Item 1B.
Unresolved Staff Comments
None.
The Company's office and the main office of the Bank are located at 131 E. 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 operations and administrative functions were consolidated in Hills, Iowa. The Bank operates its business from its main office and its 18 full service branches in the Iowa counties of Johnson, Linn and Washington. The Bank owns its main office complex and 14 of its branch offices. Four of the Bank’s branches are leased.
All of the properties owned by the Bank are free and clear of any mortgages or other encumbrances of any type. See Note 15 to the Consolidated Financial Statements for minimum future rental commitments for leased properties.
Item 3.
Item 3.
Legal Proceedings
In the normal course of business, the Company and its subsidiaries are subject to pending and threatened legal actions, some of which seek substantial relief or damages. While the ultimate outcome of such legal proceedings cannot be predicted with certainty, after reviewing pending and threatened litigation with counsel, management believes at this time that the outcome of such litigation will not have a material adverse effect on the Company’s business, financial conditions, or results of operations.
On April 10, 2019, Hills Bank was sued in a class action lawsuit in the Iowa District Court for Johnson County. The lawsuit seeks class action status for customers who had paid overdraft fees on debit card transactions that were authorized into a positive account, but settled into a negative account. Plaintiff contends that these overdraft fees breached the terms of Hills Bank’s account documents. Plaintiff seeks compensatory and punitive damages for breach of contract. The Bank disputes the merits of Plaintiff’s claims and filed a motion to dismiss the case, which the Court denied. At this stage of the proceedings, it is not possible for management of the Bank to determine the probability of an adverse outcome or reasonably estimate the amount of any potential loss.
Item 4.
Item 4.
Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5.
Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
As of January 31, 2020, the Company had 2,644 stockholders. There is no established trading market for the Company's common stock, and the Company's stock is not actively traded. Our common stock is not listed on the NASDAQ stock market or any other stock exchange. While there is no established public trading market for our common stock, our shares are currently quoted in the inter-dealer quotation, or “over-the-counter,” marketplace under the trading symbol “HBIA.” The principal over-the-counter market is operated by OTC Markets Group, Inc., which provides quotes for the Company on its OTC Pink tier.
The high and low bid information for the Company’s stock for each quarter of the two most recent fiscal years, as reported by OTC Market Groups, Inc., is provided below. The prices indicated reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.
In addition, based on the Company’s stock transfer records and information informally provided to the Company, stock trading transactions have been as follows:
(1)
2019 transactions included repurchases by the Company of 89,124 shares of stock under the 2005 Stock Repurchase Program. 2019 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $61.00 to $65.00 per share.
(2)
2018 transactions included repurchases by the Company of 116,962 shares of stock under the 2005 Stock Repurchase Program. 2018 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $54.00 to $61.00 per share.
(3)
2017 transactions included repurchases by the Company of 46,966 shares of stock under the 2005 Stock Repurchase Program. 2017 transactions made under the 2005 Stock Repurchase Program were made at prices that ranged from $48.00 to $54.00 per share.
All transactions under the 2005 Stock Repurchase Program were at a price equal to the most recent quarterly independent appraisal of the shares of the Company's common stock. The most recent independent current quarterly appraisal value of the stock is $66.00 a share. The closing bid for the Company's stock on February 14, 2020 was $65.35 a share as reported by the OTC Markets Group, Inc.
The Company currently pays an annual dividend on its common stock to stockholders, and it expects to continue to maintain its annual dividend for the foreseeable future periods.
The 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 MORNINGSTAR of Chicago, IL. The latter index reflects the performance of twenty-five bank holding companies operating principally in the Midwest as selected by MORNINGSTAR. The indexes assume the investment of $100 on December 31, 2014 in Company Common Stock, the NASDAQ Index and the Regional-Southwest Banks Index, with all dividends reinvested.
Note 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.
The following table sets forth the Company’s equity compensation plan information as of December 31, 2019, all of which relates to stock options issued under stock option plans approved by stockholders of the Company:
On July 26, 2005, the Company’s Board of Directors authorized a program to repurchase up to a total of 1,500,000 shares of the Company’s common stock (the “2005 Stock Repurchase Program”). The Company’s Board of Directors has authorized the 2005 Stock Repurchase Program through December 31, 2021. 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, 2019:
Item 6.
Item 6.
Selected Financial Data
CONSOLIDATED FIVE-YEAR STATISTICAL SUMMARY
The following table sets forth certain of our financial and statistical information for each of the years in the five-year period ended December 31, 2019. This data should be read in conjunction with the consolidated financial statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document.
(1)
Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measures section of this report in Item 7.
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operation
The following discussion by management is presented regarding the financial results for 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 2019 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 financial market disruptions and/or an economic recession, and monetary and other governmental actions designed to address such disruptions and recession.
•
The financial strength of the counterparties with which the Company or the Company’s customers do business and as to which the Company has investment or financial exposure.
•
The credit quality and credit agency ratings of the securities in the Company’s investment securities portfolio, a deterioration or downgrade of which could lead to other-than-temporary impairment of the affected securities and the recognition of an impairment loss.
•
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 electronic delivery channels.
•
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 technology systems.
•
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 natural disasters, 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.
Non-GAAP Financial Measures
This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the Company's presentation of net income without the effect of the Tax Cut and Jobs Act enacted on December 22, 2017 (the "Tax Act"), and the presentation of earnings per share, return on assets and return on equity with the adjusted net income figure. Management believes these Non-GAAP financial measures provide useful information to both management and investors to analyze and evaluate the Company's financial performance. Limitations associated with non-GAAP financial measures include the risks that persons might disagree as to the appropriateness of items included in these measures. These non-GAAP disclosures should not be considered an alternative to the Company's GAAP results. The following table reconciles the non-GAAP financial measures to GAAP.
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 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, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids, Marion and Washington, Iowa.
The Company’s net income for 2019 was $45.32 million compared to $36.77 million in 2018 and $28.06 million in 2017. Before the effect of the Tax Act, the Company's net income for 2017 would have been $32.77 million. (1) Diluted earnings per share were $4.85, $3.92, and $3.01 for the years ended December 31, 2019, 2018 and 2017, respectively. Before the effect of the Tax Act, diluted earnings per share would have been $3.51 in 2017. (1) Without the effect of the Tax Act, management estimates the Company's net income for 2018 would have been $30.96 million.
The Tax Act resulted in an approximately $4.7 million charge against net income primarily due to the write down of its deferred tax assets as a result of the Tax Act’s reduction in the base corporate tax rate from 35% to 21%. While the Tax Act negatively impacted earnings for the Company's fiscal year ended December 31, 2017, the lower corporate rate is expected to be a significant ongoing benefit to the Company.
The Bank’s net interest income is the largest component of the Bank’s revenue, and is a function of the average earning assets and the net interest margin percentage. Net interest margin is the ratio of net interest income to average earning assets. For the years ended December 31, 2019 and 2018, the Bank achieved a net interest margin of 3.18% and 3.25%, respectively. For the year ended December 31, 2019, net interest income on a tax equivalent basis increased by $5.11 million. In 2019, net interest income increased $5.55 million due to growth of $229.77 million in the Bank's average earning assets and decreased $0.44 million due to interest rate changes.
Highlights with respect to items on the Company’s balance sheet as of December 31, 2019 included the following:
•
Loans, net of allowance for loan losses and unamortized fees and costs, totaling $2.615 billion.
•
Net loan growth in 2019 of $15.19 million.
•
Deposit growth of $240.24 million in 2019. Deposits increased to $2.661 billion and included $109.29 million of brokered deposits.
•
FHLB Borrowings decreased $30.00 million.
•
Stockholders’ equity increased $40.33 million to $375.21 million in 2019, with dividends having been paid in 2019 of $7.66 million.
Reference is made to Note 13 of the Company’s consolidated financial statements for a discussion of fair value measurements which relate to methods used by the Company in recording certain assets and liabilities on its consolidated financial statements.
The return on average equity was 11.23% in 2019 compared to 9.92% in 2018. The returns for the three previous years, 2017, 2016 and 2015, were 9.24%, 11.26% and 10.79%, respectively. Before the effect of the Tax Act, the Company's 2017 return on average equity would have been 10.79%. (1) The Company remains well-capitalized as of December 31, 2019 with total risk-based capital at 18.15% and Tier 1 risk-based capital at 16.90%. The minimum regulatory guidelines are 8% and 6% respectively. The Company paid a dividend per share of $0.820 in 2019, $0.750 in 2018 and $0.700 in the year ended December 31, 2017.
A detailed discussion of the financial position and results of operations follows this overview.
(1) Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measurement section of this report.
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 financial 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.
Allowance for Loan Losses
The Company separates its portfolio loans and leases into segments for determining the allowance for loan losses. The Company's portfolio segments includes agricultural, commercial and financial, real estate, loans to individuals and obligations of state and political subdivisions. The Company further separates its portfolio into classes for purposes of monitoring and assessing credit quality based on certain risk characteristics. Classes within the real estate portfolio segment includes 1 to 4 family residential construction, land development and commercial construction, farmland, 1 to 4 family first liens, 1 to 4 family junior liens, multi-family and commercial. For an analysis of the Company's allowance for loan losses by portfolio segment and credit risk rating information by class, see Note 3 to the Company's Consolidated Financial Statements.
Loans that exhibit probable or observed credit weaknesses, as well as loans that have been modified in a troubled debt restructuring ("TDR loans"), are subject to individual review for impairment. When individual loans are reviewed for impairment, the Company determines allowances based on management's estimate of the borrower's ability to repay the loan given the availability of the collateral, other sources of cash flow, as well as evaluation of legal options available. Allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the underlying collateral.
Historical loss rates are applied to loans that are not individually reviewed for impairment. A 20 quarter migration analysis performed by management uses loan level attributes to track the movement of loans through the various credit risk rating categories in order to estimate the percentage of historical loss to apply to each specific credit risk rating in each loan category. The credit risk rating system currently utilized for allowance analysis purposes encompasses six categories.
The Company's allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include changes in lending policies and procedures; changes in national and local economic and business conditions; changes in the nature and volume of the loan portfolio; changes in the experience, ability and depth of lending management and staff; changes in the quality of the Bank's loan review system; the existence and effect of concentrations of credit; and the effect of any other identified external factors.
Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. 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 for loan losses as of December 31, 2019 and 2018 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.
The Company is currently finalizing the CECL model and upon adoption of ASU 2016-13 (CECL) in the first quarter of 2020 anticipates an increase to the allowance for credit losses for loans of approximately $3 to $4 million and an unfunded commitment liability of approximately $1 to $2 million. See Note 1 to the Company's Consolidated Financial Statements for further discussion.
Financial Position
Total assets at December 31, 2019 increased $258.42 million, or 8.49%, from the prior year-end. Asset growth from 2017 to 2018 was $79.10 million and represented a 2.67% increase. The largest growth in assets in 2019 occurred in Cash and Cash Equivalents, which increased $198.66 million as of December 31, 2019 compared to December 31, 2018 and decreased $111.05 million as of December 31, 2018 compared to December 31, 2017. Net Loans increased $15.19 million and $159.92 million for the years ended December 31, 2019 and 2018, respectively. Loans held for sale to the secondary market increased $6.42 million and decreased $3.18 for the years ended December 31, 2019 and 2018, respectively. Loans held for investment represent the largest component of the Bank’s earning assets. Loans held for investment were $2.640 billion and $2.629 billion at December 31, 2019 and 2018, respectively.
The local economy that generated consistent demand for loans was a significant factor in the trend of increasing net loans in each of the last five years. The trend of increasing Net Loans did slow in 2019 and may not continue, and as a result, may not be indicative of future performance.
Loans secured by real estate represent the largest increase in loan growth. These loans increased $21.29 million in 2019 and increased $154.56 million in 2018. Loans secured by real estate include loans for 1 to 4 family residential properties, multi-family properties, agricultural real estate, commercial real estate and construction and development.
On a net basis, the Company originated $13.02 million and $168.57 million in loans to customers for the years ended December 31, 2019 and 2018, respectively. Net loan originations decreased 92.27% in 2019 compared to 2018. The decrease in net loan originations in 2019 as compared to 2018 is reflective of a decrease in loan demand in the local commercial lending environment. The Company does not engage in significant participation activity and does not purchase participations from outside its established trade area. The Company’s policy allows for the purchase or sale of participations related to existing customers or to participate in community development activity. The Company held participations purchased of $15.17, $14.03 and $14.94 million as of December 31, 2019, 2018 and 2017, respectively. The participations purchased were less than one percent of loans held for investment for each of the three years.
