $31.02
        
     110,950Equity compensationplans not approvedby security holders
     -
        
     N/A
        
     -Total
     48,365
        
     $31.02
        
     110,950All stock option plans have been
approved by the stockholders.


On July 26, 2005, the Companys
Board of Directors authorized a program to repurchase up to a total of 750,000 shares of
the Companys common stock (the 2005 Stock Repurchase Program). This
authorization will expire on December 31, 2009. The Company expects the purchases pursuant
to the 2005 Stock Repurchase Program to be made from time to time in private transactions
at a price equal to the most recent quarterly independent appraisal of the shares of the
Companys common stock and with the Board reviewing the overall results of the 2005
Stock Repurchase Program on a quarterly basis. All purchases made pursuant to the 2005
Stock Repurchase Program since its inception have been made on that basis. The amount and
timing of stock repurchases will be based on various factors, such as the Boards
assessment of the Companys capital structure and liquidity, the amount of interest
shown by shareholders in selling shares of stock to the Company at their appraised value,
and applicable regulatory, legal and accounting factors.


The following table sets forth
information about the Companys stock purchases pursuant to the 2005 Stock Repurchase
Program for the quarter ended December 31, 2007:








Period in 2007

    Total number of shares
      purchased

    Average price paid
      per share

    Total number of shares purchased
      as part of publicly announced plans or
      programs

    Maximum number of shares
      that may yet be purchased under the plans or
      programsOctober 1 to October 31
     
     
     1,125
        
     $52.50
        
     86,070
        
     663,930November 1 to November 30
     1,859
        
     53.00
        
     87,929
        
     662,071December 1 to December 31
     5,484
        
     53.00
        
     93,413
        
     656,587Total
     8,468
        
     $52.93
        
     93,413
        
     656,587Page 33 of 97
Item 6.
Selected Financial DataCONSOLIDATED FIVE-YEAR
STATISTICAL SUMMARY




2007
    2006
    2005
    2004
    2003YEAR-END
      TOTALS (Amounts in Thousands)Total
      assets
    
    
    $
    1,661,098
    
    $
    1,551,233
    
    $
    1,433,649
    
    $
    1,290,449
    
    $
    1,183,521Investment
      securities
    
    
    
    213,768
    
    
    190,984
    
    
    209,001
    
    
    218,016
    
    
    236,157Federal
      funds sold
    
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    13,233Loans
      held for sale
    
    
    
    6,792
    
    
    3,808
    
    
    702
    
    
    3,908
    
    
    1,960Loans,
      net
    
    
    
    1,352,599
    
    
    1,279,227
    
    
    1,141,716
    
    
    998,231
    
    
    868,194Deposits
    
    
    
    1,143,926
    
    
    1,107,409
    
    
    1,036,414
    
    
    957,236
    
    
    868,652Federal
      Home Loan Bank borrowings
    
    
    
    265,348
    
    
    235,379
    
    
    223,161
    
    
    167,542
    
    
    167,574Redeemable
      common stock
    
    
    
    22,205
    
    
    20,940
    
    
    20,634
    
    
    16,336
    
    
    14,864Stockholders'
      equity
    
    
    
    130,690
    
    
    118,639
    
    
    109,479
    
    
    103,803
    
    
    96,765EARNINGS (Amounts
      in Thousands)Interest
      income
    
    
    $
    96,928
    
    $
    87,618
    
    $
    74,403
    
    $
    65,324
    
    $
    63,381Interest
      expense
    
    
    
    49,952
    
    
    42,362
    
    
    30,363
    
    
    23,885
    
    
    26,405Provision
      for loan losses
    
    
    
    3,529
    
    
    3,011
    
    
    2,101
    
    
    1,470
    
    
    424Other
      income
    
    
    
    15,984
    
    
    14,611
    
    
    12,808
    
    
    12,542
    
    
    13,852Other
      expenses
    
    
    
    36,150
    
    
    34,364
    
    
    32,861
    
    
    31,965
    
    
    29,137Income
      taxes
    
    
    
    7,138
    
    
    6,933
    
    
    6,684
    
    
    6,351
    
    
    6,998Net income
    
    
    
    16,143
    
    
    15,559
    
    
    15,202
    
    
    14,195
    
    
    14,269PER SHARENet income:Basic
    
    
    $
    3.59
    
    $
    3.42
    
    $
    3.34
    
    $
    3.12
    
    $
    3.15Diluted
    
    
    
    3.57
    
    
    3.39
    
    
    3.32
    
    
    3.11
    
    
    3.14Cash
      dividends
    
    
    
    0.86
    
    
    0.81
    
    
    0.75
    
    
    0.70
    
    
    0.63Book
      value as of December 31
    
    
    
    29.11
    
    
    26.34
    
    
    24.00
    
    
    22.82
    
    
    21.27Increase
      (decrease) in book valuedue
      to:ESOP
      obligation
    
    
    
    (4.95
    )
    
    (4.65
    )
    
    (4.52
    )
    
    (3.59
    )
    
    (3.27
    )Accumulated
      othercomprehensive
      income (loss)
    
    
    
    0.14
    
    
    (0.28
    )
    
    (0.39
    )
    
    0.13
    
    
    0.68SELECTED RATIOSReturn
      on average assets
    
    
    
    1.02
    %
    
    1.04
    %
    
    1.12
    %
    
    1.15
    %
    
    1.24
    %Return
      on average equity
    
    
    
    13.06
    
    
    13.74
    
    
    14.47
    
    
    14.34
    
    
    15.36Net
      interest margin
    
    
    
    3.24
    
    
    3.31
    
    
    3.56
    
    
    3.70
    
    
    3.53Average
      stockholders' equity toaverage
      total assets
    
    
    
    7.78
    
    
    7.56
    
    
    7.73
    
    
    8.04
    
    
    8.04Dividend
      payout ratio
    
    
    
    23.99
    
    
    23.75
    
    
    22.44
    
    
    22.44
    
    
    19.99Page 34 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition And Results of
OperationThe following discussion by
management is presented regarding the financial results for Hills Bancorporation
(The Company) for the dates and periods indicated. The discussion should be
read in conjunction with the Selected Consolidated Five-Year Statistical
Summary and the consolidated financial statements and the accompanying notes thereto
included or incorporated by reference elsewhere in this document.


An overview of the year 2007 is
presented following the section discussing a special note regarding forward looking
statements.


Special Note Regarding
Forward Looking Statements


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



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



The
strength of the United States economy in general and the strength of the local economies
in which the Company conducts its operations which may be less favorable than expected
and may result in, among other things, a deterioration in the credit quality and value of
the Companys assets.
The
effects of, and changes in, laws, regulations and policies affecting banking, securities,
insurance and monetary and financial matters as well as any laws otherwise affecting the
Company.
The
effects of changes in interest rates (including the effects of changes in the rate of
prepayments of the Companys assets) and the policies of the Board of Governors of
the Federal Reserve System.
The
ability of the Company to compete with other financial institutions as effectively as the
Company currently intends due to increases in competitive pressures in the financial
services sector.
The
ability of the Company to obtain new customers and to retain existing customers.
The
timely development and acceptance of products and services, including products and
services offered through alternative delivery channels such as the Internet.
Technological
changes implemented by the Company and by other parties, including third party vendors,
which may be more difficult or more expensive than anticipated or which may have
unforeseen consequences to the Company and its customers.
The
ability of the Company to develop and maintain secure and reliable electronic systems.Page 35 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition And Results of
Operation (Continued)
The
ability of the Company to retain key executives and employees and the difficulty that the
Company may experience in replacing key executives and employees in an effective manner.
Consumer
spending and saving habits which may change in a manner that affects the Companys
business adversely.
The
economic impact of terrorist attacks and military actions.
Business
combinations and the integration of acquired businesses and assets which may be more
difficult or expensive than expected.
The
costs, effects and outcomes of existing or future litigation.
Changes
in accounting policies and practices that may be adopted by state and federal regulatory
agencies and the Financial Accounting Standards Board.
The
ability of the Company to manage the risks associated with the foregoing as well as
anticipated.These risks and uncertainties should
be considered in evaluating forward-looking statements, and undue reliance should not be
placed on such statements. Additional information concerning the Company and its business,
including other factors that could materially affect the Companys financial results,
is included in the Companys filings with the Securities and Exchange Commission.


Overview


The Company is a bank holding company
engaged, through its wholly-owned subsidiary bank, in the business of commercial banking.
The Companys subsidiary is Hills Bank and Trust Company, Hills, Iowa (the
Bank). The Bank was formed in Hills, Iowa in 1904. The Bank is a full-service
commercial bank extending its services to individuals, businesses, governmental units and
institutional customers primarily in the communities of Hills, Iowa City, Coralville,
North Liberty, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa.


The Companys net income for
2007 was $16,143,000 compared to $15,559,000 in 2006. Diluted earnings per share were
$3.57 and $3.39 for the years ended December 31, 2007 and 2006, respectively.


The Banks net interest income
is the largest component of the Banks revenue, and it is a function of the average
earning assets and the net interest margin percentage. Net interest margin is the ratio of
tax equivalent net interest income to average earning assets. For the year ended December
31, 2007, the Bank achieved a net interest margin of 3.24% compared to 3.31% in 2006,
which resulted in a decrease of $1.9 million in net interest income. This decrease was
more than offset by an increase of $3.8 million in net interest income attributable to
growth of $91.7 million in the Banks average earning assets.

Page 36 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operation (Continued)Highlights with respect to items on
the Companys balance sheet as of December 31, 2007 included the following:



Investment
securities increased $22.8 million in 2007.
Net
loans totaling $1.359 billion.
Loan
growth in 2007 of $76.4 million and deposit growth of $36.5 million in 2007.
Deposits
increased $36.5 million to $1.144 billion.
Short-term
borrowings increased $28.0 million and Federal Home Loan Bank borrowings increased $30.0
million.
Stockholders equity
increased $12.1 million to $130.7 million in 2007, with dividends having been paid in
2007 of $3.9 million.The return on average equity was
13.06% in 2007 compared to 13.74% in 2006. The returns for the three previous years, 2005,
2004 and 2003, were 14.47%, 14.34% and 15.36%, respectively. The total equity of the
Company remains strong as of December 31, 2007 with total risk-based capital at 13.37% and
Tier 1 risk-based capital at 12.11%. The minimum regulatory guidelines are 8% and 4%
respectively. The Company continues to increase the dividend per share with $.86, $.81 and
$.75 having been paid out in the years ended December 31, 2007, 2006 and 2005,
respectively.


A detailed discussion of the
financial position and results of operations follows this overview.


Critical Accounting
Policies


The Companys consolidated
financial statements are prepared in accordance with accounting principles generally
accepted in the United States of America. The financial information contained within these
statements is, to a significant extent, financial information that is based on approximate
measures of the financial effects of transactions and events that have already occurred.
Based on its consideration of accounting policies that involve the most complex and
subjective decisions and assessments, management has identified its most critical
accounting policies to be those which are related to the allowance for loan losses. The
Companys allowance for loan loss methodology incorporates a variety of risk
considerations, both quantitative and qualitative in establishing an allowance for loan
loss that management believes is appropriate at each reporting date. Quantitative factors
include the Companys historical loss experience, delinquency and charge-off trends,
collateral values, changes in non-performing loans, and other factors. Quantitative
factors also incorporate known information about individual loans, including
borrowers sensitivity to interest rate movements. Qualitative factors include the
general economic environment in the Companys markets, including economic conditions
throughout the Midwest and in particular, the state of certain industries. Size and
complexity of individual credits in relation to loan structure, existing loan policies and
pace of portfolio growth are other qualitative factors that are considered in the
methodology. As the Company adds new products and increases the complexity of its loan
portfolio, it will enhance its methodology accordingly. This discussion of the
Companys critical accounting policies should be read in conjunction with the
Companys consolidated financial statements and the accompanying notes presented
elsewhere herein, as well as other relevant portions of Managements Discussion and
Analysis of Financial Condition and Results of Operations. Although management believes
the levels of the allowance as of December 31, 2007 and 2006 were adequate to absorb
probable losses inherent in the loan portfolio, a decline in local economic conditions, or
other factors, could result in increasing losses that cannot be reasonably predicted at
this time.


Financial Position





Year End Amounts (Amounts
      In Thousands)
    2007
    2006
    2005
    2004
    2003Total assets
    
    
    $
    1,661,098
    
    $
    1,551,233
    
    $
    1,433,649
    
    $
    1,290,449
    
    $
    1,183,521Investment securities
    
    
    
    213,768
    
    
    190,984
    
    
    209,001
    
    
    218,016
    
    
    236,157Loans, net of allowance
      for losses 
         ("Net Loans")
    
    
    
    1,359,391
    
    
    1,283,035
    
    
    1,142,418
    
    
    1,002,139
    
    
    870,154Deposits
    
    
    
    1,143,926
    
    
    1,107,409
    
    
    1,036,414
    
    
    957,236
    
    
    868,652Federal Home Loan Bank
      borrowings
    
    
    
    265,348
    
    
    235,379
    
    
    223,161
    
    
    167,542
    
    
    167,574Stockholders' equity
    
    
    
    130,690
    
    
    118,639
    
    
    109,479
    
    
    103,803
    
    
    96,765Page 37 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operations (Continued)Total assets at December 31, 2007
increased $109.9 million, or 7.08%, from the prior year-end. Asset growth from 2005 to
2006 was $117.6 million and represented an 8.20% increase. The largest growth in assets
occurred in Net Loans, which increased $76.4 million and $140.6 million for the years
ended December 31, 2007 and 2006, respectively. Net Loans include loans held for sale to
the secondary market of $6.8 million compared to $3.8 million at the end of 2006.


Interest rates are also discussed in
the net income overview that follows this financial position review. The Federal Open
Market Committee decreased the federal funds target rate on September 18, 2007 from 5.25%
to 4.75%. This was the first change in the target rate since June 29, 2006 and the first
decrease since June 25, 2003. The target rate was decreased twice more in 2007 to a rate
of 4.25% as of December 31, 2007. Prior to these decreases, the target rate increased in
June 24, 2004 when the rate was increased from 1.00% to 1.25% and increased 17 times to
5.25% over the two-year period to June 2006. Interest rates on loans are generally
affected by these decreases since interest rates for the U.S. Treasury market normally
decrease when the Federal Reserve Board lowers the federal funds rate. In pricing of loans
and deposits, the Bank considers the U.S. Treasury indexes as benchmarks in determining
interest rates. As of December 31, 2007, the average rate indexes for the one, three and
five year indexes were 4.52%, 4.32% and 4.41%, respectively. The one year index decreased
7.94% from 2006, the three year index decreased 9.24% and the five year index decreased
7.35%. During this same period, the average federal funds rate increased from 4.82% in
2006 to 4.94% in 2007. The increase in short-term federal funds of 12 basis points and a
35 point decrease in the five year index caused a flattening of the investment yield
curve. Changes in interest rates may at some point materially affect loan demand and the
economy. At the current interest rate levels, demand for loans remains good.


Loans secured by real estate
represent the largest increase in loan growth. These loans increased $37.3 million in 2007
and increased $77.3 million in 2006. Loans secured by real estate include loans for
one-to-four family residential properties, multi-family properties, agricultural real
estate and commercial real estate. Another large increase for loans occurred for
commercial loans which in 2007 increased a total of $13.7 million and $26.8 million in
2006. Also, loans to finance agricultural production and other loans to farmers increased
$10.8 million in 2007 compared to an increase of $5.5 million in 2006. The overall economy
in the Companys principal place of business, Johnson, Linn and Washington Counties,
remains in good condition with unemployment levels that remain low. Competition for
quality loans and deposits will continue to be a challenge. In Johnson and Linn Counties,
new banks and credit unions have been opened in the last few years. Between 2005 and 2007,
six new banking locations were added in Johnson County and eight in Linn County. The
fourteen new locations include an office of one of the states largest credit unions.
The increased competition for both loans and deposits could result in a lower interest
rate margin that could result in lower net interest income if the volume of loans and
deposits does not increase to offset any such reduction in the interest margin.