The Company did not experience a material change in the composition of its loans held for investment in 2019 or 2018. Residential real estate loans, including first and junior liens, were $1,059.97 million, $1,064.68 million and $975.79 million as of December 31, 2019, 2018 and 2017, respectively. The dollar total of residential real estate loans decreased 0.44% in 2019 and increased 9.11% in 2018. Residential real estate loans were 40.16% of the loan portfolio at December 31, 2019, 40.51% at December 31, 2018 and 39.67% at December 31, 2017. Commercial real estate loans totaled $402.18 million at December 31, 2019, a 4.92% increase over the December 31, 2018 total of $383.31 million. Commercial real estate loans increased 6.12% in 2018. Commercial real estate loans totaled $361.20 million at December 31, 2017. Commercial real estate loans represented 15.24%, 14.59% and 14.69% of the Company’s loan portfolio as of December 31, 2019, 2018 and 2017, respectively. The Company monitors its commercial real estate level so that it does not have a concentration in that category that exceeds 300% of its capital. Commercial real estate loan concentration was 167.37% of capital as of December 31, 2019.
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.
There were no foreign loans outstanding for any of the years presented.
The following table shows the principal payments due on loans as of December 31, 2019:
(1)
A significant portion of the commercial loans are due in one year or less. A significant percentage of the loans will be re-evaluated prior to their maturity and are likely to be extended.
(2)
Commercial, multi-family, construction 1 to 4 family residential, construction land development and commercial, and agricultural real estate loans are reflected in the Commercial and Agricultural total.
The overall economy in the Company’s trade area, Johnson, Linn and Washington Counties, remains in stable condition with levels of unemployment below national and state levels. The following table shows unemployment as of December 31, 2019, 2018 and 2017 and median income information as of December 31, 2018, 2017 and 2016, as December 31, 2019 information is not available as of the date of this report:
Competition for quality loans and deposits may continue to be a challenge. 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 $240.24 million in 2019. Deposits increased by $132.56 million in 2018. As of June 30, 2019 (latest data available from the FDIC), Johnson County total deposits were $8.154 billion and the Company’s deposits were $1.925 billion, which represent a 23.6% market share. The Company had nine office locations in Johnson County as of June 30, 2019. The total banking locations in Johnson County was 49 as of June 30, 2019. At June 30, 2018, the Company’s deposits were $1.772 billion or a 23.5% market share. As of June 30, 2019, Linn County total deposits were $6.843 billion and there were 108 total banking locations in the county. The seven Linn County offices of the Company had deposits of $488.05 million or a 7.1% share of the market. The Company’s Linn County deposits at June 30, 2018 were $438.41 million and represented a 6.9% market share. As of June 30, 2019, the Company’s three Washington County offices had deposits of $207.78 million which was 32.3% of the County’s total deposits of $643.61 million. Washington County had a total of 15 banking locations as of June 30, 2019. In 2018, the Company’s Washington County deposits were $187.30 million or a 31.1% market share.
The following tables show the amounts of the Company's average deposits and average rates paid on such deposits for the years ended December 31, 2019, 2018 and 2017 and the composition of the certificates of deposit issued in denominations in excess of $100,000 as of December 31, 2019, 2018 and 2017:
Investment securities increased $35.27 million in 2019. In 2018, investment securities increased by $30.94 million. The investment portfolio consists of $355.30 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 is used for liquidity and pledging purposes and to provide a rate of return that is acceptable to management.
The following tables show the carrying value of the investment securities held by the Bank, including stock of the Federal Home Loan Bank, as of December 31, 2019, 2018 and 2017 and the maturities and weighted average yields of the investment securities, computed on a tax-equivalent basis using a federal tax rate of 21%, as of December 31, 2019:
As of December 31, 2019, the Company held no investment securities exceeding 10% of stockholders’ equity, other than securities of the U.S. Government agencies and corporations. The Company does not hold any investments in FNMA preferred stock, any pooled trust preferred stocks or other preferred stock type investments. See Note 2 to the Company’s Consolidated Financial Statements.
During 2019, the major funding source for the growth in loans and other assets was the $240.24 million increase in deposits. In 2018, the major source of funding for the growth in loans was deposit growth of $132.56 million. Brokered deposits totaled $109.29 million and $132.46 million as of December 31, 2019 and 2018, respectively. Total advances from the FHLB were $185.00 million at December 31, 2019 and $215.00 million in 2018. It is expected that the FHLB funding source and brokered deposits funding will be considered in the future if loan growth continues to exceed core deposit increases and the interest rates on funds borrowed from the FHLB and interest rates on brokered deposits are favorable compared to other funding alternatives.
Stockholders’ equity was $375.21 million at December 31, 2019 compared to $334.88 million at December 31, 2018. 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 $170.12 million and paid shareholders dividends of $33.06 million, or 19.43% of earnings, while maintaining capital ratios in excess of regulatory requirements.
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, 2019, 2018 and 2017:
(1)
Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measures section of this report in Item 7.
Net Income Overview
Net income and diluted earnings per share for the last five years are as presented below:
(1)
Non-GAAP financial measurement. For further information, refer to the Non-GAAP Financial Measurement section of this report.
Net income for 2019 increased by $8.55 million or 23.26% and diluted earnings per share increased by 23.72%. In 2019, net interest income increased $5.55 million due to growth of $229.77 million in the Bank's average earning assets and decreased $0.44 million due to interest rate changes. Noninterest income increased by $0.97 million, the provision for loan losses decreased by $11.38 million and total noninterest expenses increased by $5.14 million.
Annual fluctuations in the Company's net income continue to be driven primarily by three generally recurring important factors. The first important factor is net interest margin. Net interest income of $97.46 million in 2019 was derived from the Company's $3.133 billion of average earning assets and its net interest margin of 3.18%, compared to $2.903 billion of average earning assets and a 3.25% net interest margin in 2018. The importance of net interest margin is illustrated by the fact that a decrease or an increase in the net interest margin of 10 basis points would result in a $3.13 million decrease or increase in income before taxes. Net interest margin in 2017 was 3.43%. Based on the current interest rate environment, the Company expects continued net interest compression to impact earnings for the foreseeable future. The Company believes net interest margin in dollars will be contingent on the growth of the Company’s earnings assets and maintaining yield on loans. Net interest income was also impacted by the increase in interest expense of $8.55 million compared to 2018, primarily driven by interest rate increases which accounted for $6.28 million of the change.
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 $2.648 billion at the end of 2019. The Company’s allowance for loan losses was $33.76 million at December 31, 2019. The allowance in 2019 decreased in comparison to 2018 due to a decreased provision for loan losses of $11.38 million resulting from a combination of the composition of loan growth, historical loss rates, changes in the composition of loans among the credit risk ratings in 2019 including decrease in specific reserve on impaired loans and management's evaluation of qualitative factors given the current and expected national and local economic conditions. The loan loss provision, which is the amount necessary to adjust the allowance to the level considered appropriate by management, totaled a reduction of expense of $2.88 million for 2019, an expense of $8.5 million for 2018 and an expense of $1.69 million for 2017. Provision expense is expected to be dependent on the Company’s loan growth, local economic conditions, asset quality and the adoption of ASU 2016-13, or CECL, through the end of 2020. See Note 3 to the Company's Consolidated Financial Statements. A detailed discussion is included in the Provision for Loan Losses section below.
The third significant factor affecting the Company’s net income is income tax expense. Federal and state income tax expenses were $12.55 million, $8.91 million and $19.54 million for the years ended December 31, 2019, 2018 and 2017, respectively. Income taxes as a percentage of income before taxes were 21.69% in 2019, 19.50% in 2018 and 41.05% in 2017. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cut and Jobs Act (the “Tax Act”). The Tax Act established new tax laws that reduced the U.S. federal corporate income tax rate from 35% to 21% in 2018. Without the effect of the Tax Act, management estimates the Company's net income for 2018 would have been $30.96 million.
Net income for 2018 was $36.77 million, or diluted earnings per share of $3.92. For 2018, diluted earnings per share increased by $0.91 per share compared to 2017. Net interest income increased $4.49 million for the year ended December 31, 2018 compared to 2017. This increase in net interest income was due to an increase in average earning assets of $251.20 million in 2018. Noninterest income increased 14.41% in 2018 to $23.82 million. Noninterest expense increased from $59.51 million in 2017 to $62.12 million in 2018, or 4.39%. Without the effect of the Tax Act, net income for 2017 would have increased by $1.22 million or 3.85%. In addition, diluted earnings per share would have increased 3.25%.(1)
Net Interest Income
Net interest income is the excess of the interest and fees received on interest-earning assets over the interest paid on 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 net loan growth. The net interest margin was 3.18% in 2019, 3.25% in 2018, 3.43% in 2017, 3.43% in 2016, and 3.50% in 2015. The measure is shown on a tax-equivalent basis using a rate of 21% for 2019 and 2018 and 35% for 2017 to make the interest earned on taxable and nontaxable assets more comparable. Interest income and expense for 2019, 2018 and 2017 are indicated on the following table:
(1) Presented on a tax equivalent basis using a rate of 21% for 2019 and 2018 and 35% for 2017.
Net interest income on a tax-equivalent basis changed in 2019 as follows:
Rate/volume variances are allocated on a consistent basis using the absolute values of changes in volume compared to the absolute values of the changes in rates. Loan fees included in interest income are not material. Interest on nontaxable securities and loans is shown at tax equivalent amounts.
Net interest income on a tax equivalent basis changed in 2018 as follows:
A summary of the average yields, average rates paid, net interest spread and margin is as follows:
(1)
Non-accruing loans 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 21% for 2019 and 2018 and 35% for 2017. The net interest spread decreased 13 basis points in 2019 compared to 2018 and the net interest spread decreased 24 basis points compared to 2017.
(3)
Net interest margin is net interest income, on a tax equivalent basis, divided by average interest-earning assets. The net interest margin decreased 7 basis points in 2019. The net interest margin decreased 18 basis points in 2018 compared to 2017.
In October 2019, the Federal Open Market Committee decreased the target rate to 1.75%. Interest rates on loans are generally affected by the target rate since interest rates for the U.S. Treasury market normally correlate to the Federal Reserve Board 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, 2019, the average rate indexes for the one, three and five year indexes were 1.59%, 1.62% and 1.69%, respectively. The one year index decreased 39.54% from December 31, 2018, the three year index decreased 34.15% and the five year index decreased 32.67%.
Provision for Loan Losses
Management has determined that the allowance for loan losses was appropriate at December 31, 2019, and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for loan losses is based on a comprehensive and well-documented applied analysis of the Company’s loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for loan losses is reviewed and compared to industry peers. This review encompasses levels of total impaired loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs.
The allowance for loan losses totaled $33.76 million at December 31, 2019 compared to $37.81 million at December 31, 2018. The decrease in 2019 is the result of the decrease in specific reserve loans, historical loss rates improving and management's evaluation of qualitative factors. Specifically for 2019, there was a decrease of $2.76 million due to changes in average balances and composition of loans outstanding. There was a decrease of $1.29 million in the amount allocated to the allowance due to improvements in credit quality. The percentage of the allowance to outstanding loans was 1.28% and 1.44% at December 31, 2019 and 2018, respectively. The provision for loan losses totaled a reduction of expense of $2.88 million in 2019, an expense of $8.50 million in 2018 and an expense of $1.69 million for 2017. Loan charge-offs net of recoveries were $1.17 million in 2019. Loan charge-offs net of recoveries were $0.88 million in 2018 and loan recoveries net of charge-offs were $1.18 million in 2017.
The provision for loan losses is the amount necessary to adjust the allowance for loan losses to the level considered appropriate by management. The adequacy of the allowance for loans and any related provision 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 significant factors, including the size and growth of the loan portfolio, the overall composition of the loan portfolio and loan concentrations, the impact of the borrowers’ ability to repay, past loss experience, loan collateral values, the level of impaired loans and loans past due ninety days or more and the trends in problem and watch loans. In addition, management considers the credit quality of the loans based on management’s review of special mention and substandard loans, including loans with historical higher credit risks. Quantitative factors include the Company’s historical loss experience, which is then adjusted for levels and trends in past due loans, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in TDR loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.
In accordance with Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues, the Company determines and assigns ratings to loans using factors that include the following: an assessment of the financial condition of the borrower; a realistic determination of the value and adequacy of underlying collateral; the condition of the local economy and the condition of the specific industry of the borrower; an analysis of the levels and trends of loan categories; and a review of delinquent and classified loans.
Through the credit risk rating process, loans are reviewed to determine if they are performing in accordance with the original contractual terms. If the borrower has failed to comply with the original contractual terms, further action may be required by the Company, including a downgrade in the credit risk rating, movement to nonaccrual status, a charge-off or the establishment of a specific impairment reserve. In the event a collateral shortfall is identified during the credit review process, the Company will work with the borrower for a principal reduction payment and/or a pledge of additional collateral and/or additional guarantees. In the event that these options are not available, the loan may be subject to a downgrade of the credit risk rating. If we determine that a loan amount, or portion thereof, is uncollectible, the loan’s credit risk rating is immediately downgraded and the uncollectible amount is charged-off. The Bank’s credit and legal departments undertake a thorough and ongoing analysis to determine if additional impairment and/or charge-offs are appropriate and to begin a workout plan for the loan to minimize realized loss.
In certain circumstances, the Bank may modify the terms of a loan to maximize the collection of amounts due. In most cases, the modification is either a reduction in interest rate, conversion to interest only payments, deferral of payments or extension of the maturity date. Generally, the borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term, so concessionary modification is granted to the borrower that otherwise would not be considered. TDR loans accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance at a level commensurate with the modified terms over several payment cycles. The Bank’s TDR loans occur on a case-by-case basis in connection with ongoing loan collection processes.
For loans that are collateral dependent, losses are evaluated based on the portion of a loan that exceeds the fair market value of the collateral that can be identified as uncollectible. In general, this is the amount that the carrying value of the loan exceeds the related appraised value less estimated selling costs. Generally, it is the Company’s policy not to rely on appraisals that are older than one year prior to the date the impairment is being measured. The most recent appraisal values may be adjusted if, in the Company’s judgment, experience and other market data indicate that the property’s value, use, condition, exit market or other variable affecting its value may have changed since the appraisal was performed, consistent with the December 2006 joint interagency guidance on the allowance for loan losses. The charge-off or loss adjustment supported by an appraisal is considered the minimum charge-off. Any adjustments made to the appraised value are to provide additional charge-off or loss allocations based on the applicable facts and circumstances. In instances where there is an estimated decline in value, a loss allocation may be provided or a charge-off taken pending confirmation of the amount of the loss from an updated appraisal. Upon receipt of the new appraisals, an additional loss allocation may be provided or charge-off taken based on the appraised value of the collateral. On average, appraisals are obtained within one month of order.
The Company has not experienced any significant time lapses in recognizing the required provisions for collateral dependent loans, nor has the Company delayed appropriate charge-offs. When an updated appraisal value has been obtained, the Company
has used the appraisal amount in determining the appropriate charge-off or required reserve. The Company also evaluates any changes in the financial condition of the borrower and guarantors (if applicable), economic conditions, and the Company’s loss experience with the type of property in question. Any information utilized in addition to the appraisal is intended to identify additional charge-offs or provisions, not to override the appraised value.
The Bank regularly reviews loans in the portfolio and assesses whether the loans are impaired in accordance with ASC 310-10-35, Accounting by Creditors for Impairment of a Loan. 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 for particular loans based upon (1) reviews of specific borrowers and (2) management’s assessment of areas that management considers are of higher credit risk, including loans that have been restructured. Loans that are determined not to be impaired and 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 determination concerning the appropriate percentage begins with historical loss experience factors, which are then adjusted for levels and trends in past due loans, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in TDR loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates.
Specific allowances for losses on impaired loans are established if the loan balances exceed the net present value of the relevant future cash flows or the fair value of the collateral based on updated appraisals and/or updated collateral analysis for the properties if the loan is collateral dependent. The Company may recognize a charge-off related to an impaired loan when loan balances exceed net present value of cash flows or collateral. Impaired loans decreased by $7.06 million from December 31, 2018 to December 31, 2019. Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more and TDR loans. Impaired loans also include loans that, based on management’s evaluation of current information and events, the Bank expects to be unable to collect in full according to the contractual terms of the original loan agreement. The decrease in impaired loans is primarily due to a decrease in specific reserve loans of $8.07 million from December 31, 2018 to December 31, 2019.
Special mention loan balances were $66.81 million at December 31, 2019 and $53.60 million at December 31, 2018. These asset quality changes decreased the provision by $0.14 million based upon the relative mix of special mention loans by category. The $13.21 million increase in special mention loans is related to management’s evaluation of its loan portfolio. The total increase of $13.21 million is comprised of approximately $2.46 million in agricultural operating loans, $0.72 million in construction 1 to 4 family residential, $1.98 million in real estate farmland, $0.73 million in 1 to 4 family residential mortgages, $0.34 million in 1 to 4 family junior mortgages, $11.49 million for multi-family real estate mortgages, $1.57 million for commercial real estate mortgages, and $0.40 million for obligations of state and political subdivisions. The increase is offset by a decrease in the special mention classification of $6.25 million in commercial loans, $0.19 million in construction land development and commercial, and $0.04 million in individual loans.
Substandard loan balances were $43.34 million at December 31, 2019 and $54.40 million at December 31, 2018. These asset quality changes decreased the provision by $0.11 million at December 31, 2019 due to the mix of the reserve required for certain substandard loans. The decrease of $11.06 million in substandard loans at December 31, 2019 includes an increase of $0.08 million in 1 to 4 family junior mortgages. The increase is offset by a decrease in the substandard classification of $1.54 million in agricultural operating loans, $2.34 million in commercial loans, $0.40 million in construction 1 to 4 family residential, $0.70 million in construction land development, $1.16 million in real estate farmland, $0.79 million of 1 to 4 family residential mortgages, $0.21 million in multi-family real estate mortgages, $3.96 million in commercial real estate mortgages, and $0.04 million in loans to individuals. A description of the Bank's credit quality indicators are discussed in Note 3 to the Company's Consolidated Financial Statements.
The Company evaluates the following loans to determine impairment: 1) all nonaccrual and TDR loans, 2) all non-consumer and non 1 to 4 family residential loans with prior charge-offs, 3) all non-consumer and non 1 to 4 family loan relationships classified as substandard and 4) loans with indications of or suspected deteriorating credit quality.
The following table summarizes the Company's impaired loans and non-performing assets as of December 31 for each of the years presented:
(1)
The gross interest income that would have been recorded if the loans had been current in accordance with their original terms and had been outstanding throughout the period or since origination if held for part of the period was $0.58 million in 2019 and $0.79 million in 2018. The amount of interest income on the loans that was included in income was $0.53 million in 2019 and $0.40 million in 2018.
(2)
The accruing loans past due 90 days or more are still believed to be adequately collateralized. Loans are placed on nonaccrual status when management believes the collection of future principal and interest is not reasonably assured.
(3)
Total TDR loans were $13.71, $13.38, $12.09, $9.64 and $10.59 million as of December 31, 2019, 2018, 2017, 2016, and 2015, respectively. Included in the total nonaccrual loans were $4.34, $4.84, $3.62, $4.23, and $2.31 million of TDR loans as of December 31, 2019, 2018, 2017, 2016, and 2015, respectively.
The ratio of allowance for loan losses to impaired loans increased to 161.34% as of December 31, 2019 compared to 135.11% as of December 31, 2018. The increase in 2019 is the result of a decrease in impaired loans with specific reserves. The ratio of impaired loans to total gross loans was 0.79% and 1.06% at December 31, 2019 and 2018, respectively. The decrease in the 2019 ratio is primarily due to the decrease in specific reserve 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 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. In most instances, the borrowers have used in their rental projections of income at least a 10% vacancy rate. As of December 31, 2019, the unemployment levels in Johnson County and Linn County were 2.2% and 3.1%, respectively, compared to 1.7% and 2.7% in December of 2018. These levels compare favorably to the State of Iowa at 2.7% and the national unemployment level at 3.5% in December 2019 compared to 2.5% and 3.9%, respectively in December 2018.
The residential rental vacancy rates in 2018 and 2019 in Johnson and Linn County were estimated between 5.0% and 7.0%. The State of Iowa vacancy rate is 6.7% and the national rate is 6.4% with the Midwest rate at 6.8%. These vacancy rates one year ago were 7.0%, 6.6% and 7.1%, 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. Favorable vacancy rates may not continue in 2020, and vacancy rates may rise and affect the overall quality of the loan portfolio.
See Note 3 to the Company's Consolidated Financial Statements for additional disclosures on loans.
SUMMARY OF LOAN LOSS EXPERIENCE
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, 2019, 2018 and 2017, recoveries were $1.80 million, $2.23 million and $3.29 million, respectively; charge-offs were $2.97 million, $2.32 million and $2.10 million in 2019, 2018 and 2017, respectively.
Overall credit quality may deteriorate in 2020. Such deterioration could cause increases in impaired loans, allowance for loan losses provision expense and net charge-offs. Management will monitor changing market conditions as a part of its allowance for loan loss methodology. The following table summarizes the Bank's loan loss experience for the years ended December 31 for each of the years presented:
The ratio of net charge-offs to average net loans outstanding during the years ended December 31, 2019, 2018, 2017, 2016 and 2015 was 0.04%, 0.00%, (0.05)%, (0.05)% and (0.04)%, respectively.
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
The following table presents the allowance for loan losses by type of loans, the percentage of the allocation for each category to the total allowance and the percentage of all loans in each category to total loans as of December 31, 2019, 2018, 2017, 2016, and 2015:
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 impaired loans, charge-offs and delinquencies could rise and require increases in the provision for loan losses. The Company will continue to monitor the adequacy of the allowance on a quarterly basis and will consider 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.
Noninterest Income
The following table sets forth the various categories of noninterest income for the year ended December 31, 2019, 2018 and 2017.
The noninterest income of the Company was $24.79 million in 2019 compared to $23.82 million in 2018. The increase of $0.97 million in 2019 was the result of a combination of factors discussed below. In 2018, the total noninterest income increased $3.00 million from 2017.
Net gain on sale of loans increased 2.02 million in 2019 primarily due to the decreasing interest rate environment. The amount of the gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates. 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 decreased $0.43 million to $9.58 million in 2019. Trust fees increased $1.96 million in 2018. As of December 31, 2019, the Bank’s Trust Department had $1.919 billion in assets under management compared to $1.618 billion and $1.649 billion at December 31, 2018 and 2017, respectively. The trust assets that are the most volatile are those that are held in common stocks, which amount to approximately 68.00% of assets under management. In 2019, the Dow Jones Industrial Average increased 22.34%. The market value of the Dow Jones Industrial Average decreased 5.63% in 2018 and increased 25.08% in 2017.
Service charges and fees increased $0.66 million in 2018 from increased debit and credit card interchange income. Service charges and fees increased $0.76 million in 2018.
Other noninterest income decreased $1.25 million in 2019 primarily due to the sale of the insurance department in August 2018 for a gain of $885,000.
Noninterest Expenses
The following table sets forth the various categories of noninterest expenses for the year ended December 31, 2019, 2018 and 2017.
Total noninterest expenses were $67.26 and $62.12 million for the years ended December 31, 2019 and 2018, respectively. The increase is $5.14 million or 8.28% in 2019 and an increase of $2.61 million or 4.39% in 2018.
Salaries and employee benefits increased $1.73 million in 2019. The increase is the result of annual salary increases and hiring additional employees.
Furniture and equipment increased $1.05 million in 2019 primarily due to increases in software maintenance contract costs.
Other noninterest expenses increased $2.63 million in 2019 primarily due to $2.09 million in fees incurred from the prepayment of FHLB borrowings.
Total noninterest expenses were $59.51 million for the year ended December 31, 2017. The increase in expenses in 2018 was $2.61 million. This included an increase of $1.78 million in salaries and benefits, which was the direct result of salary adjustments and restricted stock awards increases due to the increase in the appraised value of the Company stock.
Income Taxes
Income tax expense was $12.55, $8.91 and $19.54 million for the years ended December 31, 2019, 2018 and 2017, respectively. Income taxes as a percentage of income before income taxes were 21.69% in 2019, 19.50% in 2018 and 41.05% in 2017. The amount of tax credits were $0.53, $1.29 and $1.43 million for 2019, 2018, and 2017, respectively.
On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cut and Jobs Act (the “Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code that affected 2017, including, but not limited to, accelerated depreciation that allowed for full expensing of qualified property. The Tax Act also established new tax laws that affected 2018 and thereafter, including a reduction in the U.S. federal corporate income tax rate from 35% to 21%. As a result of the reduction of the federal corporate income tax rate, we revalued our net deferred tax asset, excluding after tax credits, as of December 22, 2017. Based on this revaluation, we recorded a net tax expense of $4.71 million to reduce our net deferred tax asset balance, which was recorded as additional income tax expense for the year ended December 31, 2017. Our effective tax rate increased by 30.99% to 41.05% primarily as a result of the revaluation of our net deferred tax asset. While the Tax Act negatively impacted earnings for the Company's fiscal year ended December 31, 2017, the lower corporate rate has been a significant ongoing benefit to the Company. For the year ended December 31, 2018, net income was $5.81 million higher than it would have been under the tax laws in effect before the Tax Act.