Total deposits increased by $36.5
million in 2007. Short-term borrowings, which include federal funds purchased and
securities sold under agreements to repurchase, increased from $59.1 million to $87.1
million. Federal funds purchased increased by $29.0 million, and repurchase agreements
decreased $1.0 million. Deposits increased by $71.0 million in 2006. As of June 30, 2007,
Johnson County total deposits were $2.4 billion and the Companys deposits were $802
million, which represent a 33.4% market share. At June 30, 2006, deposits were $781
million or a 34.8% market share. At $4.4 billion as of June 30, 2007, the Linn County
deposit market is almost twice the size of the Johnson County deposit market. The five
Linn County offices of the Company had deposits of $253 million or a 5.7% share of the
market. The Companys Linn County deposits at June 30, 2006 were $232 million and
represented the same 5.7% market share. In Washington County, the Companys two
offices had deposits of $74 million which was 16.1% of the Countys total deposits of
$459 million. In 2006, the Companys Washington County deposits were $64 million or a
15.3% market share.

Page 38 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operation (Continued)Investment securities increased $22.8
million in 2007. In 2006, investment securities decreased by $18.0 million. The investment
portfolio consists of $199.6 million of securities that are stated at fair value, with any
unrealized gain or loss, net of income taxes, reported as a separate component of
stockholders equity. The securities portfolio, which includes tax exempt securities
and stock of the FHLB that is required for borrowings, is used for liquidity and pledging
purposes and to provide a rate of return that is acceptable to management. See Note 2 to
the Companys Consolidated Financial Statements.


During 2007, the major funding
sources for the growth in loans were the $36.5 million increase in deposits and additional
funding from federal funds purchased and the Federal Home Loan Bank (FHLB). Federal funds
purchased increased by $29.0 million and borrowings from the FHLB increased by $30.0
million. In 2006, the major source of funding for the growth in loans was deposit growth
of $71.0 million. Total advances from the FHLB were $265.3 million and $235.4 million for
2007 and 2006, respectively. It is expected that the FHLB funding source will be used in
the future when loan growth exceeds deposit increases and the interest rates on funds
borrowed from the FHLB are favorable compared to other funding alternatives.


Stockholders equity was $130.7
million at December 31, 2007 compared to $118.6 million at December 31, 2006. 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 $75.4 million and paid shareholders dividends of $17.0 million, or 22.6% of
earnings, while still maintaining capital ratios in excess of regulatory requirements.

Page 39 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition and Results of Operation
(Continued)Net Income Overview


Net income and diluted earnings per
share for the last five years are as presented below:





Year
     Net Income
     % Increase (Decrease)
     E.P.S.- Diluted(In Thousands)2007
     
     
     $16,143
        
     3.75
        %
     $3.572006
     15,559
        
     2.35
        
     3.392005
     15,202
        
     7.09
        
     3.322004
     14,195
        
     (0.05
        )
     3.112003
     14,269
        
     24.47
        
     3.14Net income for 2007 increased by $0.6
million or 3.75% and diluted earnings per share increased 5.31%. A significant factor that
aided in increasing the level of net income in 2007 was the growth of average earning
assets. This item accounted for a $3.8 million increase in the net interest income on a
tax-equivalent basis and more than offset the increased provision for loan losses of $0.5
million and the decrease in net interest margin. The increase in operating expenses of
$1.8 million for the year was offset by a $1.4 million increase in other income.


Annual fluctuations in the
Companys net income continue to be driven primarily by two important factors. The
first important factor is net interest margin. Net interest income of $47.0 million in
2007 was derived from the Companys $1.515 billion of average earning assets and its
net interest margin of 3.24%, compared to $1.423 billion of average earning assets and a
3.31% net interest margin in 2006. 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 3.14% would
result in a $1.5 million decrease in income before taxes. Similarly, an increase in the
net interest margin of 10 basis points to 3.34% would increase income before income taxes
by $1.5 million. Net interest margin decreased in 2006 to 3.31% from 3.56% in 2005.


The second significant factor
affecting the Companys net income is the provision for loan losses. The majority of
the Companys interest-earning assets are in loans outstanding, which amounted to
$1.4 billion at the end of 2007. The Companys allowance for loan losses was $19.7
million at December 31, 2007. The increase in the allowance in 2007 was due to loan growth
of $76.4 million and a deterioration of credit quality. The loan loss provision, which is
the amount necessary to adjust the allowance to the level considered appropriate by
management, totaled $3,529,000, $3,011,000 and $2,101,000 for 2007, 2006 and 2005,
respectively. (See Note 3 to the Consolidated Financial Statements.) A discussion in
detail is included in the Provisions for Loan Losses section below.


Net income for 2006 was $15,559,000,
or diluted earnings per share of $3.39. For 2006, diluted earnings per share increased
$.07 per share. Net income for the year ended December 31, 2006 represented a $357,000
increase over the reported income for the same period in 2005. Net interest income,
including fees, increased $1.2 million for the year ended December 31, 2006 compared to
2005. This increase in net interest income was due to an increase in average earning
assets of $137.8 million in 2006. Noninterest income increased 14.08% in 2006 to
$14,611,000. Noninterest expense increased from $32,861,000 in 2005 to $34,364,000 in
2006, or 4.57%.

Page 40 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operation (Continued)Net Interest Income


Net interest income is the excess of
the interest and fees received on interest-earning assets over the interest expense of the
interest-bearing liabilities. The factors that have the greatest impact on net interest
income are the volume of average earning assets and the net interest margin. The volume of
average earning assets has continued to grow each year, primarily due to new loans. The
net interest margin decreased in 2007 to 3.24% and this compares to 3.31% in 2006, 3.56%
in 2005, 3.70% in 2004 and 3.53% in 2003. The measure is shown on a tax-equivalent basis
using a rate of 35% to make the interest earned on taxable and nontaxable assets more
comparable.


Net interest income on a
tax-equivalent basis changed in 2007 as follows:




Change InAverageBalance
     Change InAverageRate
     Increase (Decrease)Volume
Changes
     Rate
Changes
     Net
Change(Amounts In Thousands)Interest income:Loans, net
     $88,476
        
     0.20
        %
     $5,844
        
     $2,700
        
     $8,544Taxable securities
     (9,105
        )
     0.52
        
     (321
        )
     589
        
     268Nontaxable securities
     6,696
        
     0.03
        
     364
        
     26
        
     390Federal funds sold
     5,649
        
     0.47
        
     255
        
     30
        
     285$91,716
        
     
        
     $6,142
        
     $3,345
        
     $9,487Interest expense:Interest-bearing demand deposits
     $17,312
        
     0.45
        %
     $(169
        )
     $(704
        )
     $(873
        )Savings deposits
     (2,296
        )
     0.29
        
     374
        
     (1,091
        )
     (717
        )Time deposits
     57,425
        
     0.61
        
     (2,343
        )
     (3,503
        )
     (5,846
        )Short-term borrowings
     (11,478
        )
     (0.28
        )
     681
        
     (31
        )
     650FHLB borrowings
     17,113
        
     (0.03
        )
     (866
        )
     62
        
     (804
        )$78,076
        
     
        
     $(2,323
        )
     $(5,267
        )
     $(7,590
        )Change in net interest income
     
        
     
        
     $3,819
        
     $(1,922
        )
     $1,897Net interest income changes for 2006
were as follows:








Change In
Average
Balance
     Effect Of
Volume
Changes
     Effect Of
Rate
Changes
     Net
Change(Amounts In Thousands)Interest-earning assets
     
     
     $137,793
        
     $9,335
        
     $4,015
        
     $13,350Interest-bearing liabilities
     125,250
        
     (4,562
        )
     (7,437
        )
     (11,999
        )Change in net interest income
     
        
     $4,773
        
     $(3,422
        )
     $1,351A summary of the net interest spread and
margin is as follows:





(Tax Equivalent Basis)
     2007
     2006
     2005Yield on average interest-earning assets
     
     
     6.52
        %
     6.28
        %
     5.91
        %Rate on average interest-bearing liabilities
     3.84
        
     3.47
        
     2.77Net interest spread
     2.68
        
     2.81
        
     3.14Effect of noninterest-bearing funds
     0.56
        
     0.50
        
     0.42Net interest margin (tax equivalent interest incomedivided by average interest-earning assets)
     3.24
        %
     3.31
        %
     3.56
        %The net interest margin declined 7
basis points in 2007 and 25 basis points in 2006. The margin compression was the result of
the continued flattening of the yield curve and pricing on loans and short-term deposits.

Page 41 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operation (Continued)Provision for Loan Losses


The provision for loan losses totaled
$3,529,000, $3,011,000 and $2,101,000 for 2007, 2006 and 2005, respectively. Loan
charge-offs net of recoveries were $1,669,000 in 2007 and $521,000 in 2006 and $531,000 in
2005. The loan loss provision is the amount necessary to adjust the allowance to the level
considered appropriate by management. The provision adjustment is computed on a quarterly
basis and is a result of managements determination of the quality of the loan
portfolio. The provision reflects a number of factors, including the size of the loan
portfolio, the overall composition of the loan portfolio and loan concentrations, the
impact on the borrowers ability to repay, past loss experience, loan collateral
values, the level of impaired loans and loans past due ninety days or more. In addition,
management considers the credit quality of the loans based on managements review of
problem and watch loans, including loans with historical higher credit risks (primarily
agricultural and spec real estate construction loans).


The amount of watch loans considered
in the allowance for loan losses computation decreased by approximately $4.3 million in
2007 while substandard loans considered increased by approximately $28.0 million. The $3.3
million decrease in watch loans is comprised of improvements of $9.2 million in
multi-family residential mortgages, $3.3 million in 1-to-4 family residential mortgages
and $2.1 million in agricultural real estate loans. These improvements are offset by
increase in the watch classification of $4.4 million in construction loans, $4.4 million
in commercial loans and $1.5 million in agricultural operating loans. The increase in
substandard loans includes $8.6 million in commercial real estate loans, $7.6 million in
multi-family residential mortgages, $6.7 million in 1-to-4 family residential mortgages,
$2.8 million in agricultural real estate loans, $1.3 million in commercial loans and $1.0
million in construction loans.


Other factors that are considered in
determining the credit quality of the Companys loan portfolio are the vacancy rates
for both residential and commercial and retail space, current equity the borrower has in
the property and overall financial strength of the customer including cash flow to
continue to fund loan payments. The Company also considers the state of the total economy
including unemployment levels, vacancy rates of rental units and demand for commercial and
retail space. In most instances, the borrowers have used in their rental projections of
income at least a 10% vacancy rate. As of December 31, 2007, the unemployment levels in
Johnson County and Linn County were 2.8% and 4.0%, respectively, compared to 2.5% and 3.9%
in December of 2006. These levels compare favorably to the State of Iowa at 4.0% and the
national unemployment level at 5.0%, which were 3.5% and 4.5%, respectively in December,
2006. The residential rental vacancy rates in 2007 in Johnson County, the largest trade
area for the Company, were estimated at 5.0% in Iowa City, Coralville and North Liberty
and 5.0% in the Cedar Rapids area. The estimated vacancy rates for both markets were 10%
one year ago. The State of Iowa vacancy rate is 13.5% and the national rate is 9.8% with
the Midwest rate at 11.6%. These vacancy rates one year ago were 13.1%, 9.9% and 12.6%,
respectively. The Company continues to consider those vacancy rates among other factors in
its current evaluation of the real estate portion of its loan portfolio.


The amount of problem or watch loans
considered in the allowance for loan losses computation increased by approximately $19.2
million in 2006 and by approximately $1.2 million from the end of 2004 to 2005. The
increase related to 2006 was due to increase of $15.1 million of commercial loans
including commercial real estate, $7.3 million in construction loans, $4.2 million in
residential mortgages and $1.6 in agricultural loans. The allowance for loan losses
balance is also affected by the charge-offs and recoveries for the periods presented. For
the years ended December 31, 2007, 2006 and 2005, recoveries were $1,249,000, $1,352,000,
and $1,644,000, respectively; charge-offs were $2,918,000, $1,873,000 and $2,175,000 in
2007, 2006 and 2005, respectively.

Page 42 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition And Results of
Operation (Continued)The allowance for loan losses totaled
$19,710,000 at December 31, 2007 compared to $17,850,000 at December 31, 2006. The
percentage of the allowance to outstanding loans was 1.44% and 1.38% at December 31, 2007
and 2006, respectively. The
percentage increase was due to loan growth and an increase in the amount of
problem or watch loans as a percentage of total loans outstanding.
The allowance was based on managements consideration of a number of factors,
including composition of the loan portfolio, loans with higher credit risks (primarily
agriculture loans and spec real estate construction) and overall increases in Net Loans
outstanding. The methodology used in 2007 is consistent with the methodology used in the
prior years.


Agricultural loans totaled
$60,004,000 and $49,223,000 at December 31, 2007 and 2006, respectively. The level of
agriculture loans during the last five years compared to total loans has varied from a
high of 4.37% in 2007 to a low of 3.78% in 2005. Management has assessed the risks for
agricultural loans to be higher than other loans due to unpredictable commodity prices,
the effects of weather on crops and uncertainties regarding government support programs.
In particular, loans that are in the swine production segment continue to be of major
concern as prices for hogs are subject to severe fluctuations.


Non-performing loans increased by
$24.9 million from December 31, 2006 to December 31, 2007. Non-performing loans were 2.88%
of loans as of December 31, 2007 and 1.13% as of December 31, 2006. Non-performing loans,
which are considered impaired, include any loan that has been placed on nonaccrual status.
Non-performing loans also include loans that, based on managements evaluation of
current information and events, the Bank expects to be unable to collect in full according
to the contractual terms of the original loan agreement. These loans are also considered
impaired loans. This increase in non-performing loans is due primarily to the
deterioration in credit quality of eight borrower relationships that have an aggregate
balance of approximately $33.5 million as of December 31, 2007.


The University of Iowa, because of
its 25,200 employees and because of its total budget in Johnson County, has a tremendous
impact on the economy of the Banks primary trade area. In 2007 and 2006, the
University of Iowa helped Johnson Countys economy remain strong. The economy of the
state of Iowa has recovered from recent weakness, but the University continues to have
budget limitations. For its fiscal year beginning July 1, 2007, the University expects
continued budget constraints. The possible effects on the local economy cannot be
predicted, but such budget limitations may weaken the economy in future years.


Other Income


The other income of the Company was
$15,984,000 in 2007 compared to $14,611,000 in 2006. The increase of $1,373,000 was the
result of a combination of factors discussed below. In 2006, the total other income
increased $1,803,000 from 2005. The amount of the net gain on sale of secondary market
mortgage loans in each year can vary significantly. The gain was $934,000 in 2007,
$859,000 in 2006 and $1,074,000 in 2005. The number of loans sold in 2007 was
approximately 112% of the volume in 2006 and 105% of the activity experienced in 2005. The
fee per loan in 2006 was approximately 3% higher than the fee per loan in 2007 which was
offset by the volume of loans sold. The volume of activity in these types of loans is
directly related to the level of interest rates. In 2005 and 2006, rates did not drop
sufficiently to make it feasible for a large volume of refinancing to occur. In 2007,
secondary market rates were favorable resulting in the increase in the volume of loans
sold. The servicing of the loans sold into the secondary market is not retained by the
Company so these loans do not provide an ongoing stream of income.


Trust fees increased $505,000 to
$3,928,000 in 2007. Trust fees increased $433,000 in 2006. As of December 31, 2007, the
Banks Trust Department had $963 million in assets under management compared to $857
million and $787 million at December 31, 2006 and 2005, respectively. Trust fees are based
on total assets under management. The trust assets that are the most volatile are those
that are held in common stocks, which amount to approximately 52.5% of assets under
management. In 2007 and 2006, the market value of such common stock increased. In 2005,
the market value was stable. The Dow Jones Industrial Average increased over 6% in 2007
and over 16% in 2006. This average decreased less than 1% in 2005.

Page 43 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition And Results of
Operation (Continued)Service charges and fees increased
$934,000 in 2007 to $7,861,000 from $6,927,000 in 2006. Such charges and fees include fees
on deposit accounts and credit card processing fees on merchant accounts. Service fees on
deposit accounts increased $428,000 in 2007 compared to the prior year as a result of fee
income strategies. Service charge income on savings deposits increased $53,000 due to a
change in the related fee structure and minimum balance requirements. Debit card
interchange fees increased $293,000, point of sale (POS) interchange income increased
$116,000 and credit card merchant fees increased $63,000. These increases were due to
volume changes in debit and credit card usage. Debit card interchange income was reduced
by $50,000 due to the reserve for Visa. This reserve is related to the Banks
contingent liability, as a member of Visa, Inc. (Visa), for the Banks
portion of settlement payments arising from the expected settlement by Visa of its
litigation with American Express Company and Discover Financial Services.


Rental revenue on tax credit real
estate decreased $96,000 in 2007 due to adjustment recorded upon the receipt of the 2006
audited financial statements for the tax credit properties. Other noninterest income was
$2,576,000 in 2007 and $2,621,000 in 2006. The primary reason for the decrease in other
noninterest income was a one-time $79,000 sales tax refund received in 2006.


Service charges and fees increased by
$1,023,000 from 2005 to 2006, resulting in total fees of $6,927,000 in 2006. Service fees
on deposit accounts increased $729,000 in 2006 compared to 2005 due to fee income
strategies. In addition, debit card interchange fees increased $225,000 and point of sale
(POS) interchange income increased $134,000. Total other income was partially offset by
$234,000 in investment securities losses in 2005.


Other Expenses


Total other expenses were $36,150,000
and $34,364,000 for the years ended December 31, 2007 and 2006, respectively. The increase
is $1,786,000 or 5.20% in 2007 and $1,503,000 or 4.57% in 2006. Salaries and employee
benefits, the largest component of non-interest expense, increased $885,000 in 2007, a
4.79% change. This increase includes $657,000 in direct salaries, a 4.80% increase which
resulted from annual pay adjustments. Another component of salaries and employee benefits
expense is profit sharing plan expense which totaled $1,180,000 in 2007. This expense
increase $75,000, or 6.80% over 2006 and includes the Companys contributions to its
Profit Sharing and ESOP plans. (See Note 8 to the Consolidated Financial Statements.) The
majority of the increase is due to growth in the underlying salary base for eligible
employees. Medical expenses included with salaries and benefits increased to $1,633,000
from $1,523,000 in 2006. Increases in premiums and in the number of employees covered
resulted in the higher expense in 2007.


Occupancy expense increased $122,000
with increases of $44,000 in property taxes and $32,000 in utilities in 2007. Occupancy
expense also includes costs related to building maintenance and upkeep. This expense
increased $50,000 in 2007 due to a full year of maintenance for the Wellman location
(opened in September 2006) and higher snow removal expense.


In 2007, furniture and equipment
expense included depreciation expense of $1,670,000 and $1,251,000 in equipment and
software maintenance contracts. These expenses one year ago were $1,817,000 for
depreciation and $1,069,000 for the maintenance contracts. The increase in maintenance
contract expense in 2007 is due to a full year of expense related to various maintenance
agreements entered into in 2006. Also, maintenance expense related to the Companys
core processing system increased 20% to $356,000 in 2007.


Outside services increased $366,000
in 2007 to $5,254,000 as of December 31, 2007 compared to the same period in 2006. Outside
services include professional fees, courier services and ATM fees, and processing charges
for the merchant credit card program, retail credit cards and other data processing
services. Professional fees increased $160,000 from 2006 to a total of $1,632,000 for
2007. In 2007, professional fees included $25,000 in additional internal audit projects
and $10,000 in loan review services, both of which are outsourced to third party service
providers. Attorneys fees increased $49,000 over 2006 due in part to increased
activity related to costs of collection efforts and repossession activity. Credit card,
debit card and merchant card processing expenses increased $190,000 due to the volume of
transactions in 2007. Data processing expense also increased $44,000 due to a growth in
the volume of transactions from 2006 to 2007.

Page 44 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition And Results of
Operation (Continued)Other noninterest expense was
$1,558,000 for the year ended December 31, 2007, an increase of $313,000 over the same
period in 2006. Other noninterest expense includes fraud losses related to customer credit
and debit cards and other deposit accounts. This expense increased $75,000 in 2007 due to
increased incidents of unauthorized use of customer credit and debit cards. Also, $35,000
was recovered in 2006 related to charges expensed in 2005, reducing the 2006 expense when
compared to 2007.


Other noninterest expenses also
include $243,000 related to unauthorized activities by an officer of the Bank in a Bank
internal account. The officer has not been employed since October 3, 2007, the date the
discovery was made. The Company conducted an internal investigation with assistance from
third party fraud auditors and its internal audit department. The scope of the
Companys internal investigation was extensive and included transactions, accounts,
and other matters involving the former employee. The Company has also cooperated fully
with an investigation conducted by the U.S. Attorneys Office and the Federal Bureau
of Investigation. The internal and external investigations have shown that no customer
accounts were affected. The expense represented the portion of the improper transactions
remaining in the Companys assets as of October 3, 2007. The former employee was
indicted on February 12, 2008 for allegedly misappropriating approximately $559,000. The
difference of $316,000 was recognized mainly through other noninterest expenses over a
seven year period. The Company maintains its insurance policies covering officer or
employee dishonesty that may cover a portion of the loss, subject to the applicable
deductible of $150,000. The Company expects to finalize its insurance claim in April 2008.
Because the Company has already recognized the loss resulting from the former
employees alleged actions, if the former employee makes restitution or the Company
receives insurance proceeds, the Company will record those payments as income in the
period received.


Total other expenses were $32,861,000
for the year ended December 31, 2005. The increase in expenses in 2006 was $1,503,000.
This included an increase of $918,000 in salaries and benefits, which was the direct
result of salary adjustments for 2006 and an addition of twelve employees in 2006.
Compensation expense related to the officers deferred compensation plan and costs
associated with restricted common stock awarded to various officers decreased $199,000 in
2006. This decrease is primarily the result of the change in the appraised value of the
Companys common stock. Effective June 30, 2005, as a result of the Companys
program to repurchase up to a total of 750,000 shares of the Companys common stock,
the Company began obtaining a quarterly independent appraisal of the shares of stock.
Previously, the Company was obtaining an independent appraisal of the shares of stock on
an annual basis for the Companys ESOP. Due to the 2005 Stock Repurchase Program, no
marketability discount was given on the new quarterly appraisals and the result was the
removal by the independent appraiser of a 10% minority interest adjustment. The appraisal
value of the stock based on the latest appraisal is $50.00 per share, which resulted in a
per share increase of $3.50 for 2006. This compares to a $9.50 per share increase in 2005.
The final appraisal for each quarter will be completed approximately forty days after each
quarter end and sixty days after year-end.


Medical expenses included with
salaries and benefits increased from $1.2 million to $1.5 million in 2006. Occupancy
expense increased $67,000 due to property taxes and utilities. Furniture and equipment
expense was $111,000 higher in 2006 when compared to 2005 as a result of the costs related
to equipment and software maintenance contracts. Advertising and business development
expenses decreased $58,000 in 2006. This change was due in part to a $68,000 decrease in
the redemption of scorecard points awarded for credit card charges. In addition, there was
a decrease in outside services of $111,000. 2005 included consulting fees for a income
strategy of $226,000 which was not incurred in 2006. Credit card, debit card and merchant
card processing expense increased $81,000.


Income Taxes


Income tax expense was $7,138,000,
$6,933,000 and $6,684,000 for the years ended December 31, 2007, 2006 and 2005,
respectively. Income taxes as a percentage of income before income taxes were 30.66% in
2007, 30.82% in 2006 and 30.54% in 2005. The amount of tax credits were $566,000, $566,000
and $678,000 for 2007, 2006 and 2005, respectively. In 2005, the final tax credits were
taken on one tax credit property. The decrease in tax credits in 2006 reflects credits for
one remaining tax credit property. In 2007, the Company invested in a fourth tax credit
property. Credits related to this new property will be approximately $1.5 million and are
expected to be recognized in 2008 and future years.

Page 45 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operation (Continued)Impact of Recently Issued
Accounting Standards


In March 2006, the FASB issued FASB
Statement No. 156 (FAS 156), Accounting for Servicing of Financial Assets
and amendment of FASB Statement No. 140 (FAS 140), Accounting for Transfers
and Extinguishment of Liabilities. FAS 156 requires that all separately recognized
servicing assets and servicing liabilities be initially measured at fair value, if
practicable. The Company elected the fair value measurement method with changes in fair
value reflected in earnings for subsequent measurements. FAS 156 was effective for the
Company as of January 1, 2007. The adoption of this statement had no effect on the
Companys consolidated financial statements.


In July 2006, the FASB issued FASB
Interpretation No. 48, Accounting for Uncertainty in Income Taxes. FIN 48 requires
that the Company recognize in its financial statements, the impact of a tax position if
that position is more likely than not of being sustained on audit based on the technical
merits of the position. The provisions of FIN 48 were effective as of January 1, 2007. The
adoption of the Interpretation did not have a significant effect on the Companys
consolidated financial statements. See Note 9 to the Consolidated Financial Statements.


In September 2006, the FASB issued
FASB Statement No. 157, Fair Value Measurements. The Statement provides a single
definition of fair value, a framework for measuring fair value and expanded disclosures
concerning fair value. Previously, different definitions of fair value were contained in
various accounting pronouncements that prescribe fair value as the relevant measure of
value, except FAS 123R and related interpretation and pronouncements that require or
permit measurement similar to fair value but are not intended to measure fair value. The
Statement is effective for financial statements issued for year beginning after November
15, 2007. The adoption of this Statement will not have a significant effect on the
Companys consolidated financial statements.


In February 2007, the FASB issued
FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial
Liabilties  Including an Amendment of FASB Statement No. 115 (FAS
159). FAS 159 permits companies to choose to measure many financial instruments and
certain other items at fair value that are not currently required to be measured at fair
value. The objective of FAS 159 is to provide opportunities to mitigate volatility in
reported earnings caused by measuring related assets and liabilities differently without
having to apply hedge accounting provisions. FAS 159 also establishes presentation and
disclosure requirements designed to facilitate comparisons between companies that choose
different measurement attributes for similar types of assets and liabilities. The
Statement is effective for financial statements issued for the year beginning after
November 15, 2007. The adoption of this Statement will not have a significant effect on
the Companys consolidated financial statements.


In November 2007, the SEC issued
Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value
Through Earnings (SAB 109). SAB 109 provides interpretive guidance on the
accounting for written loan commitments recorded at fair value through earnings under
generally accepted accounting principles. SAB 109 revises and rescinds portions of Staff
Accounting Bulletin No. 105, Application of Accounting Principles to Loan
Commitments. The SEC staff belief is that the expected net future cash flows related
to the associated servicing of a loan should be included in the measurement of derivative
and other written loan commitments that are accounted for at fair value through earnings.
SAB 109 is effective for financial statements issued for the year beginning after December
15, 2007. The adoption of SAB 109 will not have a significant effect on the Companys
consolidated financial statements.


In December 2007, the FASB issued
FASB Statement No. 141 (revised), Business Combinations(FAS
141R). The standard changes the accounting for business combinations including the
measurement of acquirer shares issued in consideration for a business combination, the
recognition of contingent consideration, the accounting for pre-acquisition gain and loss
contingencies, the recognition of capitalized in-process research and development, the
accounting for acquisition-related restructuring cost accruals, the treatment of
acquisition related transaction costs and the recognition of changes in the
acquirers income tax valuation allowance. FAS 141R is effective for financial
statements issued for the year beginning after December 15, 2008. The adoption of
this Statement will not have a significant effect on the Companys consolidated
financial statements.

Page 46 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operation (Continued)In December 2007, the FASB issued
FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial
Statements, an amendment of ARB No. 51 (FAS 160). The standard
changes the accounting for noncontrolling (minority) interests in consolidated financial
statements including the requirements to classify noncontrolling interests as a component
of consolidated stockholders equity, and the elimination of minority
interest accounting in results of operations with earnings attributable to
noncontrolling interests reported as part of consolidated earnings. Additionally, FAS 160
revises the accounting for both increases and decreases in a parents controlling
ownership interest. FAS 160 is effective for financial statements issued for the year
beginning after December 15, 2008. The adoption of this Statement will not have a
significant effect on the Companys consolidated financial statements.


Interest Rate Sensitivity
and Liquidity Analysis


At December 31, 2007, the
Companys interest rate sensitivity report is as follows (amounts in thousands):






RepricingMaturitiesImmediately
     Days
     More ThanOne Year
     Total2-30
     31-90
     91-180
     181-365Earning assets:Investmentsecurities
     $-
        
     $4,465
        
     $7,690
        
     $10,765
        
     $22,635
        
     $168,213
        
     $213,768Loans
     7,508
        
     174,413
        
     48,461
        
     83,405
        
     148,636
        
     916,678
        
     1,379,101Total
     7,508
        
     178,878
        
     56,151
        
     94,170
        
     171,271
        
     1,084,891
        
     1,592,869Sources of funds:Interest-bearingchecking andsavings accounts
     150,739
        
     -
        
     -
        
     -
        
     -
        
     269,137
        
     419,876Certificates ofdeposit
     -
        
     34,101
        
     99,891
        
     157,889
        
     169,249
        
     108,701
        
     569,831Other borrowings -FHLB
     -
        
     -
        
     10,000
        
     10,000
        
     348
        
     245,000
        
     265,348Federal funds andrepurchaseagreements
     87,076
        
     -
        
     -
        
     -
        
     -
        
     -
        
     87,076237,815
        
     34,101
        
     109,891
        
     167,889
        
     169,597
        
     622,838
        
     1,342,131Other sources,primarilynoninterest-bearing
     -
        
     -
        
     -
        
     -
        
     -
        
     154,219
        
     154,219Total sources
     237,815
        
     34,101
        
     109,891
        
     167,889
        
     169,597
        
     777,057
        
     1,496,350InterestRate Gap
     $(230,307
        )
     $144,777
        
     $(53,740
        )
     $(73,719
        )
     $1,674
        
     $307,834
        
     $96,519Cumulative InterestRate Gapat December 31, 2007
     $(230,307
        )
     $(85,530
        )
     $(139,270
        )
     $(212,989
        )
     $(211,315
        )
     $96,519Page 47 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operation (Continued)The table set forth above includes
the portion of the balances in interest-bearing checking, savings and money market
accounts that management has estimated to mature within one year. The classifications are
used because the Banks historical data indicates that these have been very stable
deposits without much interest rate fluctuation. Historically, these accounts would not
need to be adjusted upward as quickly in a period of rate increases so the interest risk
exposure would be less than the re-pricing schedule indicates. The FHLB borrowings are
classified based on either their due date or if they are callable on their most likely
call date based on the interest rate.


Effects of Inflation


The consolidated financial statements
and the accompanying notes have been prepared in accordance with generally accepted
accounting principles. These principles require the measurement of financial position and
operating results in terms of historical dollar amounts without considering the changes in
the relative purchasing power of money over time due to inflation. The impact of inflation
is reflected in the increased cost of the Companys operations. Unlike industrial
companies, nearly all of the assets and liabilities of the Company are monetary in nature.
As a result, interest rates have a more significant impact in the Companys
performance than do the effects of general levels of inflation. Interest rates do not
necessarily move in the same direction or to the same extent as the price of goods and
services. In the current economic environment, liquidity and interest rate adjustments are
features of the Companys asset/liability management, which are important to the
maintenance of acceptable performance levels. The Company attempts to maintain a balance
between monetary assets and monetary liabilities, over time, to offset the potential
effects of changing interest rates.