Effects of Inflation
The consolidated financial statements and the accompanying notes have been prepared in accordance with accounting principles generally accepted in the United States of America. 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. 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. Liquidity and interest rate adjustments are features of the Company’s asset/liability management, which are important to the maintenance of acceptable performance levels. Item 7A
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
The Company's primary market risk exposure is to changes in interest rates. Interest rate risk is the risk to current or anticipated earnings or capital arising from movements in interest rates. Interest rate risk arises from repricing risk, basis risk, yield curve risk and options risk. Repricing risk is the difference between the timing of rate changes and the timing of cash flows. Basis risk is the difference from changing rate relationships among different yield curve affecting Bank activities. Yield curve risk is the difference from changing rate relationships across the spectrum of maturities. Option risk is the difference resulting from interest-related options imbedded in Bank products. The Bank’s primary source of interest rate risk exposure arises from repricing risk. To measure this risk the Bank uses a static gap measurement system that identifies the repricing gaps across the full maturity spectrum of the Bank’s assets and liabilities and an earnings simulation approach. The gap schedule is known as the interest rate sensitivity report. The report reflects the repricing characteristics of the Bank’s assets and liabilities. The report details the calculation of the gap ratio. This ratio indicated the amount of interest-earning assets repricing within a given period in comparison to the amount of interest-bearing liabilities repricing within the same period of time. A gap ratio of 1.0 indicates a matched position, in which case the effect on net interest income due to interest rate movements will be minimal. A gap ratio of less than 1.0 indicates that more liabilities than assets reprice within the time period, and a ratio greater than 1.0 indicates that more assets reprice than liabilities.
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.
The Bank maintains an Asset/Liability Committee, which meets at least quarterly to review the interest rate sensitivity position and to review and develop various strategies for managing interest rate risk within the context of the following factors: 1) capital adequacy, 2) asset/liability mix, 3) economic outlook, 4) market characteristics and 5) the interest rate forecast. 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. The Bank’s policy is to generally maintain a balance between profitability and interest rate risk.
The Bank uses derivative financial instruments, when needed, to manage the impact of changes in interest rates on future interest income or interest expense. The Bank is exposed to credit-related losses in the event of nonperformance by the counterparties to these derivative instruments, but believe the risk of the these losses has been minimized by entering into the contracts with large, stable financial institutions. The estimated fair market value of these derivative instruments are presented in Note 17 to the Consolidated Financial Statements.
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 transaction deposit accounts, which are less sensitive to changes in interest rates and can be re-priced rapidly.
The table set forth below 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.
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.
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.
(1)
Includes all available-for-sale investments, federal funds and Federal Home Loan Bank stock.
(2)
Includes NOW and other demand, savings and money market funds.
Item 8.
Item 8.
Consolidated Financial Statements and Supplementary Data
The consolidated financial statements and supplementary data are included on pages 52 through 107.
Report of Independent Registered Public Accounting Firm
To the Shareholders, Board of Directors and Audit Committee
Hills Bancorporation
Hills, Iowa
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Hills Bancorporation (the "Company") as of December 31, 2019 and 2018, 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, 2019, and the related notes (collectively referred to as the "financial statements"). In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2019, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2019, based on Internal Control-Integrated Framework (2013) and our report dated March 6, 2020, expressed an unqualified opinion.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits.
We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
BKD, LLP
We have served as the Company’s auditor since 2012.
Springfield, Missouri
March 6, 2020
Report of Independent Registered Public Accounting Firm
To the Shareholders, Board of Directors and Audit Committee
Hills Bancorporation
Hills, Iowa
Opinion on the Internal Control over Financial Reporting
We have audited Hills Bancorporation's (the "Company") internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) ("PCAOB"), the consolidated financial statements of the Company and our report dated March 6, 2020, expressed an unqualified opinion.
Basis for Opinion
The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.
We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.
Our audit included obtaining an understanding of internal control over financial reporting, 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 audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definitions and Limitations of Internal Control over Financial Reporting
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 reliable financial statements in accordance with accounting principles generally accepted in the United States of America. Because management's assessment and our audit also were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), our examination of Hills Bancorporation's internal control over financial reporting included controls over the preparation of financial statements in accordance with accounting principles generally accepted in the United States of America and with the instructions to the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C). 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 accounting principles generally accepted in the United States of America, 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 and correction 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.
BKD, LLP
Springfield, Missouri
March 6, 2020
HILLS BANCORPORATION
CONSOLIDATED BALANCE SHEETS
December 31, 2019 and 2018
(Amounts In Thousands, Except Shares)
See Notes to Consolidated Financial Statements.
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2019, 2018 and 2017
(Amounts In Thousands, Except Per Share Amounts)
See Notes to Consolidated Financial Statements.
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2019, 2018 and 2017
(Amounts In Thousands)
See Notes to Consolidated Financial Statements.
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Years Ended December 31, 2019, 2018 and 2017
(Amounts In Thousands, Except Share Data)
See Notes to Consolidated Financial Statements.
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2019, 2018 and 2017
(Amounts In Thousands)
(Continued)
HILLS BANCORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 2019, 2018 and 2017
(Amounts In Thousands)
See Notes to Consolidated Financial Statements.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1.
Nature of Activities and Significant Accounting Policies
Nature of activities: Hills Bancorporation (the "Company") is a holding company engaged in the business of commercial banking. The Company's subsidiary is Hills Bank and Trust Company, Hills, Iowa (the “Bank”), which is wholly-owned. The Bank is a full-service commercial bank extending its services to individuals, businesses, governmental units and institutional customers primarily in the communities of Hills, Iowa City, Coralville, North Liberty, Lisbon, Mount Vernon, Kalona, Wellman, Cedar Rapids, Marion and Washington, Iowa.
The Bank competes with other financial institutions and non-financial 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 involve certain significant estimates made by management. These estimates are reviewed by management routinely and it is reasonably possible that circumstances that exist at December 31, 2019 may change in the near-term and 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: Accounting Standards Codification ("ASC") 606, Revenue from Contracts with Customers ("ASC 606"), establishes principles for reporting information about the nature, amount, timing and uncertainty of revenue and cash flows arising from the Company’s contracts to provide goods or services to customers. The core principle requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it expects to be entitled to receive in exchange for those goods or services recognized as performance obligations are satisfied.
The majority of the Company’s revenue-generating transactions are not subject to ASC 606, including revenue generated from financial instruments, such as loans, letters of credit and investment securities as these activities are not subject to the requirements of ASC 606. Interest income on loans and investment securities is recognized on the accrual method in accordance with written contracts. Loan origination fees of mortgage loans originated for sale are recognized when the loans are sold.
Descriptions of the Company’s revenue-generating activities that are within the scope of ASC 606 are the following: Service charges and fees on deposit accounts represent general service fees for monthly account maintenance and activity- or transaction-based fees and consist of transaction-based revenue which includes interchange income, time-based revenue (service period), item-based revenue or some other individual attribute-based revenue. Revenue is recognized when the Company’s performance obligation is completed which is generally monthly for account maintenance services or when a transaction has been completed (such as a wire transfer). Payment for such performance obligations are generally received at the time the performance obligations are satisfied. Trust income represents monthly fees due from wealth management customers as consideration for managing the customers' assets. Wealth management and trust services include custody of assets, investment management, fees for trust services and similar fiduciary activities. Revenue is recognized when our performance obligation is completed each month, which is generally the time that payment is received.
A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity's obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. As of December 31, 2019 and 2018, the Company did not have any significant contract balances.
In connection with the adoption of ASC 606, an entity is required to capitalize, and subsequently amortize into expense, certain incremental costs of obtaining a contract with a customer if these costs are expected to be recovered. The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, sales commission). The Company utilizes the practical expedient which allows entities
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to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing these costs would have been amortized in one year or less. The Company did not capitalize any contract acquisition costs for the years ending December 31, 2019 and 2018.
Cash and cash equivalents: The Company considers all investments with original maturities of three months or less to be cash equivalents. At December 31, 2019 and 2018, cash equivalents consisted primarily of deposits with other banks.
Investment securities: 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 or held to maturity securities as of December 31, 2019 or 2018.
Stock of the Federal Home Loan Bank is carried at cost. The Company has evaluated the stock and determined there is no impairment.
Premiums on debt securities are amortized to the earliest call date and discounts on debt securities are accreted over the period to maturity of those securities. The method of amortization results in a constant effective yield on those securities (the interest method). Realized gains and losses on investment securities are included in income, determined on the basis of the cost of the specific securities sold.
Declines in the fair value of investment securities available for sale (with certain exceptions for debt securities noted below) that are deemed to be other-than-temporary are charged to earnings as a realized loss, and a new cost basis for the securities is established. In evaluating other-than-temporary impairment, the Company considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term. Declines in the fair value of debt securities below amortized cost are deemed to be other-than-temporary in circumstances where: (1) the Company has the intent to sell a security; (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis; or (3) the Company does not expect to recover the entire amortized cost basis of the security. If the Company intends to sell a security or if it is more likely than not that the Company will be required to sell the security before recovery, an other-than-temporary impairment write-down is recognized in earnings equal to the difference between the security’s amortized cost basis and its fair value. If the Company does not intend to sell the security or it is not more likely than not that the Company will be required to sell the security before recovery, the other-than-temporary impairment write-down is separated into an amount representing credit loss, which is recognized in earnings, and an amount related to all other factors, which is recognized in other comprehensive income. Realized securities gains or losses on securities sales (using specific identification method) and declines in value judged to be other-than-temporary are included in investment securities gains (losses), net, in the consolidated statements of income.
Loans: 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 Company has had very few experiences of repurchasing loans previously sold into the secondary market. A specific reserve was not considered necessary based on the Company’s historical experience with repurchase activity.
The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance when management believes the collectability of principal is unlikely. The allowance for loan losses is maintained at a level considered adequate to provide for probable losses that can be reasonably anticipated. The allowance is increased by provisions charged to expense and is reduced by net charge-offs. The Bank makes continuous reviews of the loan portfolio and considers current economic conditions, historical loss experience, review of specific problem loans and other factors in determining the adequacy of the allowance. Management classifies loans within the following categories: excellent, good, satisfactory, monitor, special mention and substandard.
The policy for charging off loans is consistent throughout all loan categories. A loan is charged off based on criteria that includes but is not limited to: delinquency status, financial condition of the entire customer credit line and underlying collateral coverage,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
economic or external conditions that might impact full repayment of the loan, legal issues, overdrafts, and the customer’s willingness to work with the Company.
Loans are considered impaired when, based on current information and events, it is probable the Bank will not be able to collect all amounts due. An impaired loan includes any loan that has been placed on nonaccrual status, loans greater than 90 days past due and still accruing and TDR loans. They also include loans, based on current information and events, that it is likely the Bank will be unable to collect all amounts due according to the contractual terms of the original loan agreement. The portion of the allowance for loan losses applicable to impaired loans has been computed based on the present value of the estimated future cash flows of interest and principal discounted at the loans effective interest rate or on the fair value of the collateral for collateral dependent loans. The entire change in present value of expected cash flows of impaired loans or of collateral value is reported as provision expense in the same manner in which impairment initially was recognized or as a reduction in the amount of provision expense that otherwise would be reported. Interest income on nonaccrual loans is recognized once principal has been recovered.
The accrual of interest income on loans is discontinued when, in the opinion of management, there is reasonable doubt as to the borrower's ability to meet payments of interest or principal when they become due, which is generally when a loan is 90 days or more past due. When a loan is placed on nonaccrual status, all previously accrued and unpaid interest is reversed. Loans are returned to an accrual status when all of the principal and interest amounts contractually due are brought current and repayment of the remaining contractual principal and interest is expected. A loan may also return to accrual status if additional collateral is received from the borrower and, in the opinion of management, the financial position of the borrower indicates that there is no longer any reasonable doubt as to the collection of the amount contractually due. Payment received on nonaccrual loans are applied first to principal. Once principal is recovered, any remaining payments received are applied to interest income. As of December 31, 2019, none of the Company’s nonaccrual loans were earning interest on a cash basis.
Nonrefundable loan fees and origination costs are deferred and recognized as a yield adjustment over the life of the related loan.
Troubled debt restructurings (“TDR loans”): A loan is classified as a troubled debt restructuring when a borrower is experiencing financial difficulties that leads to a restructuring of the loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider. These concessions may include rate reductions, principal forgiveness, extension of maturity date and other actions intended to minimize potential losses to the Company. A loan that is modified at a market rate of interest is no longer classified as troubled debt restructuring in the quarter following the modification if the borrower is no longer experiencing financial difficulties. Performance prior to the restructuring is considered when assessing whether the borrower can meet the new terms. At the time of restructuring, loans included in a troubled debt restructuring may be considered nonaccrual loans. TDR loans are returned to accrual status under the same criteria noted under loans above.
Transfers of financial assets: Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.
Credit related financial instruments: In the ordinary course of business, the Company has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded when they are funded.