Liquidity and Capital
Resources


On an unconsolidated basis, the
Company had cash balances of $257,000 as of December 31, 2007. In 2007, the Company
received dividends of $4,376,000 from its subsidiary Bank and used those funds to pay
dividends to its stockholders of $3,873,000.


The ability of the Company to pay
dividends to its shareholders is dependent upon the earnings and capital adequacy of its
subsidiary Bank, which affects the Banks dividends to the Company. The Bank is
subject to certain statutory and regulatory restrictions on the amount it may pay in
dividends. In order to maintain acceptable capital ratios in the subsidiary Bank, certain
of its retained earnings are not available for the payment of dividends. Retained earnings
available for the payment of dividends to the Company totaled approximately $19,427,000,
$16,254,000 and $13,720,000 as of December 31, 2007, 2006 and 2005, respectively. As of
December 31, 2007 and 2006, stockholders equity, before deducting for the maximum
cash obligation related to the ESOP, was $152,895,000 and $139,579,000, respectively. This
measure of stockholders equity as a percent of total assets was 9.20% at December
31, 2007 and 9.00% at December 31, 2006. As of December 31, 2007, total equity was 7.87%
of assets compared to 7.65% of assets at the prior year end.


The Company and the Bank are subject
to the Federal Deposit Insurance Corporation Improvement Act of 1991, and the Bank is
subject to Prompt Corrective Action Rules as determined and enforced by the Federal
Reserve. These regulations establish minimum capital requirements that member banks must
maintain.


As of December 31, 2007, 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.

Page 48 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operation (Continued)The Bank is an insured state bank,
incorporated under the laws of the state of Iowa. As such, the Bank is subject to
regulation, supervision and periodic examination by the Superintendent of Banking of the
State of Iowa (the Superintendent). Among the requirements and restrictions
imposed upon state banks by the Superintendent are the requirements to maintain reserves
against deposits, restrictions on the nature and amount of loans which may be made by
state banks, and restrictions relating to investments, opening of bank offices and other
activities of state banks. Changes in the capital structure of state banks are also
approved by the Superintendent. State banks must have a Tier 1 risk-based leverage ratio
of 6.5% plus a fully funded loan loss reserve. In certain circumstances, the
Superintendent may mandate higher capital, but the Superintendent has not imposed such a
requirement on the Bank. In determining the Tier 1 risk-based leverage ratio, the
Superintendent uses total equity capital without unrealized securities gains and the
allowance for loan losses less any intangible assets. At December 31, 2007, the Tier 1
risk-based leverage ratio of the Bank was 9.17% and exceeded the ratio required by the
Superintendent.


The actual amounts of risk-based
capital and risk-based capital ratios as of December 31, 2007 and the minimum regulatory
requirements for the Company and the Bank are presented below (amounts in thousands):





Actual

    For Capital
      Adequacy
      Purposes
     To Be WellCapitalized UnderPrompt CorrectiveAction ProvisionsAmount
     Ratio
     Ratio
     RatioAs of December 31, 2007:Company:Total risk-based capital
     $165,254
        
     13.37
        %
     8.00
        %
     10.00
        %Tier 1 risk-based capital
     149,749
        
     12.11
        
     4.00
        
     6.00Leverage ratio
     149,749
        
     9.18
        
     3.00
        
     5.00Bank:Total risk-based capital
     165,024
        
     13.36
        
     8.00
        
     10.00Tier 1 risk-based capital
     149,532
        
     12.11
        
     4.00
        
     6.00Leverage ratio
     149,532
        
     9.17
        
     3.00
        
     5.00The Bank is classified as well
capitalized by FDIC capital guidelines.


On a consolidated basis, 2007 cash
flows from operations provided $19,344,000 and net increases in deposits provided
$36,517,000. These cash flows were invested in Net Loans of $76,901,000 and net securities
purchased of $19,996,000. Also, net borrowings from the FHLB increased by $29,969,000 to
assist in the funding of the Banks increased loan demand. In addition, $1,408,000
was used to purchase property and equipment.


At December 31, 2007, the Bank had
total outstanding loan commitments and unused portions of lines of credit totaling
$237,138,000 (see Note 14 to the Consolidated Financial Statements). Management believes
that its liquidity levels are sufficient at this time, but the Bank may increase its
liquidity by limiting the growth of its assets, by selling more loans in the secondary
market or selling portions of loans to other banks through participation agreements. It
may also obtain additional funds from the Federal Home Loan Bank (FHLB). The Bank as of
December 31, 2007 can obtain an additional $184 million from the FHLB based on the current
real estate mortgage loans held. In addition, the Bank has arranged $99 million of credit
lines at three banks. The borrowings under these credit lines would be secured by the
Banks investment securities.


While the Bank has off-balance sheet
commitments to fund additional borrowings of customers, it does not use other
off-balance-sheet financial instruments, including interest rate swaps, as part of its
asset and liability management. Contractual commitments to fund loans are met from the
proceeds of federal funds sold or investment securities and additional borrowings. Many of
the contractual commitments to extend credit will not be funded because they represent the
credit limits on credit cards and home equity lines of credits.

Page 49 of 97
Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operation (Continued)Contractual Obligations
and Commitments


As disclosed in Note 14 to the
Consolidated Financial Statements, the Company has certain obligations and commitments to
make future payments under contracts. The following table summarizes significant
contractual obligations and other commitments as of December 31, 2007:




Payments Due By Period(Amounts In Thousands)Total
     Less ThanOne Year
     One -Three Years
     Three -Five Years
     More ThanFive YearsContractual obligations:Long-term debt obligations
     $265,348
        
     $20,348
        
     $80,000
        
     $105,000
        
     $60,000Operating lease obligations
     1,176
        
     209
        
     424
        
     333
        
     210Total contractual obligations:
     $266,524
        
     $20,557
        
     $80,424
        
     $105,333
        
     $60,210Other commitments:Lines of credit
     $237,138
        
     $183,006
        
     $49,952
        
     $4,078
        
     $102Standby letters of credit
     10,961
        
     10,961
        
     -
        
     -
        
     -Total other commitments
     $248,099
        
     $193,967
        
     $49,952
        
     $4,078
        
     $102


Item 7A.
Quantitative and Qualitative Disclosures About Market RiskRelated 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, 2007 and 2006, loan balances to related
individuals and businesses totaled $36,683,000 and $32,638,000, respectively. Deposits
from these related parties totaled $11,416,000 and $7,512,000 as of December 31, 2007 and
2006, respectively.


Commitments and Trends


The Company and the Bank have no
material commitments or plans that will materially affect liquidity or capital resources.
Property and equipment may be acquired in cash purchases, or they may be financed if
favorable terms are available.


Market Risk Exposures


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

Page 50 of 97
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk (Continued)The Bank maintains an asset/liability
committee, which meets at least quarterly to review the interest rate sensitivity position
and to review various strategies as to interest rate risk management. In addition, the
Bank uses a simulation model to review various assumptions relating to interest rate
movement. The model attempts to limit rate risk even if it appears the Banks asset
and liability maturities are perfectly matched and a favorable interest margin is present.


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


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

Page 51 of 97
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk (Continued)The following table, which presents
principal cash flows and related weighted average interest rates by expected maturity
dates, provides information about the Companys loans, investment securities and
deposits that are sensitive to changes in interest rates.








2008
     2009
     2010
     2011
     2012
     Thereafter
     Total
     Fair Value(Amounts In Thousands)Assets:Loans, fixed:Balance
     $190,689
        
     $95,797
        
     $129,455
        
     $82,278
        
     $109,325
        
     $63,174
        
     $670,718
        
     $624,547Averageinterest rate
     6.65
        %
     6.34
        %
     6.54
        %
     7.12
        %
     7.16
        %
     5.77
        %
     6.64
        %Loans, variable:Balance
     $247,131
        
     $115,500
        
     $116,943
        
     $126,691
        
     $87,731
        
     $7,595
        
     $701,591
        
     $691,515Averageinterest rate
     7.04
        %
     6.36
        %
     6.06
        %
     6.24
        %
     6.94
        %
     6.50
        %
     6.60
        %Investments (1):Balance
     $59,659
        
     $37,172
        
     $18,663
        
     $24,956
        
     $24,814
        
     $48,504
        
     $213,768
        
     $213,768Averageinterest rate
     4.03
        %
     4.52
        %
     4.66
        %
     4.87
        %
     4.83
        %
     5.60
        %
     4.72
        %Liabilities:Liquiddeposits (2):Balance
     $419,876
        
     $-
        
     $-
        
     $-
        
     $-
        
     $-
        
     $419,876
        
     $419,876Averageinterest rate
     1.81
        %
     0.00
        %
     0.00
        %
     0.00
        %
     0.00
        %
     0.00
        %
     1.81
        %Deposits,certificates:Balance
     $461,130
        
     $43,772
        
     $53,395
        
     $9,950
        
     $1,584
        
     $-
        
     $569,831
        
     $569,831Averageinterest rate
     4.77
        %
     3.98
        %
     4.61
        %
     4.46
        %
     4.54
        %
     0.00
        %
     4.69
        %(1)
Includes
all available-for-sale investments, federal funds and Federal Home Loan           Bank
stock.(2)
Includes
passbook accounts, NOW accounts, Super NOW accounts and money market           funds.Page 52 of 97
Item 8. Consolidated
Financial Statements and Supplementary Data


The consolidated financial statements
and supplementary data are included on Pages 54 through 86.

Page 53 of 97
KPMG LLP2500 Ruan Center
666 Grand Avenue
Des Moines, IA 50309Report of Independent
Registered Public Accounting Firm


The Board of Directors and Stockholders
Hills Bancorporation:


We have audited the accompanying
consolidated balance sheets of Hills Bancorporation and subsidiary as of December 31,
2007 and 2006, and the related consolidated statements of income, comprehensive income,
stockholders equity, and cash flows for each of the years in the three-year period
ended December 31, 2007. We also have audited Hills Bancorporations internal
control over financial reporting as of December 31, 2007, based on criteria
established in Internal Control  Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission (COSO). Hills Bancorporations
management is responsible for these consolidated financial statements, for maintaining
effective internal control over financial reporting, and for its assessment of the
effectiveness of internal control over financial reporting, included in the accompanying
managements report on internal control over financial reporting. Our responsibility
is to express an opinion on these consolidated financial statements and an opinion on the
Companys internal control over financial reporting based on our audits.


We conducted our audits in accordance
with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audits to obtain reasonable assurance about
whether the financial statements are free of material misstatement and whether effective
internal control over financial reporting was maintained in all material respects. Our
audits of the consolidated financial statements included examining, on a test basis,
evidence supporting the amounts and disclosures in the consolidated financial statements,
assessing the accounting principles used and significant estimates made by management, and
evaluating the overall consolidated financial statement presentation. Our audit of
internal control over financial reporting included obtaining an understanding of internal
control over financial reporting, assessing the risk that a material weakness exists, and
testing and evaluating the design and operating effectiveness of internal control based on
the assessed risk. Our audits also included performing such other procedures as we
considered necessary in the circumstances. We believe that our audits provide a reasonable
basis for our opinions.


A companys internal control
over financial reporting is a process designed to provide reasonable assurance regarding
the reliability of financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting principles. A
companys internal control over financial reporting includes those policies and
procedures that (1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are recorded as necessary
to permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are being made
only in accordance with authorizations of management and directors of the company; and
(3) provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of the companys assets that could have
a material effect on the financial statements.


Because of its inherent limitations,
internal control over financial reporting may not prevent or detect misstatements. Also,
projections of any evaluation of effectiveness to future periods are subject to the risk
that controls may become inadequate because of changes in conditions, or that the degree
of compliance with the policies or procedures may deteriorate.


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, 2007 and
2006, and the results of its operations and its cash flows for each of the years in the
three-year period ended December 31, 2007, in conformity with accounting principles
generally accepted in the United States of America. Also in our opinion, Hills
Bancorporation maintained, in all material respects, effective internal control over
financial reporting as of December 31, 2007, based on criteria established in
Internal Control  Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission.


/s/ KPMG LLP


March 11, 2008


Page 54  of 97
HILLS BANCORPORATION
CONSOLIDATED BALANCE SHEETS
December 31, 2007 and 2006
(Amounts In Thousands, Except Shares)

ASSETS
     
     
     2007
        
     
    2006Cash and cash equivalents (Note 10)
     $32,383
        
     $23,397Investment securities (Notes 2 and 6):Available for sale at fair value (amortized cost 2007 $198,551;
       2006 $180,106)
     199,599
        
     178,057Held to maturity at amortized cost (fair value 2007 none; 2006 $177)
     -
        
     170Stock of Federal Home Loan Bank
     14,169
        
     12,757Loans held for sale
     6,792
        
     3,808Loans, net of allowance for loan losses (2007 $19,710; 2006 $17,850)       (Notes 3, 7 and 11)
     1,352,599
        
     1,279,227Property and equipment, net (Note 4)
     21,220
        
     22,061Tax credit real estate
     8,803
        
     7,111Accrued interest receivable
     11,391
        
     10,292Deferred income taxes, net (Note 9)
     7,731
        
     7,613Goodwill
     2,500
        
     2,500Other assets
     3,911
        
     4,240$1,661,098
        
     $1,551,233LIABILITIES AND STOCKHOLDERS' EQUITYLiabilitiesNoninterest-bearing deposits
     $154,219
        
     $143,274Interest-bearing deposits (Note 5)
     989,707
        
     964,135Total deposits
     1,143,926
        
     1,107,409Short-term borrowings (Note 6)
     87,076
        
     59,063Federal Home Loan Bank borrowings (Note 7)
     265,348
        
     235,379Accrued interest payable
     3,227
        
     3,500Other liabilities
     8,626
        
     6,3031,508,203
        
     1,411,654Commitments and Contingencies (Notes 8 and 14)Redeemable Common Stock Held By Employee StockOwnership Plan (ESOP) (Note 8)
     22,205
        
     20,940Stockholders' Equity (Note 10)Capital stock, no par value; authorized 10,000,000 shares;issued 2007 4,583,520 shares; 2006 4,571,659 shares
     -
        
     -Paid in capital
     12,823
        
     12,364Retained earnings
     144,122
        
     131,852Accumulated other comprehensive income (loss)
     647
        
     (1,265
        )Treasury stock at cost (2007 93,413 shares; 2006 67,921 shares)
     (4,697
        )
     (3,372
        )152,895
        
     139,579Less maximum cash obligation related to ESOP shares (Note 8)
     22,205
        
     20,940130,690
        
     118,639$1,661,098
        
     $1,551,233See Notes to Consolidated
Financial Statements.