Tax credit real estate: Tax credit real estate represents two multi-family rental properties, three assisted living rental properties, a multi-tenant rental property for persons with disabilities, and a multi-family senior living rental property, all which are affordable housing projects as of December 31, 2019. The Bank has a 99% or greater limited partnership interest in each limited partnership. The investment in each was completed after the projects had been developed by the general partner. 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.
In February 2019, the Company entered into a Letter of Intent to invest in a limited partnership, as limited partner, which will own and operate an affordable housing property in Iowa City, Iowa. The Company provides construction financing for the project and will contribute capital of $4.18 million upon construction completion which is anticipated to be in April 2020.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In 2016, the Company adopted ASU 2015-02 and the investments in tax credit real estate are recorded for all years presented using the equity method of accounting. The 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. 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. Interest and penalties on unrecognized tax benefits are classified as other noninterest expense. As of December 31, 2019, 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. The Bank will obtain updated appraisals to determine the estimated fair value of the property based on the type of collateral securing the loan and the date of the latest appraisal. Subsequent write downs estimated on the basis of later valuations are charged to net loss on sale of other real estate owned and other repossessed assets. Net operating expenses incurred in maintaining such properties are charged to other non-interest expense. Net capital expenditures incurred are capitalized to the property.
Derivative financial instruments: The Bank uses interest rate swaps as part of its interest rate risk management. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 815 establishes accounting and reporting standards for derivative instruments and hedging activities. The Bank records all interest rate swaps on the balance sheet at fair value. Derivatives used to hedge the exposure to variability in expected future cash flows are considered cash flow hedges. To qualify for hedge accounting, the Bank must comply with the detailed rules and documentation requirements at the inception of the hedge, and hedge effectiveness is assessed at inception and periodically throughout the life of the hedging relationship.
For derivatives designated as cash flow hedges, the changes in the fair value of the derivatives is initially reported in other comprehensive income and subsequently reclassified to interest income or expense when the hedged transaction affects earnings. The Bank assesses the effectiveness of each hedging relationship by comparing the cumulative changes in cash flows of the derivative hedging instruments with the cumulative changes in cash flows of the designated hedged item or transaction. No component of the change in the fair value of the hedging instrument is excluded from the assessment of hedge effectiveness.
The Bank does not use derivatives for trading or speculative purposes.
Earnings 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. ESOP shares are considered outstanding for this calculation unless unearned.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table presents calculations of earnings per share:
Stock awards and options: Compensation expense for stock issued through the stock award plan is accounted for using the fair value method prescribed by FASB ASC 718, “Share-Based Payment” (“ASC 718”). 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 award as of the date of the grant.
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.
Treasury Stock: Treasury stock is accounted for by the cost method, whereby shares of common stock reacquired are recorded at their purchase price.
Trust Department Assets: Property held for customers in fiduciary or agency capacities is not included in the accompanying consolidated balance sheets, as such items are not assets of the Company.
Effect of New Financial Accounting Standards:
In May 2014, The FASB and International Accounting Standards Board (IASB) issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). The core principle of ASU 2014-09 is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. ASU 2014-09 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. The Company has evaluated all of its noninterest income streams and contracts to determine potential impact. The adoption of ASU 2014-09 by the Company did not have a material impact on the recognition of revenue though did require additional disclosures on our material noninterest income streams discussed in revenue recognition above.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 created Subtopic 321-10, Investments-Equity Securities which is applicable to all entities except those in industries that account for substantially all investments at fair value through earnings or the change in net assets. Under this new subtopic, equity securities are generally required to be measured at fair value with unrealized holding gains and losses reflected in net income. ASU 2016-01 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2017. The Company adopted ASU 2016-01 for the period ending March 31, 2018. There was no material impact on the financial statements, however, it required the use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes and eliminated the requirement to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. The revised disclosures are in Note 13 Fair Value Measurements.
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In February 2016, the FASB issued ASU No. 2016-02 (Topic 842), Leases. The ASU provides guidance requiring lessees to recognize right-of-use (ROU) assets and lease liabilities for all leases other than those that meet the definition of short-term leases. For short-term leases, lessees may elect an accounting policy by class of underlying asset under which these assets and liabilities are not recognized and lease payments are generally recognized over the lease term on a straight-line basis. Under this new ASU, lessees will recognize right-of use assets and lease liabilities for most leases currently accounted for as operating leases under generally accepted accounting principles. For public companies, ASU 2016-02 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company adopted the ASU on January 1, 2019 and used the effective date as the date of initial application. Consequently, financial information will not be updated and the disclosures required under the new standard will not be provided for dates and periods before January 1, 2019. The new standard provides a number of optional practical expedients in transition. We elected the 'package of practical expedients', which permits us not to reassess under the new standard our prior conclusions about lease identification, lease classification and initial direct costs. We did not elect the use-of-hindsight or the practical expedient pertaining to land easements; the latter not being applicable to us. The most significant impact upon adoption relates to the recognition of new ROU assets and lease liabilities on our balance sheet for our equipment and real estate operating leases. Upon adoption, we recognized additional operating liabilities of $3.58 million, with corresponding ROU assets of the same amount based on the present value of the remaining minimum rental payments under current leasing standards for existing operating leases.
In March 2016, the FASB issued ASU No. 2016-04, Liabilities - Extinguishments of Liabilities (Subtopic 405-20), Recognition of Breakage for Certain Prepaid Stored-Value Products. ASU 2016-04 applies to all entities that offer certain prepaid stored - value products. The ASU provides guidance for the derecognition of financial liabilities related to the issuance of these products and aligns the recognition of breakage to current authoritative guidance. For public companies, ASU 2016-04 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. The Company adopted ASU 2016-04 for the period ending March 31, 2018. There was no material impact on the financial statements.
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments (CECL). The ASU changes the way entities recognize impairment of financial assets by requiring immediate recognition of estimated credit losses expected to occur over the remaining life of many financial assets. Under the CECL model, we will be required to present certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the "incurred loss" model required under current GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, we expect that the adoption of the CECL model will materially affect how we determine our allowance for loan losses and could require us to significantly increase our allowance. For public companies, ASU 2016-13 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company has implemented a software solution provided by a third party vendor to assist in the determination of the CECL model. The CECL model is being finalized and we completed the validation process for the CECL model using an independent outside party in January 2020. Our current planned approach for estimating expected life-time credit losses for loans upon adoption includes the following key components:
•
An initial forecast period of one year for all portfolio segments and off-balance-sheet credit exposures. This period reflects management’s expectation of losses based on forward-looking economic scenarios over that time.
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A historical loss forecast period covering the remaining contractual life, adjusted for prepayments, by portfolio segment based on the change in key historical economic variables.
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A reversion period of up to 3 years connecting the initial loss forecast to the historical loss forecast based on economic conditions at the measurement date.
•
We will primarily utilize discounted cash flow (DCF) methods to estimate credit losses by portfolio segment. The DCF methods obtain estimated life-time credit losses using the conceptual components described above.
Based on our portfolio composition upon adoption and the current economic environment, we anticipate an increase in our Allowance for Credit Losses (ACL) for loans of approximately $3 million to $4 million. We also anticipate an unfunded commitments liability of approximately $1 million to $2 million. We will continue to evaluate and refine the results of our loss estimates throughout the first quarter of 2020. The future effects of CECL on our ACL will depend on the size and composition of our portfolio, the portfolio’s credit quality and economic conditions, as well as any refinements to our model, methodology and other key assumptions. We will recognize a one-time cumulative-effect adjustment to our ACL upon adoption of the new standard. The increase in the ACL will result in a decrease to our regulatory capital amounts and ratios.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In January 2017, the FASB issued ASU No. 2017-03, Accounting Changes and Error Corrections (Topic 250) and Investments - Equity Method and Joint Ventures (Topic 323), Amendments to SEC Paragraphs Pursuant to Staff Announcements at the September 22, 2016 and November 17, 2016 EITF Meetings. This ASU adds an SEC paragraph and amends other Topics pursuant to an SEC staff Announcement made at the September 22, 2016 Emerging Issues Task Force (EITF) meeting. The SEC paragraph applies to ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606); ASU No. 2016-02, Leases (Topic 842); and ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The ASU provides that a company should evaluate ASUs that have not yet been adopted to determine the appropriate financial statement disclosures about the potential material effects of those ASUs on the financial statements when adopted. If the company does not know or cannot reasonably estimate the impact that adoption of the ASUs referenced in this announcement is expected to have on the financial statements, then in addition to making a statement to that effect, the company should consider additional qualitative financial statement disclosures to assist the reader in assessing the significance of the impact that the standard will have on the financial statements of the company when adopted. Additional qualitative disclosures should include a description of the effect of the accounting policies that the company expects to apply and a comparison to the company's current accounting policies. Also, the company should describe the status of its process to implement the new standards and the significant implementation matters yet to be addressed.
In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 250), Simplifying the Test for Goodwill Impairment. The ASU simplifies the goodwill impairment test by requiring a company to perform its annual or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized when the carrying amount exceeds fair value. For public companies, ASU 2017-04 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The adoption of ASU No. 2017-04 by the Company on January 1, 2020 did not have a material impact on the financial statements.
In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities. This ASU requires companies to change the recognition and presentation of the effects of hedge accounting by eliminating the requirement to separately measure and report hedge ineffectiveness and requiring companies to present all of the elements of hedge accounting that affect earnings in the same income statement line as the hedged item. Furthermore, the standard eases the requirements for effectiveness testing, hedge documentation and applying the critical terms match method and introduces new alternatives that will permit companies to reduce the risk of material error corrections if they misapply the shortcut method. For public companies, ASU 2017-12 is effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018. The Company adopted ASU 2017-12 for the period ending March 31, 2019. There was no material impact on the financial statements.
In February 2018, the FASB issued ASU No. 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220), Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This ASU allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. ASU 2018-02 is effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. The Company adopted ASU 2018-02 for the period ending March 31, 2018 and elected the specific identification method accounting policy. Upon adoption, there was a $0.53 million reclassification recorded in stockholders' equity.
In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718), Improvements to Nonemployee Share-Based Payment Accounting. The amendments in this ASU expand the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. ASU 2018-07 is effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within that fiscal year. The Company adopted ASU 2018-07 for the period ending March 31, 2019. There was no material impact on the financial statements.
In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820), Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. The amendments in this ASU modify the disclosure requirements on fair value measurements in Topic 820, Fair Value Measurement, including removal of the requirement to disclose the valuation processes for Level 3 fair value measurements and the additional requirement to disclose the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. ASU 2018-13 is effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The amendments on changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements, and the narrative description of measurement uncertainty should be applied prospectively for only the most recent interim or annual period presented in the initial fiscal year of adoption. All other amendments should be applied retrospectively
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to all periods presented upon their effective date. Early adoption is permitted upon issuance of this ASU. An entity is permitted to early adopt any removed or modified disclosures upon issuance of this ASU and delay adoption of the additional disclosures until their effective date. The adoption of ASU 2018-13 by the Company on January 1, 2020 did not have a material impact on the financial statements.
In August 2018, the FASB issued ASU No. 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40), Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangements That Is a Service Contract. The amendments in this ASU align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). ASU 2018-15 is effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early adoption of the amendments in this ASU is permitted, including adoption in any interim period, for all entities. The amendments in this ASU should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. The adoption of ASU 2018-15 by the Company on January 1, 2020 did not have a material impact on the financial statements.
In October 2018, the FASB issued ASU No. 2018-16, Derivatives and Hedging (Topic 815), Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes. The amendments in this ASU permit use of the OIS rate based on SOFR as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815 in addition to the interest rates on direct Treasury obligations of the U.S. government, the London Interbank Offered Rate (LIBOR) swap rate, the Overnight Index Swap (OIS) Rate based on the Fed Funds Effective Rate and the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate. The amendments in this ASU are required to be adopted concurrently with the amendments in ASU 2017-12. For public companies, this would be for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018. The Company adopted ASU No. 2018-16 for the period ending March 31, 2019 concurrently with ASU 2017-12. There was no material impact on the financial statements.
In July 2019, the FASB issued ASU No. 2019-07, Codification Updates to SEC Sections, Amendments to SEC Paragraphs Pursuant to SEC Final Rule Releases No. 33-10532, Disclosure Update and Simplification, and Nos. 33-10231 and 33-10442, Investment Company Reporting Modernization, and Miscellaneous Updates. The amendments in this ASU update the Codification to reflect the amendments of various SEC disclosure requirements that the agency determined were redundant, duplicative, overlapping, outdated or superseded. The SEC amended its disclosure rules in 2018 with the aim of providing investors with useful disclosure information and to simplify compliance without significantly altering the mix of the information being provided. This ASU was effective upon release and there was no material impact on the financial statements.