Page 55 of 97
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2007, 2006 and 2005
(Amounts In Thousands, Except Per Share Amounts)




2007
    2006
    2005Interest
      income:Loans,
      including fees
    
    
    $
    88,743
    
    $
    80,240
    
    $
    66,688Investment
      securities:Taxable
    
    
    
    4,706
    
    
    4,438
    
    
    4,795Nontaxable
    
    
    
    3,154
    
    
    2,900
    
    
    2,685Federal
      funds sold
    
    
    
    325
    
    
    40
    
    
    235Total
      interest income
    
    
    
    96,928
    
    
    87,618
    
    
    74,403Interest expense:Deposits
    
    
    
    35,277
    
    
    27,841
    
    
    19,665Short-term
      borrowings
    
    
    
    2,151
    
    
    2,801
    
    
    749FHLB
      borrowings
    
    
    
    12,524
    
    
    11,720
    
    
    9,949Total
      interest expense
    
    
    
    49,952
    
    
    42,362
    
    
    30,363Net
      interest income
    
    
    
    46,976
    
    
    45,256
    
    
    44,040Provision for loan losses
      (Note 3)
    
    
    
    3,529
    
    
    3,011
    
    
    2,101Net
      interest income after provision for loan losses
    
    
    
    43,447
    
    
    42,245
    
    
    41,939Other income:Net
      gain on sale of loans
    
    
    
    934
    
    
    859
    
    
    1,074Net
      losses on sale of investment securities
    
    
    
    -
    
    
    -
    
    
    (234
    )Trust
      fees
    
    
    
    3,928
    
    
    3,423
    
    
    2,990Service
      charges and fees
    
    
    
    7,861
    
    
    6,927
    
    
    5,904Rental
      revenue on tax credit real estate
    
    
    
    685
    
    
    781
    
    
    742Other
      noninterest income
    
    
    
    2,576
    
    
    2,621
    
    
    2,33215,984
    
    
    14,611
    
    
    12,808Other expenses:Salaries
      and employee benefits
    
    
    
    19,353
    
    
    18,468
    
    
    17,089Occupancy
    
    
    
    2,344
    
    
    2,222
    
    
    2,155Furniture
      and equipment
    
    
    
    3,482
    
    
    3,443
    
    
    3,332Office
      supplies and postage
    
    
    
    1,329
    
    
    1,297
    
    
    1,161Advertising
      and business development
    
    
    
    1,859
    
    
    1,843
    
    
    1,901Outside
      services
    
    
    
    5,254
    
    
    4,888
    
    
    4,999Rental
      expenses on tax credit real estate
    
    
    
    971
    
    
    958
    
    
    955Other
      noninterest expenses
    
    
    
    1,558
    
    
    1,245
    
    
    1,26936,150
    
    
    34,364
    
    
    32,861Income
      before income taxes
    
    
    
    23,281
    
    
    22,492
    
    
    21,886Income taxes (Note 9)
    
    
    
    7,138
    
    
    6,933
    
    
    6,684Net
      income
    
    
    $
    16,143
    
    $
    15,559
    
    $
    15,202Earnings
      per share:Basic
    
    
    $
    3.59
    
    $
    3.42
    
    $
    3.34Diluted
    
    
    
    3.57
    
    
    3.39
    
    
    3.32See Notes to Consolidated Financial Statements.




Page 56 of 97
HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2007, 2006 and 2005
(Amounts In Thousands)




2007
    2006
    2005Net income
    
    
    $
    16,143
    
    $
    15,559
    
    $
    15,202Other comprehensive income
      (loss),Unrealized
      gains (losses) on securities:Unrealized
      holding gains (losses) arising during the year,net
      of income taxes 2007 $1,185; 2006 $320; 2005 ($1,443)
    
    
    
    1,912
    
    
    518
    
    
    (2,503
    )Less:
      reclassification adjustment for losses included in netincome, net of income taxes
    
    
    
    -
    
    
    -
    
    
    144Other comprehensive income
      (loss)
    
    
    
    1,912
    
    
    518
    
    
    (2,359
    )Comprehensive income
    
    
    $
    18,055
    
    $
    16,077
    
    $
    12,843See Notes to Consolidated Financial Statements.

Page 57 of 97
HILLS BANCORPORATION


CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Years Ended December 31, 2007, 2006 and 2005
(Amounts In Thousands, Except Share Amounts)








Paid In
Capital
     Retained
Earnings
     Accumulated
Other
Comprehensive
Income (Loss)
     Maximum
Cash
Obligation
Related
To ESOP
Shares
     Treasury
Stock
     TotalBalance, December 31, 2004
     $11,364
        
     $108,199
        
     $576
        
     $(16,336
        )
     $-
        
     $103,803Issuance of 14,882 shares ofcommon stock
     619
        
     -
        
     -
        
     -
        
     -
        
     619Forfeiture of 901 sharesof common stock
     (29
        )
     -
        
     -
        
     -
        
     -
        
     (29
        )Change related to ESOP shares
     -
        
     -
        
     -
        
     (4,298
        )
     -
        
     (4,298
        )Net income
     -
        
     15,202
        
     -
        
     -
        
     -
        
     15,202Income tax benefit related toshare-based compensation
     16
        
     -
        
     -
        
     -
        
     -
        
     16Cash dividends ($.75 per share)
     -
        
     (3,412
        )
     -
        
     -
        
     -
        
     (3,412
        )Purchase of 1,400 sharesof common stock
     -
        
     -
        
     -
        
     -
        
     (63
        )
     (63
        )Other comprehensive (loss)
     -
        
     -
        
     (2,359
        )
     -
        
     -
        
     (2,359
        )Balance, December 31, 2005
     $11,970
        
     $119,989
        
     $(1,783
        )
     $(20,634
        )
     $(63
        )
     $109,479Issuance of 9,715 shares ofcommon stock
     346
        
     -
        
     -
        
     -
        
     -
        
     346Forfeiture of 1,693 sharesof common stock
     (63
        )
     -
        
     -
        
     -
        
     -
        
     (63
        )Share-based compensation
     44
        
     
        
     
        

        

        
44Income tax benefit related toshare-based compensation
     67
        
     -
        
     -
        
     -
        
     -
        
     67Change related to ESOP shares
     -
        
     -
        
     -
        
     (306
        )
     -
        
     (306
        )Net income
     -
        
     15,559
        
     -
        
     -
        
     -
        
     15,559Cash dividends ($.81 per share)
     -
        
     (3,696
        )
     -
        
     -
        
     -
        
     (3,696
        )Purchase of 66,521 sharesof common stock
     -
        
     -
        
     -
        
     -
        
     (3,309
        )
     (3,309
        )Other comprehensive income
     -
        
     -
        
     518
        
     -
        
     -
        
     518Balance, December 31, 2006
     $12,364
        
     $131,852
        
     $(1,265
        )
     $(20,940
        )
     $(3,372
        )
     $118,639Issuance of 13,030 shares ofcommon stock
     326
        
     -
        
     -
        
     -
        
     -
        
     326Forfeiture of 1,169 sharesof common stock
     (54
        )
     -
        
     -
        
     -
        
     -
        
     (54
        )Share-based compensation
     42
        
     -
        
     -
        
     -
        
     -
        
     42Income tax benefit related toshare-based compensation
     145
        
     -
        
     -
        
     -
        
     -
        
     145Change related to ESOP shares
     -
        
     -
        
     -
        
     (1,265
        )
     -
        
     (1,265
        )Net income
     -
        
     16,143
        
     -
        
     -
        
     -
        
     16,143Cash dividends ($.86 per share)
     -
        
     (3,873
        )
     -
        
     -
        
     -
        
     (3,873
        )Purchase of 25,492 sharesof common stock
     -
        
     -
        
     -
        
     -
        
     (1,325
        )
     (1,325
        )Other comprehensive income
     -
        
     -
        
     1,912
        
     -
        
     -
        
     1,912Balance, December 31, 2007
     $12,823
        
     $144,122
        
     $647
        
     $(22,205
        )
     $(4,697
        )
     $130,690See Notes to Consolidated
Financial Statements.

Page 58 of 97
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2007, 2006 and 2005
(Amounts In Thousands)





2007
    2006
    2005Cash Flows
      from Operating ActivitiesNet income
    
    
    $
    16,143
    
    $
    15,559
    
    $
    15,202Adjustments
      to reconcile net income to net cash and cashequivalents
      provided by operating activities:Depreciation
    
    
    
    2,249
    
    
    2,403
    
    
    2,418Provision
      for loan losses
    
    
    
    3,529
    
    
    3,011
    
    
    2,101Net losses
      on sale of investment securities
    
    
    
    -
    
    
    -
    
    
    234Share-based
      compensation
    
    
    
    42
    
    
    44
    
    
    -Compensation
      expensed through issuance of common stock
    
    
    
    133
    
    
    207
    
    
    590Excess
      tax benefits related to share-based compensation
    
    
    
    (145
    )
    
    (67
    )
    
    (16
    )Forfeiture
      of common stock
    
    
    
    (54
    )
    
    (63
    )
    
    (29
    )Provision
      for deferred income taxes
    
    
    
    (1,303
    )
    
    (1,114
    )
    
    (870
    )Increase
      in accrued interest receivable
    
    
    
    (1,099
    )
    
    (1,673
    )
    
    (1,270
    )Amortization
      of discount on investment securities, net
    
    
    
    310
    
    
    504
    
    
    810(Increase)
      decrease in other assets
    
    
    
    474
    
    
    303
    
    
    (1,353
    )Increase
      in accrued interest and other liabilities
    
    
    
    2,049
    
    
    379
    
    
    1,878Loans
      originated for sale
    
    
    
    (114,169
    )
    
    (104,286
    )
    
    (113,565
    )Proceeds
      on sales of loans
    
    
    
    112,119
    
    
    102,039
    
    
    117,845Net gain
      on sales of loans
    
    
    
    (934
    )
    
    (859
    )
    
    (1,074
    )Net
      cash and cash equivalents provided by operating 
              activities
    
    
    
    19,344
    
    
    16,387
    
    
    22,901Cash Flows from Investing
      ActivitiesProceeds
      from maturities of investment securities:Available
      for sale
    
    
    
    36,592
    
    
    40,270
    
    
    56,394Held
      to maturity
    
    
    
    170
    
    
    45
    
    
    4,785Proceeds from sales
      of investment securities available for sale
    
    
    
    -
    
    
    -
    
    
    10,465Purchases of investment
      securities available for sale
    
    
    
    (56,758
    )
    
    (21,964
    )
    
    (67,475
    )Loans made to customers,
      net of collections
    
    
    
    (76,901
    )
    
    (140,522
    )
    
    (145,586
    )Purchases of property
      and equipment
    
    
    
    (1,408
    )
    
    (2,199
    )
    
    (2,869
    )Investment in tax
      credit real estate, net
    
    
    
    (1,692
    )
    
    484
    
    
    415Net
      cash used in investing activities
    
    
    
    (99,997
    )
    
    (123,886
    )
    
    (143,871
    )(Continued)

Page 59 of 97
HILLS BANCORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 2007, 2006 and 2005
(Amounts In Thousands)




2007
    2006
    2005Cash Flows
      from Financing ActivitiesNet increase
      in deposits
    
    
    
    36,517
    
    
    70,995
    
    
    79,178Net (increase)
      decrease in short-term borrowings
    
    
    
    28,013
    
    
    24,526
    
    
    (3,448
    )Borrowings
      from FHLB
    
    
    
    60,000
    
    
    45,000
    
    
    60,000Payments
      on FHLB borrowings
    
    
    
    (30,031
    )
    
    (32,782
    )
    
    (4,381
    )Borrowings
      from FRB
    
    
    
    9
    
    
    -
    
    
    -Payments
      on FRB borrowings
    
    
    
    (9
    )
    
    -
    
    
    -Stock options
      exercised
    
    
    
    193
    
    
    139
    
    
    28Excess tax
      benefits related to share-based compensation
    
    
    
    145
    
    
    67
    
    
    16Purchase of
      treasury stock
    
    
    
    (1,325
    )
    
    (3,309
    )
    
    (63
    )Dividends
      paid
    
    
    
    (3,873
    )
    
    (3,696
    )
    
    (3,412
    )Net
      cash provided by financing activities
    
    
    
    89,639
    
    
    100,940
    
    
    127,918Increase (decrease)
      in cash and cash equivalents
    
    
    $
    8,986
    
    $
    (6,559
    )
    $
    6,948Cash and cash equivalents:Beginning
      of year
    
    
    
    23,397
    
    
    29,956
    
    
    23,008End of year
    
    
    $
    32,383
    
    $
    23,397
    
    $
    29,956Supplemental
      DisclosuresCash payments
      for:Interest
      paid to depositors
    
    
    $
    35,550
    
    $
    26,654
    
    $
    18,984Interest
      paid on other obligations
    
    
    
    14,675
    
    
    14,521
    
    
    10,698Income
      taxes
    
    
    
    7,877
    
    
    8,193
    
    
    6,770Noncash financing
      activities:Increase
      in maximum cash obligation related toESOP
      shares
    
    
    $
    1,265
    
    $
    306
    
    $
    4,298See Notes to Consolidated Financial Statements.


Page 60 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 1.
Nature of Activities and Significant Accounting PoliciesNature of activities: Hills Bancorporation
(the Company) is a holding company engaged in the business of commercial
banking. The Companys subsidiary is Hills Bank and Trust Company, Hills, Iowa (the
Bank), which is wholly-owned. The Bank is a full-service commercial bank
extending its services to individuals, businesses, governmental units and institutional
customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty,
Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids and Marion, Iowa.


The Bank competes with other
financial institutions and nonfinancial institutions providing similar financial products.
Although the loan activity of the Bank is diversified with commercial and agricultural
loans, real estate loans, automobile, installment and other consumer loans, the
Banks credit is concentrated in real estate loans. All of the Companys
operations are considered to be one reportable operating segment.


Accounting estimates: The
preparation of consolidated financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make estimates
and assumptions that affect the reported amount of assets and liabilities and disclosure
of contingent assets and liabilities at the date of the consolidated financial statements
and the reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.


Certain significant estimates:
The allowance for loan losses, fair values of securities and other financial instruments,
and share-based compensation expense 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, 2007 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 consisted solely of debt securities, which the Company had the
positive intent and ability to hold to maturity and were stated at amortized cost. There
are no held-to-maturity securities as of December 31, 2007.


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, 2007 and 2006.


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


Premiums on debt securities are
amortized over the earliest of the call date or the maturity date and discounts on debt
securities are accreted over the period to maturity of those securities. The method of
amortization results in a constant effective yield on those securities (the interest
method). Realized gains and losses on investment securities are included in income,
determined on the basis of the cost of the specific securities sold.


Unrealized losses judged to be other
than temporary are charged to operations for both securities available for sale and
securities held to maturity, and a new cost basis of the securities is established.

Page 61 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 1.
Nature of Activities and Significant Accounting Policies (Continued)Loans: Loans are stated at the amount of unpaid principal, reduced by the allowance for loan losses. Interest
income is accrued on the unpaid balances as earned.


Loans held for sale are stated at the
lower of aggregate cost or estimated fair value. Loans are sold on a non-recourse basis
with servicing released and gains and losses are recognized based on the difference
between sales proceeds and the carrying value of the loan.


The allowance for loan losses is
established through a provision for loan losses charged to expense. Loans are charged
against the allowance when management believes the collectability of principal is
unlikely. The allowance for loan losses is maintained at a level considered adequate to
provide for probable losses that can be reasonably anticipated. The allowance is increased
by provisions charged to expense and is reduced by net charge-offs. The Bank makes
continuous reviews of the loan portfolio and considers current economic conditions,
historical loss experience, review of specific problem loans and other factors in
determining the adequacy of the allowance. Management classifies loans within the
following industry standard categories: watch, substandard and loss.


Loans are considered non-performing
when, based on current information and events, it is probable the Bank will not be able to
collect all amounts due. A non-performing loan includes any loan that has been placed on
nonaccrual status. They also include loans based on current information and events that it
is likely the Bank will be unable to collect all amounts due according to the contractual
terms of the original loan agreement. The portion of the allowance for loan losses
applicable to non-performing loans has been computed based on the present value of the
estimated future cash flows of interest and principal discounted at the loans effective
interest rate or on the fair value of the collateral for collateral dependent loans. The
entire change in present value of expected cash flows of non-performing loans or of
collateral value is reported as bad debt expense in the same manner in which impairment
initially was recognized or as a reduction in the amount of bad debt expense that
otherwise would be reported. Interest income on nonaccrual loans is recognized on the cash
basis.


The accrual of interest income on
loans is discontinued when, in the opinion of management, there is reasonable doubt as to
the borrowers ability to meet payments of interest or principal when they become
due.


Loan fees and origination costs are
reflected in the consolidated statements of income as collected or incurred. Compared to
the net deferral method, this practice had no significant effect on income in any of the
years presented.


Transfers of financial assets:
Transfers of financial assets are accounted for as sales, when control over the assets has
been surrendered. Control over transferred assets is deemed to be surrendered when (1) the
assets have been isolated from the Company, (2) the transferee obtains the right (free of
conditions that constrain it from taking advantage of that right) to pledge or exchange
the transferred assets and (3) the Company does not maintain effective control over the
transferred assets through an agreement to repurchase them before their maturity or the
ability to unilaterally cause the holder to return specific assets.

Page 62 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 1.
Nature of Activities and Significant Accounting Policies (Continued)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.


Tax credit real estate: Tax
credit real estate represents two multi-family rental properties, an assisted living
rental property and a multi-tenant rental property for persons with disabilities, all
which are affordable housing projects as of December 31, 2007. The Bank has a 99% limited
partnership interest in each limited partnership. The investment in each was completed
after the projects had been developed by the general partner. The properties are recorded
at cost less accumulated depreciation. The Company evaluates the recoverability of the
carrying value on a regular basis. If the recoverability was determined to be in doubt, a
valuation allowance would be established by way of a charge to expense. Depreciation
expense is provided on a straight-line basis over the estimated useful life of the assets.
Expenditures for normal repairs and maintenance are charged to expense as incurred.


The financial condition, results of
operations and cash flows of each limited partnership is consolidated in the
Companys consolidated financial statements. The operations of the properties are not
expected to contribute significantly to the Companys income before income taxes.
However, the properties do contribute in the form of income tax credits, which lowers the
Companys effective tax rate. Once established, the credits on each property last for
ten years and are passed through from the limited partnerships to the Bank and reduces the
consolidated federal tax liability of the Company.


Property and equipment:
Property and equipment is stated at cost less accumulated depreciation. Depreciation is
computed using primarily declining-balance methods over the estimated useful lives of 7-40
years for buildings and improvements and 3-10 years for furniture and equipment.


Deferred income taxes:
Deferred income taxes are provided under the asset and liability method whereby deferred
tax assets are recognized for deductible temporary differences and net operating loss, and
tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary
differences. Temporary differences are the differences between the reported amounts of
assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation
allowance when, in the opinion of management, it is more likely than not that some or all
of the deferred tax assets will not be realized. Deferred tax assets and liabilities are
adjusted for the effects of changes in tax laws and rates on the date of enactment.
Beginning with the adoption of FASB Interpretation No. 48, Accounting for Uncertainty
in Income Taxes (FIN 48) as of January 1, 2007, the Company recognizes the effect of
income tax positions only if those positions are more likely than not of being sustained.
Recognized income tax positions are measured at the largest amount that is greater than
50% likely of being realized. Changes in recognition or measurement are reflected in the
period in which the change in judgment occurs. Prior to the adoption of FIN 48, the
Company recognized the effect of income tax positions only if such positions were probable
of being sustained. Interest and penalties on unrecognized tax benefits are classified as
an other noninterest expense. As of December 31, 2007, the Company had no material
unrecognized tax benefits.


Goodwill: Goodwill represents
the excess of cost over the fair value of the net assets acquired, and is not subject to
amortization, but requires, at a minimum, annual impairment tests for intangibles that are
determined to have an indefinite life.


Other real estate: Other real
estate represents property acquired through foreclosures and settlements of loans.
Property acquired is carried at the lower of the principal amount of the loan outstanding
at the time of acquisition, plus any acquisition costs, or the estimated fair value of the
property, less disposal costs. Subsequent write downs estimated on the basis of later
valuations, gains or losses on sales and net expenses incurred in maintaining such
properties are charged to other non-interest expense. Other real estate is included in
other assets and totaled $473,000 and $801,000 as of 2007 and 2006, respectively.

Page 63 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


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







Year Ended December 31,2007
    2006
    2005(Amounts In Thousands)Computation
      of weighted average number of basic and 
        diluted shares:Common shares
      outstanding at the beginning of the year
    
    
    
    4,503,738
    
    
    4,562,237
    
    
    4,549,656Weighted
      average number of net shares issued
           (redeemed)
    
    
    
    (4,158
    )
    
    (6,215
    )
    
    4,165Weighted
      average shares outstanding (basic)
    
    
    
    4,499,580
    
    
    4,556,022
    
    
    4,553,821Weighted
      average of potential dilutive sharesattributable
      to stock options granted, computed under 
          the treasury stock method
    
    
    
    19,495
    
    
    25,581
    
    
    22,354Weighted
      average number of shares (diluted)
    
    
    
    4,519,075
    
    
    4,581,603
    
    
    4,576,175Net income (In Thousands)
    
    
    $
    16,143
    
    $
    15,559
    
    $
    15,202Earnings per share:Basic
    
    
    $
    3.59
    
    $
    3.42
    
    $
    3.34Diluted
    
    
    $
    3.57
    
    $
    3.39
    
    $
    3.32Stock awards and options: For
the years ended December 31, 2007 and 2006, compensation expense for stock issued through
the stock award plan is accounted for using the fair value method prescribed by Statement
of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment
(FAS 123R). Under this method, compensation expense is measured and recognized for all
stock-based awards made to employees and directors based on the fair value of each option
as of the date of the grant.


For the year ended December 31, 2005,
compensation expense for stock issued through the stock award plan was accounted for using
the intrinsic value based method of accounting prescribed by APB Opinion No. 25,
Accounting for Stock Issues to Employees. Under this method, compensation was
measured as the difference between the estimated fair value of the stock at the date of
award less the amount required to be paid for the stock. The difference, if any, was
amortized straight line to expense over the vesting period of five years of service. No
share-based employee compensation cost was recognized in 2005 because all options granted
under the plan had an exercise price equal to the market value of the underlying common
stock on the date of grant. See Note 8 to the Consolidated Financial Statements for a
tabular presentation of the reconciliation between net income, basic earnings per share
and diluted earnings per share as reported in the consolidated 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 64 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


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


The following methods and assumptions
were used by the Company in estimating the fair value of its financial instruments:


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

Page 65 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 2.
Investment SecuritiesInvestment 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, 2007 or
2006. The carrying amount of available-for-sale securities and their approximate fair
values were as follows December 31 (in thousands):


Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
(Losses)
     Estimated
Fair
ValueDecember 31, 2007:Other securities (FHLB, FHLMC and FNMA)
     $104,041
        
     $1,070
        
     $(146
        )
     $104,965State and political subdivisions
     94,510
        
     426
        
     (302
        )
     94,634Total
     $198,551
        
     $1,496
        
     $(448
        )
     $199,599December 31, 2006:Other securities (FHLB, FHLMC and FNMA)
     $95,554
        
     $3
        
     $(1,489
        )
     $94,068State and political subdivisions
     84,552
        
     257
        
     (820
        )
     83,989Total
     $180,106
        
     $260
        
     $(2,309
        )
     $178,057The amortized cost and estimated fair
market value of available-for-sale securities classified according to their contractual
maturities at December 31, 2007, were as follows (in thousands):








Amortized
Cost
     Fair
ValueDue in one year or less
     
     
     $45,576
        
     $45,490Due after one year through five years
     104,846
        
     105,605Due after five years through ten years
     46,718
        
     47,082Due over ten years
     1,411
        
     1,422Total
     $198,551
        
     $199,599As of December 31, 2007, investment
securities with a carrying value of $87,076,000 were pledged to collateralize public
deposits, short-term borrowings and for other purposes, as required or permitted by law.

Page 66 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
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):



2007
     2006
     2005Sales proceeds
     
     
     $-
        
     $-
        
     $10,465Gross realized gains
     -
        
     -
        
     -Gross realized losses
     -
        
     -
        
     (234
        )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, 2007 and 2006 (in thousands):








Less than 12 months
     
     12 months or more
     
     Total2007
Description
of Securities
     #
     Fair Value
     Unrealized
Loss
     %
     
     #
     Fair  Value
     Unrealized
Loss
     %
     
     #
     Fair  Value
     Unrealized
Loss
     %Other securities(FHLB, FHLMC and    FNMA)
     3
        
     $6,571
        
     $(29
        )
     0.44
        %


     
     16
        
     $36,391
        
     $(117
        )
     0.32
        %
     
     19
        
     $42,962
        
     $(146
        )
     0.34
        %State and municipal bonds
     41
        
     10,892
        
     (41
        )
     0.38
        %
     
     159
        
     32,069
        
     (261
        )
     0.81
        %
     
     200
        
     42,961
        
     (302
        )
     0.70
        %Total temporarilyimpaired securities
     44
        
     $17,463
        
     $(70
        )
     0.40
        %
     
     175
        
     $68,460
        
     $(378
        )
     0.55
        %
     
     219
        
     $85,923
        
     $(448
        )
     0.52
        %Less than 12 months
     
     12 months or more
     
     Total2006
Description
of Securities
     #
     Fair Value
     Unrealized
Loss
     %
     
     #
     Fair Value
     Unrealized
Loss
     %
     
     #
     Fair Value
     Unrealized
Loss
     %Other securities(FHLB, FHLMC    and FNMA)
     1
        
     $3,529
        
     $(10
        )
     0.28
        %
     
     38
        
     $87,538
        
     $(1,479
        )
     1.69
        %
     
     39
        
     $91,067
        
     $(1,489
        )
     1.64
        %State and municipal bonds
     52
        
     9,431
        
     (36
        )
     0.38
        %
     
     209
        
     41,396
        
     (784
        )
     1.89
        %
     
     261
        
     50,827
        
     (820
        )
     1.61
        %Total temporarilyimpaired securities
     53
        
     $12,960
        
     $(46
        )
     0.35
        %
     
     247
        
     $128,934
        
     $(2,263
        )
     1.76
        %
     
     300
        
     $141,894
        
     $(2,309
        )
     1.63
        %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, 2007 was as follows: other securities (19
positions issued and guaranteed by FNMA, FHLB, or FHLMC); and state and municipal bonds
(53 issues are local issues, nonrated and 147 issues are A1 or better rated, general
obligation bonds). Therefore, none of the impairments in the above table was due to the
deterioration in the credit quality of any of the issues that might result in the
non-collection of contractual principal and interest. The cause of the impairments is due
to changes in interest rates. The Company has not recognized any unrealized loss in income
because management has the intent and ability to hold the securities for the foreseeable
future.

Page 67 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 2.
Investment Securities (Continued)Investment Securities
Held to Maturity:


At December 31, 2007, there were no
investment securities held to maturity.







Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
(Losses)
     Fair
Value(Amounts In Thousands)December 31, 2006:State and political subdivisions
     $170
        
     $7
        
     $-
        
     $177Note 3.
LoansThe composition of loans is as
follows:





December 31,2007
     2006
     2005(Amounts In Thousands)Agricultural
     
     
     $60,004
        
     $49,223
        
     $43,730Commercial and financial
     132,070
        
     118,339
        
     91,501Real estate:Construction
     123,144
        
     114,199
        
     83,456Mortgage
     1,020,802
        
     983,489
        
     906,188Loans to individuals
     36,289
        
     31,827
        
     32,2011,372,309
        
     1,297,077
        
     1,157,076Less allowance for loan losses
     19,710
        
     17,850
        
     15,360$1,352,599
        
     $1,279,227
        
     $1,141,716Changes in the allowance for loan
losses are as follows:


Year Ended December 31,2007
     2006
     2005(Amounts In Thousands)Balance, beginning
     
     
     $17,850
        
     $15,360
        
     $13,790Provision charged to expense
     3,529
        
     3,011
        
     2,101Recoveries
     1,249
        
     1,352
        
     1,644Loans charged off
     (2,918
        )
     (1,873
        )
     (2,175
        )Balance, ending
     $19,710
        
     $17,850
        
     $15,360Page 68 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 3.
Loans (Continued)Information about impaired and
nonaccrual loans as of and for the years ended December 31, 2007, 2006 and 2005 are as
follows:






2007
    2006
    2005(Amounts In Thousands)Impaired
      loans receivable for which there is a related allowance
         for loan losses
    
    
    $
    4,950
    
    $
    947
    
    $
    586Impaired loans receivable
      for which there is no related allowance 
         for loan losses
    
    
    
    34,633
    
    
    13,734
    
    
    16,016Total
    
    
    $
    39,583
    
    $
    14,681
    
    $
    16,602Related allowance for credit
      losses on impaired loans
    
    
    $
    355
    
    $
    292
    
    $
    66Average balance of impaired
      loans
    
    
    
    32,246
    
    
    15,722
    
    
    16,334Nonaccrual loans (included
      as impaired loans)
    
    
    
    4,948
    
    
    879
    
    
    175Loans past due ninety
      days or more and still accruing
    
    
    
    6,019
    
    
    4,983
    
    
    1,910Interest income recognized
      on impaired loans
    
    
    
    2,554
    
    
    1,212
    
    
    1,147Interest income forfeited
      on non-accrual loans
    
    
    
    279
    
    
    34
    
    
    19The increase in impaired loans is due
primarily to the deterioration in credit quality of eight borrower relationships that have
an aggregate balance of approximately $33.5 million as of December 31, 2007.


Note 4.
Property and EquipmentThe major classes of property and
equipment and the total accumulated depreciation are as follows:





December 31,2007
    2006
    2005(Amounts In Thousands)Land
    
    
    $
    4,846
    
    $
    4,648
    
    $
    4,404Buildings and improvements
    
    
    
    19,178
    
    
    18,929
    
    
    18,856Furniture and equipment
    
    
    
    26,687
    
    
    25,726
    
    
    23,84450,711
    
    
    49,303
    
    
    47,104Less accumulated depreciation
    
    
    
    29,491
    
    
    27,242
    
    
    24,839Net
    
    
    $
    21,220
    
    $
    22,061
    
    $
    22,265Page 69 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 5.
Interest-Bearing DepositsA summary of these deposits is as
follows:


December 31,2007

    2006(Amounts In Thousands)NOW and other demand
     
     
     $164,531
        
     $138,862Savings
     255,345
        
     248,714Time, $100,000 and over
     131,159
        
     149,452Other time
     438,672
        
     427,107$989,707
        
     $964,135Time deposits have a maturity as
follows:




December 31,2007

    2006(Amounts In Thousands)Due in one year or less
     
     
     $461,130
        
     $447,351Due after one year through two years
     43,772
        
     76,637Due after two years through three years
     53,395
        
     28,379Due after three years through four years
     9,950

        
     17,423Due over four years
     1,584
        
     6,769$569,831
        
     $576,559Note 6.
Short-Term BorrowingsThe following table sets forth
selected information for short-term borrowings (borrowings with a maturity of less than
one year):
December 31,2007

    2006(Amounts In Thousands)Federal funds purchased, secured by other securities (FHLB, FHLMC and FNMA)
     
     
     $39,675
        
     $10,670Repurchase agreements with customers, renewable daily, interest payablemonthly, secured by other securities (FHLB, FHLMC and FNMA)
     43,886
        
     43,503Repurchase agreements with customers, interest fixed, maturities of lessthan one year, secured by other securities (FHLB, FHLMC and FNMA)
     3,515
        
     4,890$87,076
        
     $59,063The weighted average interest rate on
short-term borrowings outstanding as of December 31, 2007 and 2006 was 3.90% and 4.40%,
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 investment securities. The
repurchase agreement is a commitment to sell these securities to a customer at a certain
price and repurchase them at a future date at that same price plus interest accrued at an
agreed upon rate. The Bank uses customer repurchase agreements in its liquidity plan as
well as an accommodation to customers. At December 31, 2007, $47.4 million of securities
sold under repurchase agreements with a weighted average interest rate of 3.47%, maturing
in 2008, were collateralized by investment securities having an amortized cost of $47.4
million.