In November 2019, the FASB issued ASU No. 2019-08, Compensation - Stock Compensation (Topic 718) and Revenue from Contracts with Customers (Topic 606), Codification Improvements - Share-Based Consideration Payable to a Customer. The amendments in this ASU require that an entity measure and classify share-based payment awards granted to a customer by applying the guidance in Topic 718. The amount recorded as a reduction of the transaction price is required to be measured on the basis of the grant-date fair value of the share-based payment award in accordance with Topic 718. The grant date is the date at which a grantor (supplier) and a grantee (customer) reach a mutual understanding of the key terms and conditions of a share-based payment award. The classification and subsequent measurement of the award are subject to the guidance in Topic 718 unless the share-based payment award is subsequently modified and the grantee is no longer a customer. The Company adopted ASU 2019-08 for the period ending December 31, 2019. There was no material impact on the financial statements.
In November 2019, the FASB issued ASU No. 2019-11, Codification Improvements to Topic 326, Financial Instruments - Credit Losses. The amendments in this ASU clarify or address stakeholders' specific issues about certain aspects of the amendments in ASU 2016-13 in the following areas: expected recoveries for purchased financial assets with credit deterioration, transition relief for troubled debt restructurings, disclosures related to accrued interest receivables and financial assets secured by collateral maintenance provisions. For public companies, ASU 2019-11 is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 and will be adopted concurrently with ASU 2016-13.
In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740), Simplifying the Accounting for Income Taxes. The amendments in this ASU simplify the accounting for income taxes by removing specific exceptions included in Topic 740, introducing other simplifications and making technical corrections. For public business entities, the amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption is permitted. The Company is currently evaluating the impact the adoption of this ASU will have on the financial statements.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 2.
Investment Securities
The carrying values of investment securities at December 31, 2019 and December 31, 2018 are summarized in the following table (Amounts in Thousands):
Investment securities have been classified in the consolidated balance sheets according to management’s intent. 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. The Company had no securities designated as trading or held to maturity in its portfolio at December 31, 2019 or 2018. The carrying amount of available-for-sale securities and their approximate fair values were as follows (Amounts in Thousands):
The amortized cost and estimated fair value of available-for-sale securities classified according to their contractual maturities at December 31, 2019, were as follows (Amounts in Thousands):
As of December 31, 2019, investment securities with a carrying value of $12.93 million were pledged to collateralize derivative financial instruments and other borrowings.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Sales proceeds and gross realized gains and losses on available-for-sale securities were as follows (in thousands):
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, 2019 and 2018 (Amounts in Thousands):
The Company considered the following information in reaching the conclusion that the impairments disclosed in the table above are temporary and not other-than-temporary impairments. None of the unrealized losses in the above table was due to the deterioration in credit quality that might result in the non-collection of contractual principal and interest. The unrealized losses are due to changes in interest rates. The Company has not recognized any unrealized loss in income because management does not have the intent to sell the securities included in the previous table. Management has concluded that it is more likely than not that the Company will not be required to sell these securities prior to recovery of the amortized cost basis.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 3.
Loans
Classes of loans are as follows:
Changes in the allowance for loan losses and the allowance for loan loss balance applicable to impaired loans and the related loan balance of impaired loans for the years ended December 31, 2019, 2018 and 2017 are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company evaluates the following loans to determine impairment: 1) all nonaccrual and TDR loans, 2) all non consumer and non 1 to 4 family residential loans with prior charge-offs, 3) all non consumer and non 1 to 4 family loan relationships classified as substandard and 4) loans with indications of or suspected deteriorating credit quality.
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The following table presents the credit quality indicators by type of loans in each category as of December 31, 2019:
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The following table presents the credit quality indicators by type of loans in each category as of December 31, 2018:
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The below are descriptions of the credit quality indicators:
Excellent - Excellent rated loans are prime quality loans covered by highly-liquid collateral with generous margins or supported by superior current financial conditions reflecting substantial net worth, relative to total credit extended, and based on assets of a stable and non-speculative nature whose values can be readily verified. Identified repayment source or cash flow is abundant and assured.
Good - Good rated loans are adequately secured by readily-marketable collateral or good financial condition characterized by liquidity, flexibility and sound net worth. Loans are supported by sound primary and secondary payment sources and timely and accurate financial information.
Satisfactory - Satisfactory rated loans are loans to borrowers of average financial means not especially vulnerable to changes in economic or other circumstances, where the major support for the extension is sufficient collateral of a marketable nature, and the primary source of repayment is seen to be clear and adequate.
Monitor - Monitor rated loans are identified by management as warranting special attention for a variety of reasons that may bear on ultimate collectability. This may be due to adverse trends, a particular industry, loan structure, or repayment that is dependent on projections, or a one-time occurrence.
Special Mention - Special mention rated loans are supported by a marginal payment capacity and are marginally protected by collateral. There are identified weaknesses that if not monitored and corrected may adversely affect the Company’s credit position. A special mention credit would typically have a weakness in one of the general categories (cash flow, collateral position or payment history) but not in all categories.
Substandard - Substandard loans are not adequately supported by the paying capacity of the borrower and may be inadequately collateralized. These loans have a well-defined weakness or weaknesses. For these loans, it is more probable than not that the Company could sustain some loss if the deficiency(ies) is not corrected.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Past due loans as of December 31, 2019 and 2018 were as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company does not have a significant amount of loans that are past due less than 90 days where there are serious doubts as to the ability of the borrowers to comply with the loan repayment terms.
Accruing loans past due 90 days or more increased $0.24 million from December 31, 2018 to December 31, 2019. As of December 31, 2019 and 2018, accruing loans past due 90 days or more were 0.02% and 0.01% of total loans, respectively. The average balance of the accruing loans past due 90 days or more decreased in 2019 as compared to 2018. The average 90 days or more past due accruing loan balance per loan was $0.08 million as of December 31, 2019 compared to $0.19 million as of December 31, 2018. The loans 90 days or more past due and still accruing are believed to be adequately collateralized. Loans are placed on nonaccrual status when management believes the collection of future principal and interest is not reasonably assured.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Certain impaired loan information by loan type at December 31, 2019 and 2018 was as follows:
(1)
There were $4.34 million and $4.84 million of TDR loans included within nonaccrual loans as of December 31, 2019 and 2018, respectively.
The Company may modify the terms of a loan to maximize the collection of amounts due. In most cases, the modification is a reduction in interest rate, conversion to interest only payments or an extension of the maturity date. The borrower is experiencing financial difficulties or is expected to experience financial difficulties in the near-term, so a concessionary modification is granted to the borrower that would otherwise not be considered. TDR loans accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance at a level commensurate with the modified terms over several payment cycles.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Below is a summary of information for TDR loans as of December 31, 2019 and 2018:
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A summary of TDR loans that were modified during the year ended December 31, 2019 and 2018 was as follows:
The Bank has commitments to lend additional borrowings to TDR loan customers. These commitments are in the normal course of business and allow the borrowers to build pre-sold homes and commercial property which increase their overall cash flow. The additional borrowings are not used to facilitate payments on these loans.
There was one TDR loan totaling $0.065 million modified during the year that was in payment default (defined as past due 90 days or more) as of December 31, 2019 and none as of December 31, 2018.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Information regarding impaired loans as of and for the year ended December 31, 2019 is as follows:
HILLS BANCORPORATION
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Information regarding impaired loans as of and for the year ended December 31, 2018 is as follows:
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Information regarding impaired loans as of and for the year ended December 31, 2017 is as follows:
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Impaired loans decreased by $7.06 million from December 31, 2018 to December 31, 2019. Impaired loans include any loan that has been placed on nonaccrual status, accruing loans past due 90 days or more, TDR loans and specific reserve loans. Impaired loans also include loans that, based on management’s evaluation of current information and events, the Bank expects to be unable to collect in full according to the contractual terms of the original loan agreement. Impaired loans were 0.79% and 1.06% of loans held for investment as of December 31, 2019 and 2018, respectively. The decrease in impaired loans is due mainly to a decrease of $8.07 million in specific reserve loans and a decrease in nonaccrual loans of $0.06 million and offset by an increase of accruing loans past due 90 days or more of $0.24 million, and an increase in TDR loans of $0.77 million from December 31, 2018 to December 31, 2019.
For loans that are collateral dependent, losses are evaluated based on the portion of a loan that exceeds the fair market value of the collateral that can be identified as uncollectible. In general, this is the amount that the carrying value of the loan exceeds the related appraised value. Generally, it is the Company’s policy not to rely on appraisals that are older than one year prior to the date the impairment is being measured. The most recent appraisal values may be adjusted if, in the Company’s judgment, experience and other market data indicate that the property’s value, use, condition, exit market or other variable affecting its value may have changed since the appraisal was performed, consistent with the December 2006 joint interagency guidance on the allowance for loan losses. The charge-off or loss adjustment supported by an appraisal is considered the minimum charge-off. Any adjustments made to the appraised value are to provide additional charge-off or loss allocations based on the applicable facts and circumstances. In instances where there is an estimated decline in value, either a loss allocation is provided or a charge-off taken pending confirmation of the amount of the loss from an updated appraisal. Upon receipt of the new appraisals, an additional loss allocation may be provided or charge-off taken based on the appraised value of the collateral. On average, appraisals are obtained within one month of order.
The Company has not experienced any significant time lapses in recognizing the required provisions for collateral dependent loans, nor has the Company delayed appropriate charge-offs. When an updated appraisal value has been obtained, the Company has used the appraisal amount in helping to determine the appropriate charge-off or required reserve. The Company also evaluates any changes in the financial condition of the borrower and guarantors (if applicable), economic conditions, and the Company’s loss experience with the type of property in question. Any information utilized in addition to the appraisal is intended to identify additional charge-offs or provisions, not to override the appraised value.
The Company separates its portfolio loans and leases into segments for determining the allowance for loan losses. The Company's portfolio segments includes agricultural, commercial and financial, real estate, loans to individuals and obligations of state and political subdivisions. The Company further separates its portfolio into classes for purposes of monitoring and assessing credit quality based on certain risk characteristics. Classes with the real estate portfolio segment includes 1 to 4 family residential constructions, land development and commercial construction, farmland, 1 to 4 family first liens, 1 to 4 family junior liens, multi-family and commercial.
Loans that exhibit probable or observed credit weaknesses, as well as loans that have been modified in a TDR, are subject to individual review for impairment. When individual loans are reviewed for impairment, the Company determines allowances based on management's estimate of the borrower's ability to repay the loan given the availability of the collateral, other sources of cash flow, as well as evaluation of legal options available. Allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the underlying collateral.
Historical loss rates are applied to loans that are not individually reviewed for impairment. The 20 quarter migration analysis performed by management uses loan level attributes to track the movement of loans through the various credit risk rating categories in order to estimate the percentage of historical loss to apply to each specific credit risk rating in each loan category. The credit risk rating system currently utilized for allowance analysis purposes encompasses six categories.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company's allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in impaired loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers' sensitivity to interest rate movements. Qualitative factors include changes in lending policies and procedures; changes in national and local economic and business conditions; changes in the nature and volume of the loan portfolio; changes in the experience, ability and depth of lending management and staff; changes in the quality of the Bank's loan review system; the existence and effect of concentrations of credit; and the effect of any other identified external factors.
Determinations relating to the possible level of future loan losses are based in part on subjective judgments by management. Future loan losses in excess of current estimates, could materially adversely affect our results of operations or financial position. As the Company adds new products and increases the complexity of its loan portfolio, it will enhance its methodology accordingly. Although management believes the levels of the allowance for loan losses as of December 31, 2019 and 2018 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.
Note 4.
Property and Equipment
The major classes of property and equipment and the total accumulated depreciation are as follows:
Note 5.
Leases
The Bank leases branch offices, parking facilities and certain equipment under operating leases. The leases have remaining lease terms of 1 year to 16 years, some of which include options to extend the leases for up to 10 years, and some of which include options to terminate the leases within 1 year. As the options are reasonably certain to be exercised, they are recognized as part of the right-of-use assets and lease liabilities.
For the year ended December 31, 2019, total operating lease expense was $0.62 million included in occupancy expenses in the consolidated statement of income. Included in this were $0.53 million of operating lease costs, $0.03 million of short term lease costs, and $0.06 million of variable lease costs.
For the year ended December 31, 2019, cash paid for amounts included in the measurement of operating lease liabilities was $0.53 million and right-of-use assets obtained in exchange for lease obligations was $3.58 million.
As of December 31, 2019, operating lease right-of-use assets included in other assets was $3.20 million and liabilities was $3.23 million. The weighted average remaining lease term for operating leases was 10.86 years and the weighted average discount rate for operating leases was 3.46%. Discount rates used were determined from FHLB borrowing rates for comparable terms.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As of December 31, 2019, maturities of lease liabilities were as follows:
Note 6.