Page 70 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 7.
Federal Home Loan Bank BorrowingsAs of December 31, 2007 and 2006, the borrowings
were as follows:


2007

    2006(Effective interest rates as of December 31, 2007)
     (Amounts In Thousands)Due 2007
     
     
     $-
        
     $20,000Due 2008, 5.38% to 6.00%
     20,348
        
     30,379Due 2009, 5.66% to 6.22%
     40,000
        
     40,000Due 2010, 5.77% to 6.61%
     40,000
        
     40,000Due 2015, 3.70% to 4.56%
     60,000
        
     60,000Due 2016, 4.46% to 4.69%
     45,000
        
     45,000Due 2017, 4.09% to 4.89%
     60,000
        
     -$265,348
        
     $235,379$265 million of the borrowings were
callable with $130 million callable in the first quarter of 2008. The advances are
unlikely to be called unless rates would move significantly upwards.


The advances from the FHLB are
collateralized by the Companys investment in FHLB stock of $14,169,000 and
$12,757,000 at December 31, 2007 and 2006, respectively. Additional collateral is provided
by the Companys 1-4 family mortgage loans totaling $318,417,000 at December 31, 2007
and $282,455,000 at December 31, 2006.


Note 8.
Employee Benefit PlansThe Company has an Employee Stock
Ownership Plan (the ESOP) to which it makes discretionary cash contributions.
The Companys contribution to the ESOP totaled $131,000, $123,000 and $115,000 for
the years ended December 31, 2007, 2006 and 2005, 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 tradable, a sponsor must reflect the maximum
cash obligation related to those securities outside of stockholders equity.
Effective June 30, 2005, as a result of the Companys program to repurchase up to a
total of 750,000 shares of the Companys common stock, the Company began obtaining a
quarterly independent appraisal of the shares of stock. Previously, the Company was
obtaining an independent appraisal of the shares of stock on an annual basis for the
Companys ESOP. As of December 31, 2007 and 2006, the shares held by the ESOP, fair
value and maximum cash obligation were as follows:



2007

    2006Shares held by the ESOP
     
     
     418,959
        
     418,788Fair value per share
     $53.00
        
     $50.00Maximum cash obligation
     $22,205,000
        
     $20,940,000Page 71 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
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
$1,049,000, $983,000, and $905,000 for the years ended December 31, 2007, 2006 and 2005,
respectively. The Companys made matching contributions under its 401(k) plan of
$111,000 in 2007, $105,000 in 2006 and $98,200 in 2005 and is included in salaries and
employee benefits.


The Company provides a deferred
compensation program for executive officers. This program allows executive officers to
elect to defer a portion of their salaried compensation for payment by the Company at a
subsequent date. The executive officers can defer up to 30% of their base compensation and
up to 100% of any bonus into the deferral plan. Any amount so deferred is credited to the
executive officers deferred compensation account and converted to units equivalent
in value to the fair market value of a share of stock in Hills Bancorporation. The
stock units are book entry only and do not represent an actual purchase of
stock. The executive officers account is adjusted each year for dividends paid and
the change in the market value of Hills Bancorporation stock. The deferrals and earnings
grow tax deferred until withdrawn from the plan. Earnings credited to the
individuals accounts are recorded as compensation expense when earned. The deferred
compensation liability is recorded in other liabilities and totals $2.8 million and $2.5
million at December 31, 2007 and 2006, respectively. Expense related to the deferred
compensation plan was $198,000, $213,000 and $491,000 for 2007, 2006 and 2005,
respectively and is included in salaries and employee benefits expense.


The Company has a Stock Option and
Incentive Plan for certain key employees and directors whereby shares of common stock have
been reserved for awards in the form of stock options or restricted stock awards. Under
the plan, the aggregate number of options and shares granted cannot exceed 198,000 shares.
A Stock Option Committee may grant options at prices equal to the fair value of the stock
at the date of the grant. Options expire 10 years from the date of the grant. Director
options granted on or before December 31, 2006 may be exercised immediately. Director
options granted on or after January 1, 2007, and officers rights under the plan vest
over a five-year period from the date of the grant. Prior to January 1, 2006, the Company
accounted for the stock options under the recognition and measurement principles of
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to
Employees.


On January 1, 2006, the Company
adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based
Payment(FAS 123R), which requires the measurement and recognition of compensation
expense for all stock-based awards made to employees and Directors. The Company adopted
FAS 123R using the modified prospective transition method. The Consolidated Financial
Statements as of and for year ended December 31, 2007 reflect the impact of FAS 123R and
include $42,000 of share-based compensation expense. Share-based compensation expense was
$44,000 in 2006. In accordance with the modified prospective transition method, the
Consolidated Financial Statements for prior periods have not been restated.

Page 72 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 8.
Employee Benefit Plans (Continued)The results for the years ended
December 31, 2007 and 2006 are not directly comparable to the same period in 2005. Prior
to the adoption of FAS 123R, the Company applied the existing accounting rules under APB
Opinion No. 25, which provided that no compensation expense was charged for options
granted at an exercise price equal to the market value of the underlying common stock on
the date of the grant. If the fair value recognition provisions of FAS 123R had been
applied to share-based compensation for the year ended December 31, 2005, the
Companys pro forma net income and earnings per share would have been as follows:

Net income:As reported
     $15,202Deduct total share-based employee compensation expense determinedunder fair value based method for all awards, net of related tax effects
     (84
        )Pro forma
     $15,118Basic earnings per share:As reported
     $3.34Pro forma
     $3.32Diluted earnings per share:As reported
     $3.32Pro forma
     $3.30A summary of the stock options are as
follows:




Number of Shares
     Weighted-Average
Exercise Price
     Weighted-Average
Remaining Contractual
Term (Years)
     Aggregate
Intrinsic Value
(In Thousands)Balance, December 31, 2004
     
     
     63,753
        
     $26.64Granted
     -
        
     -Exercised
     (1,134
        )
     24.33Balance, December 31, 2005
     62,619
        
     26.69Granted
     -
        
     -Exercised
     (5,424
        )
     25.62Balance, December 31, 2006
     57,195
        
     26.79
        
     4.88
        
     $1,532Granted
     4,580
        
     52.00Exercised
     (10,410
        )
     18.55Forfeited
     (3,000
        )
     25.67Balance, December 31, 2007
     48,365
        
     31.02
        
     5.05
        
     $1,500The weighted-average fair value of
options granted in 2007 was $16.98 per share. The intrinsic value of options exercised was
$193,000 and $139,000 for 2007 and 2006, respectively.

Page 73 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


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


2007Risk-free interest rate
     
     
     5.21
        %Expected option life
     7.5 yearsExpected volatility
     25.33
        %Expected dividends
     1.69
        %Other pertinent information related
to the options outstanding at December 31, 2007 is as follows:


Exercise Price
     Number Outstanding
     Remaining Contractual Life
     Number Exercisable$25.67
        
     19,105
        
     41 Months
        
     19,10525.00
        
     200
        
     36 Months
        
     20029.33
        
     15,600
        
     60 Months
        
     15,60033.67
        
     3,000
        
     72 Months
        
     -34.50
        
     2,940
        
     76 Months
        
     2,94036.25
        
     2,940
        
     81 Months
        
     2,94052.00
        
     4,580
        
     113 Months
        
     -48,365
        
     
        
     40,785As of December 31, 2007, the
outstanding options have a weighted-average exercise price of $31.02 per share and a
weighted average remaining contractual term of 5.05 years. The intrinsic value of all
options outstanding was $1,500,000 as of December 31, 2007.


As of December 31, 2007, there was
$73,100 in unrecognized compensation cost for stock options granted under the plan. This
cost is expected to be recognized over a weighted-average period of 3.02 years.


As of December 31, 2007, the vested
options totaled 40,785 shares with a weighted-average exercise price of $28.47 per share
and a weighted-average remaining contractual term of 4.49 years. The intrinsic value for
the vested options was $1,161,000. The fair value of the 15,100 options vested during 2007
was $123,000. The fair value of the 31,200 options vested in 2006 was $248,000.


As of December 31, 2007, 110,950
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 2,192 shares of
common stock in 2007, 4,291 in 2006 and 13,748 in 2005 to certain employees. The vesting
period for these awards is five years and the Bank amortizes the expense on a straight
line basis during the vesting period. The expense relating to these awards for the years
ended December 31, 2007, 2006 and 2005 was $166,000, $149,000 and $70,000, respectively.

Page 74 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 9.
Income TaxesIncome taxes for the years ended
December 31, 2007, 2006 and 2005 are summarized as follows:



2007
    2006
    2005(Amounts In Thousands)Current:Federal
    
    
    $
    7,091
    
    $
    6,771
    
    $
    6,335State
    
    
    
    1,350
    
    
    1,276
    
    
    1,219Deferred:Federal
    
    
    
    (1,133
    )
    
    (968
    )
    
    (756
    )State
    
    
    
    (170
    )
    
    (146
    )
    
    (114
    )$
    7,138
    
    $
    6,933
    
    $
    6,684Temporary differences between the
amounts reported in the consolidated financial statements and the tax basis of assets and
liabilities result in deferred taxes. Deferred tax assets and liabilities at December 31,
2007 and 2006 were as follows:




December 31,2007

    2006(Amounts In Thousands)Deferred income tax assets:Allowance for loan losses
     $7,539
        
     $6,827Deferred compensation
     1,647
        
     1,440Accrued expenses
     379
        
     281Unrealized losses on investment securities
     -
        
     784Interest on nonaccrual loans
     107
        
     -State net operating loss
     341
        
     314Other
     -
        
     13Gross deferred tax assets
     10,013
        
     9,659Valuation allowance
     (341
        )
     (314
        )Deferred tax asset, net of valuation allowance
     9,672
        
     9,345Deferred income tax liabilities:Property and equipment
     904
        
     1,005FHLB dividends
     132
        
     132Prepaid expenses
     78
        
     277Unrealized gains on investment securities
     401
        
     -Goodwill
     382
        
     318Other
     44
        
     -Gross deferred tax liabilities
     1,941
        
     1,732Net deferred income tax assets
     $7,731
        
     $7,613Page 75 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 9.
Income Taxes (Continued)The Company has recorded a deferred
tax asset for the future tax benefits of Iowa net operating loss carry-forwards. The net
operating loss carry-forwards are generated by the parent company largely from its
investment in tax credit real estate properties. The parent company is required to file a
separate Iowa tax return and cannot be consolidated with the Bank. The net operating loss
carry-forwards will expire, if not utilized, between 2007 and 2022. The Company has
recorded a valuation allowance to reduce the net operating loss carry-forwards. At
December 31, 2007 and 2006, the Company believes it is more likely than not that the Iowa
net operating loss carry-forwards will not be realized. The increase in net operating loss
carry-forward in 2007 compared to 2006 reflects the additional Iowa income tax net
operating loss generated during 2007 less any expiring carry-forward. A valuation
allowance related to the remaining deferred tax assets has not been provided because
management believes it is more likely than not that the results of future operations will
generate sufficient taxable income to realize the deferred tax assets.


The valuation allowance increased by
$28,000 and $27,000 for each of the years ended December 31, 2007 and 2006, respectively.


The net change in the deferred income
taxes for the years ended December 31, 2007, 2006 and 2005 is reflected in the
consolidated financial statements as follows:





Year Ended December 31,2007
    2006
    2005(Amounts In Thousands)Consolidated
      statements of income
    
    
    $
    1,303
    
    $
    1,114
    
    $
    870Consolidated statements
      of stockholders' equity
    
    
    
    (1,185
    )
    
    (320
    )
    
    1,443$
    118
    
    $
    794
    
    $
    2,313Income tax expense for the years
ended December 31, 2007, 2006 and 2005 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:



2007
    2006
    2005Amount
    % Of
      Pretax
      Income
    Amount
    % Of
      Pretax
      Income
    Amount
    % Of
      Pretax
      Income(Amounts In Thousands)Expected
      tax expense
    
    
    $
    8,148
    
    
    35.0
    %
    $
    7,872
    
    
    35.0
    %
    $
    7,660
    
    
    35.0
    %Tax-exempt interest
    
    
    
    (1,230
    )
    
    (5.2
    )
    
    (1,114
    )
    
    (5.0
    )
    
    (1,026
    )
    
    (4.7
    )Interest expenselimitation
    
    
    
    212
    
    
    0.9
    
    
    185
    
    
    0.8
    
    
    130
    
    
    0.6State income taxes,net of
      federal income tax benefit
    
    
    
    767
    
    
    3.3
    
    
    735
    
    
    3.3
    
    
    718
    
    
    3.3Income tax credits
    
    
    
    (566
    )
    
    (2.4
    )
    
    (566
    )
    
    (2.5
    )
    
    (679
    )
    
    (3.1
    )Other
    
    
    
    (193
    )
    
    (0.9
    )
    
    (179
    )
    
    (0.8
    )
    
    (119
    )
    
    (0.6
    )$
    7,138
    
    
    30.7
    %
    $
    6,933
    
    
    30.8
    %
    $
    6,684
    
    
    30.5
    %Page 76 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 9.
Income Taxes (Continued)Federal income tax expense for the
years ended December 31, 2007 and 2006 was computed using the consolidated effective
federal tax rate. The Company also recognized income tax expense pertaining to state
franchise taxes payable individually by the subsidiary bank. On January 1, 2007, the
Company adopted FIN 48, Accounting for Uncertainty in Income Taxes. The evaluation
was performed for those tax years which remain open to audit. The Company files a
consolidated tax return for federal purposes and separate tax returns for the State of
Iowa purposes. The tax years ended December 31, 2006, 2005 and 2004, remain subject to
examination by the Internal Revenue Service. For state tax purposes, the tax years ended
December 31, 2006, 2005 and 2004, remain open for examination. As a result of the
implementation of FIN 48, the Company did not recognize any increase or decrease for
unrecognized tax benefits. There were no material unrecognized tax benefits on January 1,
2007 and December 31, 2007. No interest or penalties on these unrecognized tax benefits
has been recorded. As of December 31, 2007, the Company does not anticipate any
significant increase or decrease in unrecognized tax benefits during the next twelve
months.


Note 10.
Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and CashRestrictionsThe 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, 2007 and 2006, the Company and the Bank met all capital adequacy requirements
to which they are subject.


As of December 31, 2007, the most
recent notifications from the Federal Reserve System categorized the Bank as well
capitalized under the regulatory framework for prompt corrective action. To be categorized
as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based
and Tier 1 leverage ratios as set forth in the table that follows. There are no conditions
or events since that notification that management believes have changed the
institutions category.

Page 77 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 10.
Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and Cash
Restrictions (Continued)The actual amounts and capital ratios
as of December 31, 2007 and 2006, 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, 2007:Company:Total risk-based capital
     $165,254
        
     13.37
        %
     8.00
        %
     10.00
        %Tier 1 risk-based capital
     149,749
        
     12.11
        
     4.00
        
     6.00Leverage ratio
     149,749
        
     9.18
        
     3.00
        
     5.00Bank:Total risk-based capital
     165,024
        
     13.36
        
     8.00
        
     10.00Tier 1 risk-based capital
     149,532
        
     12.11
        
     4.00
        
     6.00Leverage ratio
     149,532
        
     9.17
        
     3.00
        
     5.00Actual
     For Capital
Adequacy
Purposes
     To Be Well
Capitalized Under
Prompt Corrective
Action ProvisionsAmount
     Ratio
     Ratio
     RatioAs of December 31, 2006:Company:Total risk-based capital
     $152,737
        
     13.31
        %
     8.00
        %
     10.00
        %Tier 1 risk-based capital
     138,344
        
     12.05
        
     4.00
        
     6.00Leverage ratio
     138,344
        
     9.00
        
     3.00
        
     5.00Bank:Total risk-based capital
     151,983
        
     13.25
        
     8.00
        
     10.00Tier 1 risk-based capital
     137,599
        
     11.99
        
     4.00
        
     6.00Leverage ratio
     137,599
        
     8.95
        
     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 $19,427,000 as of December 31, 2007 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
$2,436,000 and $1,914,000 as of December 31, 2007 and 2006, respectively.