Interest - Bearing Deposits
A summary of these deposits is as follows:
Brokered deposits totaled $109.29 million and $132.46 million as of December 31, 2019 and 2018, respectively, with an average interest rate of 1.65% and 2.46% as of December 31, 2019 and 2018, respectively. As of December 31, 2019, brokered deposits of $109.29 million are included in savings deposits. At December 31, 2018, brokered deposits of $132.46 million were included in savings deposits.
Time deposits have a maturity as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 7.
Federal Home Loan Bank Borrowings
As of December 31, 2019 and 2018, the borrowings were as follows:
On December 13, 2019 the Company paid $30.00 million in FHLB Borrowings due in 2025. On January 17, 2018 the Company paid $15.00 million in FHLB Borrowings due in 2019 and $15.00 million due in 2021. On February 6, 2018 the Company paid $15.00 million in FHLB Borrowings due in 2021. On February 28, 2018 the Company paid $15.00 million in FHLB Borrowings due in 2022. There were no prepayment fees incurred with these prepayments. Fees incurred with the 2019 prepayments were $2.09 million. The remaining borrowings with the FHLB may have prepayment fees based on the current FHLB borrowing rate.
To participate in the FHLB advance program, the Company is required to have an investment in FHLB stock. The Company’s investment in FHLB stock was $11.06 million and $12.17 million at December 31, 2019 and 2018, respectively. Collateral is provided by the Company’s 1 to 4 family mortgage loans totaling $249.75 million at December 31, 2019 and $290.25 million at December 31, 2018. The Company also has the ability to borrow against agricultural real estate, commercial real estate and multi-family loans totaling $306.86 million as of December 31, 2019 and $296.53 million as of December 31, 2018 and there was $0 borrowed against this collateral as of December 31, 2019 or 2018.
Note 8.
Accumulated Other Comprehensive Income
The components of accumulated other comprehensive income (AOCI), included in stockholders’ equity, are as follows:
Note 9.
Employee Benefit Plans
The Company has an Employee Stock Purchase Plan (the “ESPP”). For each quarterly offering period, eligible employees can elect to contribute from 1% to 15% of his or her compensation. The purchase price is the lesser of 90% of the fair market value on the first day of the offering period or the last day of the offering period. The maximum dollar amount any one employee can elect to contribute in a year is $9,000. During the year ended December 31, 2019, 7,720 shares of stock were purchased by employees of the Bank through the ESPP. 8,172 shares of stock were purchased by employees of the Bank through the ESPP for the year ended December 31, 2018.
The Company has an Employee Stock Ownership Plan (the "ESOP") to which it makes discretionary cash contributions. The Company's contribution to the ESOP totaled $1.08 million, $1.05 million and $1.01 million for the years ended December 31, 2019, 2018 and 2017, respectively. The 2019, 2018 and 2017 discretionary contribution rate was 4.5% of qualified salaries.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In the event a terminated plan participant desires to sell his or her shares of the Company stock, or for certain employees who elect to diversify their account balances, the Company may be required to purchase the shares from the participant at their fair value. To the extent that shares of common stock held by the ESOP are not readily traded, a sponsor must reflect the maximum cash obligation related to those securities outside of stockholders' equity. The Company obtains a quarterly independent appraisal of the shares of stock. As of December 31, 2019 and 2018, the shares held by the ESOP, fair value and maximum cash obligation were as follows:
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 Company made a 4.50% or $1.08 million contribution to the profit sharing plan for the year ended December 31, 2019. The Company made a 4.50% or $1.05 million contribution to the profit sharing plan for the year ended December 31, 2018. The Company made a 4.50% or $1.01 million contribution to the profit sharing plan for the year ended December 31, 2017. The Company made matching contributions under its 401(k) plan of $0.22 million in 2019, $0.21 million in 2018, and $0.20 million in 2017 and each such amount is included in salaries and employee benefits expense.
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 $4.89 million and $5.90 million at December 31, 2019 and 2018, respectively. Expense related to the deferred compensation plan was $0.42 million for 2019, $0.85 million for 2018 and $0.81 million for 2017 and is included in salaries and employee benefits expense.
The Company also provides a deferred compensation program for its Board of Directors. Under the plan, each director may elect to defer up to 50% of such director’s cash compensation from retainers and meeting fees for payment by the Company at a subsequent date. Any amount so deferred is credited to the director’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 director’s account is adjusted each year for dividends paid and the change in the market value of Hills Bancorporation stock. The deferred compensation liability for the directors’ plan is recorded in other liabilities and totaled $3.94 million and $3.52 million at December 31, 2019 and 2018, respectively. Expense related to the directors’ deferred compensation plan was $0.28 million for 2019, $0.43 million for 2018 and $0.37 million for 2017 and is included in other noninterest 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 188,000 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 and officers' rights under the plan vest over a five-year period from the date of the grant.
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 ten year interest rate swap rate as published by the Federal Reserve Bank on the date of issuance. Expected volatility is based on volatility levels of the Company’s peers’ common stock as the Company’s stock has limited trading activity. Expected dividend yield was based on historical dividend rates. Significant assumptions at the date of grant on May 14, 2019 include the risk-free interest rate of 2.39%, expected option life of 7.5 years, expected volatility of 33% and expected dividends of 1.23%.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
There were 5,805 stock options granted in 2019 and none in 2018 and 2017. The weighted-average fair value of options granted in 2019 was $21.31 per share. The intrinsic value of options exercised was $0.06 million, $0.03 million and $0.24 million for 2019, 2018 and 2017, respectively.
A summary of the stock options is as follows:
Other pertinent information related to the options outstanding at December 31, 2019 is as follows:
As of December 31, 2019, the outstanding options have a weighted-average exercise price of $45.92 per share and a weighted average remaining contractual term of 5.47 years. There was $0.11 million in unrecognized compensation cost for stock options granted under the plan as of December 31, 2019. The cost is expected to be recognized over a weighted-average period of 4.40 years. As of December 31, 2019, the vested options totaled 7,220 shares with a weighted-average exercise price of $33.00 per share.
As of December 31, 2019, 19,853 shares were available for stock options and awards. The Compensation and Incentive Stock Committee is also authorized to grant awards of restricted common stock. A summary of the restricted stock option activity for the year ended December 31, 2019 is as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company authorized the issuance of 23,527 shares in 2019, 24,899 shares in 2018, and 27,407 shares in 2017 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, 2019, 2018 and 2017 was $0.96 million, $0.85 million and $0.58 million, respectively. 7,200, 15,200 and 15,200 shares of the restricted common stock shares awarded in December 31, 2019, 2018 and 2017, are subject to forfeiture upon termination of the employee's employment with the Company within eight years of the award.
Note 10.
Income Taxes
Income taxes for the years ended December 31, 2019, 2018 and 2017 are summarized as follows:
Temporary 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, 2019 and 2018 were as follows:
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 Company largely from its investment in tax credit real estate properties. The 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 2020 and 2038. The Company has recorded a valuation allowance to reduce the deferred tax asset attributable to the net operating loss carry-forwards. At December 31, 2019 and 2018, the Company believes
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
it is more likely than not that the Iowa net operating loss carry-forwards will not be realized. 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 (decreased) by $134,000 and ($41,000) for the years ended December 31, 2019 and 2018, respectively.
On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cut and Jobs Act (the “Tax Act”). The Tax Act made broad and complex changes to the U.S. tax code that affected 2017, including, but not limited to, accelerated depreciation that allows for full expensing of qualified property. The Tax Act also established new tax laws that affects 2018 and after, including a reduction in the U.S. federal corporate income tax rate from 35% to 21%.
On December 22, 2017, the SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”), which provided guidance on accounting for the tax effects of the Tax Act. SAB 118 provided that a measurement period should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740, Income Taxes. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under ASC 740 is complete.
As a result of the reduction of the federal corporate income tax rate, we revalued our net deferred tax asset, excluding after tax credits, as of December 22, 2017. Based on this revaluation, we recorded a net tax expense of $4.71 million to reduce the net deferred tax asset balance, which was recorded as additional income tax expense for the year ended December 31, 2017. Our effective tax rate increased by 30.99% to 41.0% primarily as a result of the revaluation of our net deferred tax asset for the year ended December 31, 2017.
The net change in the deferred income taxes for the years ended December 31, 2019, 2018 and 2017 is reflected in the consolidated financial statements as follows:
Income tax expense for the years ended December 31, 2019, 2018 and 2017 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:
Federal income tax expense for the years ended December 31, 2019, 2018 and 2017 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
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subsidiary bank. 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, 2019, 2018, 2017 and 2016, remain subject to examination by the Internal Revenue Service. For state tax purposes, the tax years ended December 31, 2019, 2018, 2017 and 2016, remain open for examination. There were no material unrecognized tax benefits at December 31, 2019 and December 31, 2018. No interest or penalties on these unrecognized tax benefits has been recorded. As of December 31, 2019, the Company does not anticipate any significant increase or decrease in unrecognized tax benefits during the twelve month period ending December 31, 2020.
Note 11.
Regulatory Capital Requirements, Restrictions on Subsidiary Dividends and Cash Restrictions
The Company and the Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial results. Under capital adequacy guidelines and the regulatory frameworks for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classifications of the Company and the Bank are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.Quantitative measures established by the regulations to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of capital. Under the BASEL III rules, the minimum capital ratios are 4% for Tier 1 Leverage Capital Ratio, 4.5% for the Common Equity Tier 1 Capital Ratio, 6% for the Tier 1 Risk-Based Capital Ratio and 8% for the Total Risk-Based Capital Ratio. A capital conservation buffer was phased in beginning January 1, 2016, at 0.625% of risk-weighted assets and increased each subsequent year by an additional 0.625% until reaching 2.5% on January 1, 2019. Management believes that, as of December 31, 2019 and 2018, the Company and the Bank met all capital adequacy requirements to which they are subject.
As of December 31, 2019, 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, Tier 1 common equity 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 Bank's category.
The actual amounts and capital ratios as of December 31, 2019 and 2018, with the minimum regulatory requirements for the Company and Bank are presented below (amounts in thousands):
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The ability of the Company to pay dividends to its stockholders is dependent upon dividends paid by the Bank. The Bank is subject to certain statutory and regulatory restrictions on the amount it may pay in dividends. To maintain acceptable capital ratios in the Bank, certain of its retained earnings are not available for the payment of dividends. To maintain a ratio of capital to assets of 8.00%, retained earnings of $223.92 million as of December 31, 2019 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 $221.18 million and $14.68 million as of December 31, 2019 and 2018, respectively.
Note 12.
Related Party Transactions
Certain directors of the Company and the Bank, 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, 2019 and 2018:
Deposits from these related parties totaled $11.16 million and $7.13 million as of December 31, 2019 and 2018, respectively. Deposits from related parties are accepted subject to the same interest rates and terms as those from nonrelated parties.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 13.
Fair Value Measurements
The carrying value and estimated fair values of the Company’s financial instruments as of December 31, 2019 are as follows:
(1)
Considered Level 1 under Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”).
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The carrying value and estimated fair values of the Company’s financial instruments as of December 31, 2018 are as follows:
(1)
Considered Level 1 under Accounting Standards Codification (“ASC”) Topic 820, Fair Value Measurements and Disclosures (“ASC 820”).
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Fair value of financial instruments: FASB ASC 820, Fair Value Measurements and Disclosures (“ASC 820”) provides a single definition for fair value, a framework for measuring fair value and expanded disclosures concerning fair value. Fair value is defined under ASC 820 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.
The Company determines the fair market value of its financial instruments based on the fair value hierarchy established in ASC 820. There are three levels of inputs that may be used to measure fair value as follows:
Level 1
Quoted prices in active markets for identical assets or liabilities.
Level 2
Observable inputs other than quoted prices included within Level 1. Observable inputs include the quoted prices for similar assets or liabilities in markets that are not active and inputs other than quoted prices that are observable for the asset or liability.
Level 3
Unobservable inputs supported by little or no market activity for financial instruments. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.
It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. The Company is required to use observable inputs, to the extent available, in the fair value estimation process unless that data results from forced liquidations or distressed sales.
The following is a description of valuation methodologies used for assets and liabilities recorded at fair value.
ASSETS
Investment securities available for sale: Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If a quoted price is not available, the fair value is obtained from benchmarking the security against similar securities. U.S. Treasury securities are considered Level 1 with the remaining securities considered Level 2.
The pricing for investment securities is obtained from an independent source. There are no Level 3 investment securities owned by the Company. The Company obtains an understanding of the independent source’s valuation methodologies used to determine fair value by level of security. The Company validates assigned fair values on a sample basis using an additional third-party provider pricing service to determine if the fair value measurement is reasonable. Due to the nature of our investment portfolio, we do not expect significant and unusual fluctuations as fair value changes primarily relate to interest rate changes. No unusual fluctuations were identified during the year ended December 31, 2019. If a fluctuation requiring investigation was identified, the Company would research the change with the independent source or other available information.