Page 78 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 11.
Related Party TransactionsCertain 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, 2007 and
2006:




Year Ended December 31,2007
     2006(Amounts In Thousands)Balance, beginning
     
     
     $32,638
        
     $38,951Advances
     50,042
        
     50,087Collections
     (44,544
        )
     (56,400
        )Balance, ending
     $38,136
        
     $32,638Deposits from related parties are
accepted subject to the same interest rates and terms as those from nonrelated parties.

Page 79 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 12.
Fair Value of Financial InstrumentsThe carrying value and estimated fair
values of the Companys financial instruments as of December 31, 2007 and 2006
are as follows:




2007

    2006Carrying
Amount
     Estimated
Fair Value
     Carrying
Amount
     Estimated
Fair Value(Amounts In Thousands)Cash and due from banks
     
     
     $32,383
        
     $32,383
        
     $23,397
        
     $23,397Investment securities
     213,768
        
     213,768
        
     190,984
        
     190,991Loans
     1,359,391
        
     1,316,062
        
     1,283,035
        
     1,214,320Accrued interest receivable
     11,391
        
     11,391
        
     10,292
        
     10,292Deposits
     1,143,926
        
     1,143,926
        
     1,107,409
        
     1,107,409Federal funds purchased and securitiessold under agreements to repurchase
     87,076
        
     87,076
        
     59,063
        
     59,063Borrowings from Federal Home LoanBank
     265,348
        
     232,191
        
     235,379
        
     195,208Accrued interest payable
     3,227
        
     3,227
        
     3,500
        
     3,500Face Amount
     
     Face AmountOff-balance sheet instruments:Loan commitments
     $237,138
        
     $-
        
     $200,786
        
     $-Letters of credit
     10,961
        
     -
        
     10,107
        
     -Page 80 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 13.
Parent Company Only Financial InformationFollowing is condensed financial
information of the Company (parent company only):



CONDENSED BALANCE SHEETS
December 31, 2007 and 2006
(Amounts In Thousands)




ASSETS
     2007

    2006Cash at subsidiary bank
     
     
     $257
        
     $983Investment in subsidiary bank
     152,679
        
     138,834Other assets
     1,029
        
     668Total assets
     $153,965
        
     $140,485LIABILITIES AND STOCKHOLDERS' EQUITYLiabilities
     $1,070
        
     $906Redeemable common stock held by ESOP
     22,205
        
     20,940Stockholders' equity:Capital stock
     12,823
        
     12,364Retained earnings
     144,122
        
     131,852Accumulated other comprehensive income (loss)
     647
        
     (1,265
        )Treasury stock at cost
     (4,697
        )
     (3,372
        )152,895
        
     139,579Less maximum cash obligation related to ESOP shares
     22,205
        
     20,940Total stockholders' equity
     130,690
        
     118,639Total liabilities and stockholders' equity
     $153,965
        
     $140,485Page 81 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 13.
Parent Company Only Financial Information (Continued)CONDENSED STATEMENTS OF INCOME
Years Ended December 31, 2007, 2006 and 2005
(Amounts In Thousands)



2007
     2006
     2005Interest on checking account and investment securities
     
     
     $18
        
     $160
        
     $81Dividends received from subsidiary
     4,376
        
     3,696
        
     3,413Other expenses
     (273
        )
     (265
        )
     (291
        )Income before income tax benefit andequity in undistributed income of subsidiary
     4,121
        
     3,591
        
     3,203Income tax benefit
     89
        
     37
        
     714,210
        
     3,628
        
     3,274Equity in undistributed income of subsidiary
     11,933
        
     11,931
        
     11,928Net income
     $16,143
        
     $15,559
        
     $15,202Page 82 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 13.
Parent Company Only Financial Information (Continued)CONDENSED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2007, 2006 and 2005
(Amounts In Thousands)



2007
     2006
     2005Cash flows from operating activities:Net income
     $16,143
        
     $15,559
        
     $15,202Noncash items included in net income:Equity in undistributed income of subsidiary
     (11,933
        )
     (11,931
        )
     (11,928
        )Share-based compensation
     42
        
     44
        
     -Compensation expensed through issuance of common stock
     133
        
     207
        
     590Excess tax benefits related to share-based compensation
     (145
        )
     (67
        )
     (16
        )Forfeiture of common stock
     (54
        )
     (63
        )
     (29
        )Increase in other assets
     (216
        )
     (48
        )
     (68
        )Increase in liabilities
     164
        
     147
        
     223Net cash provided by operating activities
     4,134
        
     3,848
        
     3,974Cash flows from investing activities:Proceeds from maturities of investment securities
     -
        
     -
        
     500Net cash provided by investing activities
     -
        
     -
        
     500Cash flows from financing activities:Stock options exercised
     193
        
     139
        
     28Excess tax benefits related to share-basedcompensation
     145
        
     67
        
     16Purchase of treasury stock
     (1,325
        )
     (3,309
        )
     (63
        )Dividends paid
     (3,873
        )
     (3,696
        )
     (3,412
        )Net cash used in financing activities
     (4,860
        )
     (6,799
        )
     (3,431
        )(Decrease) increase in cash
     (726
        )
     (2,951
        )
     1,043Cash balance:Beginning
     983
        
     3,934
        
     2,891Ending
     $257
        
     $983
        
     $3,934Page 83 of 97
HILLS BANCORPORATION


NOTES TOCONSOLIDATED
FINANCIAL STATEMENTS


Note 14.
Commitments and ContingenciesConcentrations 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 $24,489,000. The concentrations of credit by type of
loan are set forth in Note 3 to the Consolidated Financial Statements. Outstanding letters
of credit were granted primarily to commercial borrowers. Although the Bank has a
diversified loan portfolio, a substantial portion of its debtors ability to honor
their contracts is dependent upon the economic conditions in Johnson County and Linn
County, Iowa.


Contingencies: In the normal
course of business, the Company and Bank are involved in various legal proceedings. In the
opinion of management, any liability resulting from such proceedings would not have a
material adverse effect on the accompanying consolidated 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, 2007 and 2006 is as
follows:



2007

    2006(Amounts In Thousands)Firm loan commitments and unused portion of lines of credit:Home equity loans
     $21,152
        
     $18,796Credit card participations
     30,737
        
     28,091Commercial, real estate and home construction
     94,769
        
     83,699Commercial lines
     90,480
        
     70,200Outstanding letters of credit
     10,961
        
     10,107Page 84 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
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, 2007
and 2006 no amounts have been recorded as liabilities for the Banks potential
obligations under these guarantees.


Lease commitments: The Company
leases certain facilities under operating leases. The minimum future rental commitments as
of December 31, 2007 for all non-cancelable leases relating to Bank premises were as
follows:




Year ending December 31:
     (Amounts In Thousands)2008
        
     2092009
        
     2112010
        
     2132011
        
     1752012
        
     158Thereafter
        
     210$1,176Page 85 of 97
HILLS BANCORPORATION


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS


Note 15.
Quarterly Results of Operations (unaudited, amounts in thousands, except per share
amounts)Quarter EndedMarch
     June
     September
     December
     Year2007Interest income
     $23,284
        
     $24,008
        
     $24,724
        
     $24,912
        
     $96,928Interest expense
     11,966
        
     12,396
        
     12,698
        
     12,892
        
     49,952Net interest income
     $11,318
        
     $11,612
        
     $12,026
        
     $12,020
        
     $46,976Provision for loan losses
     532
        
     954
        
     1,270
        
     773
        
     3,529Other income
     3,629
        
     4,136
        
     4,217
        
     4,002
        
     15,984Other expense
     8,612
        
     8,921
        
     9,070
        
     9,547
        
     36,150Income before income taxes
     $5,803
        
     $5,873
        
     $5,903
        
     $5,702
        
     23,281Income taxes
     1,798
        
     1,806
        
     1,814
        
     1,720
        
     7,138Net income
     $4,005
        
     $4,067
        
     $4,089
        
     $3,982
        
     $16,143Basic earnings per share
     $0.89
        
     $0.90
        
     $0.91
        
     $0.89
        
     $3.59Diluted earnings per share
     0.88
        
     0.90
        
     0.90
        
     0.89
        
     3.572006Interest income
     $20,229
        
     $21,594
        
     $22,620
        
     $23,175
        
     $87,618Interest expense
     9,164
        
     10,177
        
     11,143
        
     11,878
        
     42,362Net interest income
     $11,065
        
     $11,417
        
     $11,477
        
     $11,297
        
     $45,256Provision for loan losses
     655
        
     1,054
        
     433
        
     869
        
     3,011Other income
     3,455
        
     3,772
        
     3,756
        
     3,628
        
     14,611Other expense
     8,122
        
     8,674
        
     8,516
        
     9,052
        
     34,364Income before income taxes
     $5,743
        
     $5,461
        
     $6,284
        
     $5,004
        
     $22,492Income taxes
     1,794
        
     1,671
        
     1,991
        
     1,477
        
     6,933Net income
     $3,949
        
     $3,790
        
     $4,293
        
     $3,527
        
     $15,559Basic earnings per share
     $0.87
        
     $0.83
        
     $0.94
        
     $0.78
        
     $3.42Diluted earnings per share
     0.86
        
     0.83
        
     0.93
        
     0.77
        
     3.39Page 86 of 97
PART II




Item 9.
Changes In and Disagreements with Accountants on Accounting and Financial DisclosureNone.




Item 9A.
Controls and ProceduresDisclosure Controls and
Procedures


As of the end of the period covered
by this report, the Company carried out an evaluation under the supervision and with the
participation of the Companys management, including the Companys Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the design and
operation of the Companys disclosure controls and procedures (as defined in Rule
13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934). Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the
Companys disclosure controls and procedures are effective.


Managements Report
on Internal Control Over Financial Reporting


The Companys management is
responsible for establishing and maintaining an adequate system of internal control over
financial reporting (as defined in Rule 13a-15(f) and Rule 15d-15(f) under the Securities
Exchange Act of 1934). Internal control over financial reporting of the Company includes
those policies and procedures that: (1) pertain to the maintenance of records that, in
reasonable detail, accurately and fairly reflect the transactions of the Company; (2)
provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the Company are being made only in
accordance with authorizations of management and directors of the Company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized acquisition,
use or disposition of the Companys assets that could have a material effect on the
Companys consolidated financial statements. Important features of the Companys
system of internal control over financial reporting include the adoption and
implementation of written policies and procedures, careful selection and training of
financial management personnel, a continuing management commitment to the integrity of the
system and through examinations by an internal audit function that coordinates its
activities with the Companys Independent Registered Public Accounting Firm.


All internal control systems, no
matter how well designed, have inherent limitations, including the possibility of human
error and the circumvention of overriding controls. Accordingly, even effective internal
control can provide only reasonable assurance with respect to financial statement
preparation. Further, because of changes in conditions, the effectiveness of internal
control may vary over time.


The Companys management
conducted an evaluation of the effectiveness of the Companys internal controls over
financial reporting as of December 31, 2007. Managements assessment is based on the
criteria described in Internal Control  Integrated Framework issued by
the Committee of Sponsoring Organizations of the Treadway Commission. Based on this
assessment, the Companys management concluded that the Company maintained effective
internal control over financial reporting as of December 31, 2007.


There was no change in the
Companys internal control over financial reporting during the most recently
completed fiscal quarter that has materially affected, or is reasonably likely to
materially affect, the Companys internal control over financial reporting.


The Companys independent
registered public accounting firm, that audited the consolidated financial statements
included in this annual report, has issued a report on the Companys internal control
over financial reporting as of December 31, 2007.

Page 87 of 97
Item 9B.
Other InformationNot
applicable




PART III




Item 10.
Directors, Executive Officers and Corporate GovernanceThe 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
21, 2008 for the Annual Meeting of Stockholders on April 21, 2008. Such information is
incorporated herein by reference.


The Company has a Code of Ethics in
place for the Chief Executive Officer and Chief Financial Officer. A copy of the
Companys Code of Ethics will be provided free of charge, upon written request to:



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


Item 11.
Executive CompensationThe information required by Item 11 of
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 21, 2008. Such information is incorporated herein by reference.




Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
MattersThe information required by Item 12
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
21, 2008. Such information is incorporated herein by reference.




Item 13.
Certain Relationships and Related Transactions, and Director IndependenceThe 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 21, 2008. Such information
is incorporated herein by reference.




Item 14.
Principal Accounting Fees and ServicesInformation required by this item is
contained in the Registrants Proxy Statement dated March 21, 2008, under the heading
Independent Auditors  Audit and Other Fees, which section is
incorporated herein by this reference.

Page 88 of 97
PART IV




Item 15.
Exhibits, Financial Statement SchedulesForm 10-K
Reference(a)
     1.
     Financial StatementsIndependent registered public accounting firm's report on the financial statements
     54Consolidated balance sheets as of December 31, 2007 and 2006
     55Consolidated statements of income for the years ended 
    December 31, 2007, 2006, and 2005
     56Consolidated statements of comprehensive income for the years ended
    December 31, 2007, 2006 and 2005
     57Consolidated statements of stockholders' equity for the years ended
    December 31, 2007, 2006 and 2005
     58Consolidated statements of cash flows for the years ended
    December 31, 2007, 2006 and 2005
     59Notes to financial statements
     612.
     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 A to the Hills Bancorporation Proxy Statement dated March 23, 2001 is incorporated by reference.11
     Statement Regarding Computation of Basic and Diluted Earnings Per Share on Page 92.21
     Subsidiary of the Registrant is Attached on Page 93.23
     Consent of Independent Registered Public Accounting Firm is Attached on Page 94.     KPMG LLP31
     Certifications under Section 302 of the Sarbanes-Oxley Act of 2002 on Pages 95 - 96.32
     Certifications under Section 906 of the Sarbanes-Oxley Act of 2002 on Page 97.(b)
     
     Reports on Form 8-K:The Registrant filed no reports on Form 8-K for the three months ended December 31, 2007.Page 89 of 97
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 11, 2008
     By: /s/ Dwight O. SeegmillerDwight O. Seegmiller, Director, President and Chief Executive OfficerDate:  March 11, 2008
     By: /s/ James G. PrattJames G. Pratt, Secretary, 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 11, 2008
     By: /s/ Willis M. BywaterWillis M. Bywater, DirectorDate:  March 11, 2008
     By: /s/ Michael S. DonovanMichael S. Donovan, DirectorDate:  March 11, 2008
     By: /s/ Thomas J. GillThomas J. Gill, DirectorDate:  March 11, 2008
     By: /s/ Michael E. HodgeMichael E. Hodge, DirectorDate:  March 11, 2008
     By: /s/ James A. NowakJames A. Nowak, DirectorDate:  March 11, 2008
     By: /s/ Richard W. ObermanRichard W. Oberman, DirectorDate:  March 11, 2008
     By: /s/ Theodore H. PachaTheodore H. Pacha, DirectorDate:  March 11, 2008
     By: /s/ John W. PhelanJohn W. Phelan, DirectorDate:  March 11, 2008
     By: /s/ Ann M. RhodesAnn M. Rhodes, DirectorDate:  March 11, 2008
     By: /s/ Ronald E. StutsmanRonald E. Stutsman, DirectorDate:  March 11, 2008
     By: /s/ Sheldon E. YoderSheldon E. Yoder, DirectorPage 90 of 97
HILLS BANCORPORATION
ANNUAL REPORT OF FORM 10-K FOR THE
FISCAL YEAR ENDED DECEMBER 31, 2007








Exhibit
Number
     Description
     Page Number
In The Sequential
Numbering System
For 2007 Form 10-K11
     Statement Re Computation of Basic and Diluted Earnings Per Share
     9221
     Subsidiary of the Registrant
     9323
     Consent of Independent Registered Public Accounting Firm, KPMG LLP
     9431
     Certifications under Section 302 of the Sarbanes-Oxley Act of 2002
     95-9632
     Certifications under Section 906 of the Sarbanes-Oxley Act of 2002
     97Page 91 of 97