Loans held for sale and Loans: ASU 2016-1, Financial Instruments -Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. Methodologies utilized for this financial statement period are as follows:
•Income Approach: Fair value is determined based on a discounted cash flow analysis. The discounted cash flow analysis was based on the contractual maturity of the loan and market indications of rates, prepayment speeds, defaults and credit risk.
•Asset Approach: Fair value is determined based on the estimated values of the underlying collateral or individual analysis of receipts. This provides a better indication of value than the contractual income streams as these loans are not performing or exhibit strong signs indicative of non-performance.
Fair value has been estimated in accordance with ASC 820, Fair Value Measurements and Disclosures, and is intended to represent the price that would be received in an orderly transaction between market participants as of the measurement date. In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, at least one significant assumption not observable in the market was utilized. These unobservable assumptions reflect estimates that market participants would use in pricing the asset or liability. Inputs to these valuation techniques are subjective in nature, involve uncertainties and
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
require significant judgment and therefore cannot be determined with precision. Accordingly, the fair value estimates presented are not necessarily indicative of the amounts to be realized in a current market exchange. Loans are classified as Level 3.
Loans held for sale are carried at historical cost. The carrying amount is a reasonable estimate of fair value because of the short time between origination of the loan and its sale on the secondary market (Level 2). The market is active for these loans and as a result prices for similar assets are available.
The Company does record nonrecurring fair value adjustments to impaired loans to reflect (1) partial write-downs that are based on the observable market price or appraised value of the collateral or (2) the full charge-off of the loan carrying value (Level 3).
A loan is considered to be impaired when it is probable that all of the principal and interest due may not be collected according to its contractual terms. Generally, when a loan is considered impaired, the amount of reserve required under ASC 310, Receivables, is measured based on the fair value of the underlying collateral. The Company makes such measurements on all material loans deemed impaired using the fair value of the collateral for collateral dependent loans or based on the present value of the estimated future cash flows of interest and principal discounted at the loans effective interest rate or the fair value of the loan if determinable. The fair value of collateral used by the Company is determined by obtaining an observable market price or by obtaining an appraised value from an independent, licensed or certified appraiser, using observable market data. This data includes information such as selling price of similar properties and capitalization rates of similar properties sold within the market, expected future cash flows or earnings of the subject property based on current market expectations, and other relevant factors. All appraised values are adjusted for market-related trends based on the Company's experience in sales and other appraisals of similar property types as well as estimated selling costs. Each quarter management reviews all collateral dependent impaired loans on a loan-by-loan basis to determine whether updated appraisals are necessary based on loan performance, collateral type and guarantor support. At times, the Company measures the fair value of collateral dependent impaired loans using appraisals with dates prior to one year from the date of review. These appraisals are discounted by applying current, observable market data about similar property types such as sales contracts, estimations of value by individuals familiar with the market, other appraisals, sales or collateral assessments based on current market activity until updated appraisals are obtained. Depending on the length of time since an appraisal was performed, the data provided through reviews and estimated selling costs, collateral values are typically discounted by 0-35%. These loans are considered Level 3 as the instruments used to determine fair market value require significant management judgment and estimation.
Foreclosed assets: The Company does not record foreclosed assets at fair value on a recurring basis. Foreclosed assets consist mainly of other real estate owned but may include other types of assets repossessed by the Company. Foreclosed assets are adjusted to the lower of carrying value or fair value less the costs of disposal. Fair value is generally based upon independent market prices or appraised values of the collateral, and may include a marketability discount as deemed necessary by management based on its experience with similar types of real estate. The value of foreclosed assets is evaluated periodically as a nonrecurring fair value adjustment. Foreclosed assets are classified as Level 3.
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 (Level 2).
LIABILITIES
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Interest Rate Swap Agreements: The fair value is estimated using forward-looking interest rate curves and is calculated using discounted cash flows that are observable or that can be corroborated by observable market data (Level 2).
Assets and Liabilities Recorded at Fair Value on a Recurring Basis
The table below represents the balances of assets and liabilities measured at fair value on a recurring basis:
(1)
Considered Level 1 under ASC 820.
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.
There were no transfers between Levels 1, 2 or 3 during the years ended December 31, 2019 and 2018.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis
The Company is required to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower-of-cost-or-market accounting or write-downs of individual assets. The valuation methodologies used to measure these fair value adjustments are described above. For assets measured at fair value on a nonrecurring basis that were still held on the balance sheet at December 31, 2019 and 2018, the following tables provide the level of valuation assumptions used to determine the adjustment and the carrying value of the related individual assets at year end.
(1)
Considered Level 1 under ASC 820.
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.
(4)
Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully charged off is zero.
(5)
Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1)
Considered Level 1 under ASC 820.
(2)
Considered Level 2 under ASC 820.
(3)
Considered Level 3 under ASC 820 and are based on valuation models that use significant assumptions that are not observable in an active market.
(4)
Represents carrying value and related write-downs of loans for which adjustments are based on the value of the collateral. The carrying value of loans fully charged off is zero.
(5)
Represents the fair value and related losses of foreclosed real estate and other collateral owned that were measured at fair value subsequent to their initial classification as foreclosed assets.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 14.
Parent Company Only Financial Information
Following is condensed financial information of the Company (parent company only):
CONDENSED BALANCE SHEETS
December 31, 2019 and 2018
(Amounts In Thousands)
CONDENSED STATEMENTS OF INCOME
Years Ended December 31, 2019, 2018 and 2017
(Amounts In Thousands)
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CONDENSED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2019, 2018 and 2017
(Amounts In Thousands)
Note 15.
Commitments and Contingencies
Concentrations of credit risk: The Bank’s loans, commitments to extend credit, unused lines of credit and outstanding letters of credit have been granted to customers within the Bank's market area. Investments in securities issued by state and political subdivisions within the state of Iowa totaled approximately $101.94 million. 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, Linn and Washington Counties, Iowa.
Contingencies: In the normal course of business, the Company and its subsidiaries are subject to pending and threatened legal actions, some of which seek substantial relief or damages. While the ultimate outcome of such legal proceedings cannot be predicted with certainty, after reviewing pending and threatened litigation with counsel, management believes at this time that the outcome of such litigation will not have a material adverse effect on the Company’s business, financial conditions, or results of operations.
On April 10, 2019, Hills Bank was sued in a class action lawsuit in the Iowa District Court for Johnson County. The lawsuit seeks class action status for customers who had paid overdraft fees on debit card transactions that were authorized into a positive account, but settled into a negative account. Plaintiff contends that these overdraft fees breached the terms of Hills Bank’s account documents. Plaintiff seeks compensatory and punitive damages for breach of contract. The Bank disputes the merits of Plaintiff’s claims and filed a motion to dismiss the case, which the Court denied. At this stage of the proceedings, it is not possible for management of the Bank to determine the probability of an adverse outcome or reasonably estimate the amount of any potential loss.
HILLS BANCORPORATION
NOTES TO 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, 2019 and 2018 is as follows:
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 commitments 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, 2019 and 2018, 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, 2019 for all non-cancelable leases relating to Bank premises were as follows:
Rent expense was $0.40 million, $0.36 million and $0.37 million for the years ended December 31, 2019, 2018 and 2017, respectively.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 16.
Quarterly Results of Operations (unaudited, amounts in thousands, except per share amounts)
Note 17.
Derivative Financial Instruments
In the normal course of business, the Bank may use derivative financial instruments to manage its interest rate risk. These instruments carry varying degrees of credit, interest rate and market or liquidity risks. Derivative instruments are recognized as either assets or liabilities in the accompanying consolidated financial statements and are measured at fair value. The Bank’s objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates. The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amount to be exchanged between the counterparties. The Bank is exposed to credit risk in the event of nonperformance by counterparties to financial instruments. The Bank minimizes this risk by entering into derivative contracts with large, stable financial institutions. The Bank has not experienced any losses from nonperformance by counterparties. The Bank monitors counterparty risk in accordance with the provisions of ASC 815. In addition, the Bank’s interest rate-related derivative instruments contain language outlining collateral pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty. The Bank was required to pledge $2.35 million of collateral as of December 31, 2019.
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Cash Flow Hedges:
The Bank executed two forward-starting interest rate swap transactions on November 7, 2013. One of the interest rate swap transactions had an effective date of November 9, 2015, and an expiration date of November 9, 2020, effectively converting $25.00 million of variable rate debt to fixed rate debt. The other interest rate swap transaction had an effective date of November 7, 2016 and an expiration date of November 7, 2023, effectively converting $25.00 million of variable rate debt to fixed rate debt. For accounting purposes, these swap transactions are designated as a cash flow hedge of the changes in cash flows attributable to changes in three-month LIBOR, the benchmark interest rate being hedged, associated with the interest payments made on an amount of the Bank’s debt principal equal to the then-outstanding swap notional amount. At inception, the Bank asserted that the underlying principal balance would remain outstanding throughout the hedge transaction making it probable that sufficient LIBOR-based interest payments would exist through the maturity date of the swaps.
The table below identifies the balance sheet category and fair values of the Bank’s derivative instruments designated as cash flow hedges as of December 31, 2019 and 2018:
The table below identifies the gains and losses recognized on the Bank’s derivative instruments designated as cash flow hedges for the years ended December 31, 2019 and 2018:
HILLS BANCORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 18.
Subsequent Events
The Company is currently finalizing the CECL model and upon adoption of ASU 2016-13 (CECL) in the first quarter of 2020 anticipates an increase to the allowance for credit losses for loans of approximately $3 to $4 million and an unfunded commitment liability of approximately $1 to $2 million. See Note 1 for further discussion.
Subsequent events have been evaluated through March 6, 2020.
Item 9.
Item 9.
Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
Disclosure Controls and Procedures
As of the end of the period covered by this report, the Company carried out an evaluation under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective.
Management’s Report on Internal Control over Financial Reporting
The Company’s management is responsible for establishing and maintaining an adequate system of internal control over financial reporting (as defined in Rule 13a-15(f) and Rule 15d-15(f) under the Securities Exchange Act of 1934). Internal control over financial reporting of the Company includes those policies and procedures that: (1) pertain to the 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, 2019. Management’s assessment is based on the criteria described in “Internal Control - Integrated Framework” issued in 2013 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, 2019.
Attestation Report of the Registered Public Accounting Firm
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, 2019. Reference is made to the Report of Independent Registered Public Accounting Firm included in this Annual Report.
Changes in Internal Control over Financial Reporting
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.
Item 9B.
Item 9B.
Other Information
Not applicable.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance
The information required by Item 10 of Part III is presented under the items entitled “Information Concerning Nominees for Election as Directors,” "Information Concerning Directors other than Nominees," "Corporate Governance and Board of Directors," and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s Definitive Proxy Statement dated March 20, 2020 for the Annual Meeting of Stockholders on April 20, 2020. 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:
Shari DeMaris
Treasurer
Hills Bancorporation
131 Main Street
PO Box 160
Hills, Iowa 52235
Information about our Executive Officers is incorporated into this section by reference to Part I, Item 1 of this Form 10-K.
The information required by Item 11
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by Item 12 of Part III is presented under the item entitled “Security Ownership of Certain Beneficial Owners and Management” in the Company’s Definitive Proxy Statement dated March 20, 2020 for the Annual Meeting of Stockholders on April 20, 2020. Such information is incorporated herein by reference.
The following table sets forth information regarding the Company’s equity compensation plan as of December 31, 2019, all of which relates to stock options issued under stock option plans approved by stockholders of the Company.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
The information required by Item 13 of Part III is presented under the items entitled “Corporate Governance and the Boards of Directors,” and “Compensation and Incentive Stock Committee Interlocks and Certain other Transactions with Executive Officers and Directors” in the Company’s Definitive Proxy Statement dated March 20, 2020 for the Annual Meeting of Stockholders on April 20, 2020. Such information is incorporated herein by reference.
Item 14.
Item 14.
Principal Accounting Fees and Services
Information required by this item is contained in the Company’s Definitive Proxy Statement dated March 20, 2020 for the Annual Meeting of Shareholders on April 20, 2020, under the heading “Audit Committee,” which information is incorporated herein by this reference.
PART IV
Item 15.
Item 15.
Exhibits, Consolidated Financial Statement Schedules
(1) The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
HILLS BANCORPORATION
Date:
March 6, 2020
By: /s/Dwight O. Seegmiller
Dwight O. Seegmiller, Director, President and Chief Executive Officer
Date:
March 6, 2020
By: /s/Shari DeMaris
Shari DeMaris, Secretary, Treasurer and Chief Accounting Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
HILLS BANCORPORATION
ANNUAL REPORT OF FORM 10-K FOR THE
FISCAL YEAR ENDED DECEMBER 31, 2019